In the past, we have discussed how Bitcoin and Ethereum are in increasing demand by institutional investors and why, leading to more investment products for them to allocate capital to these new assets. After the adoption of the two largest cryptocurrencies by institutional investors, it is likely that the entire DeFi sector will follow as well.
Rise of DeFi
DeFi is a decentralized form of finance that revolutionizes the entire finance industry by not relying on middlemen like banks, brokers, insurance providers etc. that make the process inefficient, charge massive fees, and have the power to block transactions etc. Instead, DeFi relies on the use of smart contracts, automating processes and lowering fees.
The DeFi market has come a long way, especially the past year or so when the total value locked (TVL) in smart contracts stood around $1 bln. Since then, we have seen a rapid rate of innovation that brought us new types of stablecoins, lending protocols, insurance providers, decentralized exchanges, etc. These often allow users/investors to generate a return on their investments that is unparalleled in the world of traditional finance.
Last month, we briefly passed $153 bln in TVL. With DeFi making processes more accessible and efficient in a financial services market that is worth over $22 trln globally, we can definitely expect to see the TVL rise significantly in the future with an increasing rate of innovation due to the success the industry has seen within the past year. We must also not forget that a large selling point of DeFi is the effort to bank the unbanked and underbanked which currently stands at 1.7 bln adults worldwide. DeFi can help them set up payment accounts while also allowing them to lend and borrow at attractive rates among other things.
Unsurprisingly, more institutional investors are starting to look at DeFi as they too are seeing the massive change that this market is bringing to finance as well as the returns that they are able to generate in this industry.
The easiest way for them to profit off the rise of DeFi is by simply owning the tokens of the projects involved in this industry since these will rise as the projects gain more traction. However, just as with Bitcoin and Ethereum, this is difficult for them to do due to regulatory issues. Institutional investors are not allowed to directly hold cryptocurrencies themselves, forcing them to look at custodians that do this for them.
Bitcoin and Ethereum are only recently being adopted more widely by institutions, so it is no surprise that the possibility of investing in DeFi projects by institutional investors is still severely limited although we are already seeing an increase in efforts to bring investment products to the market.
Grayscale, a custodian that offers cryptocurrency investment trusts to institutional investors, has long been a major provider of a Bitcoin investment product to institutional investors. As Bitcoin ETFs and ETPs became more common, its own product, which includes a lockup period, became less attractive. So since the end of 2020, it has been looking to expand its offering of crypto investment trusts. It is currently looking to introduce investment trusts for DeFi projects such as Aave and Uniswap.
Bitwise has launched the DeFi Index earlier this year which contains tokens of 10 large DeFi projects in the following weighting as of the 31st of March:
Before that, it had already launched a Bitcoin, Ethereum, and top 10 Crypto Index as well. It reached $1 bln in assets under management (AUM) in February this year. ETFs are an easy way for institutions as well as retail investors to gain exposure to DeFi.
VanEck, the ETF provider and Mutual Fund manager which had $69 bln in AUM in Q4 2020, is also seeing the benefit and possibilities of DeFi.
“….the scope for potential disruption in financial flows thanks to blockchain-based solutions is still enormous, in our view”
The company is already looking to launch a Bitcoin ETF in the US. Chances of one getting approved in the country soon are rising due to the rollouts of Bitcoin and Ethereum ETFs in neighbouring Canada. Once this finally gets approved, the next step would be Ethereum ETFs, and finally DeFi ETFs as well.
What is required
Simply buying the token is of course the most simple manner to participate in this industry but not the most fruitful. In order to get the most out of the industry, investors would have to be able to directly participate in the protocols by staking and yield farming. The major hurdles are the requirement for KYC/AML, overall regulations, security risks, and transparency of the investor’s actions to the entire blockchain.
There are some DeFi protocols out there that are specifically looking to target the market for institutional investors. Aave, a decentralized lending protocol with over $11 bln in total value locked, has announced that it is currently working on permissioned pools that can serve institutional investors’ interest. KYC and AML will be conducted for all users, specifically aimed at institutions. But the actual pool will still be on public chains.
MetaMask, the crypto wallet with over 5 mln monthly active users, is looking to provide institutions with its “MetaMask Institutional Wallet”. MetaMask claims that this will simplify capital deployment into DeFi applications with multi-signature support, built-in compliance mechanisms, and direct integration with the leading custody providers.
Panther Protocol is another project that is looking to provide a solution for institutions looking to get into DeFi that includes KYC/AML for the onboarding process but also offers privacy for the transactions by utilizing zk-SNARKS, thus protecting information regarding what the institutions are doing.
As institutions are looking to dive into DeFi, it is more than likely that we will see an increased number of projects that have some type of centralized feature in order to be able to conduct KYC/AML.
For the risks of hacks and exploits of smart contracts that can result in million dollar losses for institutions, there are insurance protocols like Nexus Mutual for which they pay a fee to secure their capital.
With DeFi rapidly growing, institutional investors will not want to be left behind. Just as with Bitcoin and Ethereum now, we expect to see a rapid increase of demand in DeFi projects, both in terms of exposure in the tokens as well as participating in the yield farming process. This will be done through the launch of simple investment products like ETFs, but also by setting up specialized funds that are able to perform every required step while maintaining compliance with regulatory requirements, allowing investors to simply buy into the fund and enjoy its staking and yield farming efforts. We expect to see an increase in DeFi projects that are looking to cater for institutional investors as well and thus will include privacy and KYC/AML options.
So DeFi is expected to go more mainstream, even if some projects have to give up certain decentralized/permissionless aspects in some areas. As it happens, more capital will flow into this industry.
It will not be too surprising to see a range of cryptocurrencies, including in DeFi, to become widely accepted investment products (and strategies) in the coming years. This will ultimately lead to a large capital injection from the institutional players, driving further growth of the industry, although this capital will likely be concentrated in the large caps.
Icoinic Capital B.V. (‘Icoinic Capital) is an investment group based in the Netherlands. Icoinic Capital is registered at the Dutch Authority for the Financial Markets (www.afm.nl) under the AIFM light regime and reports to the Dutch central bank (www.dnb.nl). Icoinic Capital manages a range of alternative investment funds focused on crypto-assets.
The statements and communications in our articles can never be construed as financial advice.