The global financial landscape has undergone substantial transformations over the past few years, thanks to the emergence of blockchain-powered Decentralized Finance (DeFi). Retail investors seeking to diversify their investments and multiply their gains led to the initial phase of crypto adoption.
After years of skepticism, traditional financial institutions, businesses, and banks opened their doors to DeFi. But that was only after leading businesses like Microsoft and Amazon expanded their horizons to explore potential smart contract solutions for enhanced efficiency, transparency, and security. However, blockchain’s immutable ledger could only do little to safeguard institutional assets and complement organizational hierarchy.
Hurdles For Institutions Transitioning to DeFi
As leading global banks like JP Morgan and Morgan Stanley open their arms to crypto assets, security, operational efficiency, scalability, and regulatory compliance remain major challenges. Crypto assets worth over $1.7 billion were stolen in 2023. However, this was nearly 50% less than the previous year, and the number of hacks increased significantly. Secure and agile digital asset custody can answer all these challenges and allow institutions to extract the maximum out of the DeFi ecosystem.
What Is Institutional DeFi (And What It Is Not)
Contrary to what the name would suggest, institutional DeFi does not refer to increasing institutional investments in DeFi. It refers to leading institutions leveraging DeFi protocols to tokenize real-world assets, expanding the horizon of on-chain assets. All this while complying with the regulations of the land, offering total transparency and institution-grade controls to ensure consumer protection.
Traditional Finance (TradFi) involved people lining up outside banks for the smallest transactions. Then came the digital transformation, allowing users to send money over the internet. However, lack of transparency, the existence of middlemen, and operational inefficiency still exist. However, the biggest downside was a single point of failure interlinked with monopoly.
TradFi meant transactions on one channel and record-keeping on another. Thus emerged DeFi, bringing both transactions and record-keeping on the same channel.
Tokenization meant the seamless transfer of not just money but different assets on-chain with proof of transfer of ownership and complete transparency.
Due to the above benefits, banks and institutions are keen on embracing DeFi. However, it is very different for institutions than it is for retail users. Most DeFi protocols still have a monopoly with uneven governance token distribution. Plus, existing infrastructure may not complement the hierarchical requirements of businesses.
Let us have a look at some of these challenges.
Navigating Regulatory Challenges
Let us be honest, banks go through rigorous checks and audits before any offering. Will DeFi platforms survive any of these checks? The answer is no. The lack of a uniform operational framework and absence of standardization prevents DeFi from being globally acceptable.
Stringent KYC and AML laws turn out to be fatal for crypto businesses. How often do we see an SEC lawsuit against crypto businesses in the US? The recent action of the Indian government against several crypto exchanges, including Binance, is a recent example.
Institutional DeFi is aimed at solving these challenges by serving as a bridge between DeFi and TradFi.
The Cost Of Regulatory Compliance
Complying with the regulations of the land comes at a cost. Traditional banks spend nearly $270 Billion every year to comply with regulatory obligations for offering services. This is when there are established frameworks, unambiguous in nature.
Once dApps witness a bank-level adoption in such an ambiguous environment, one can only imagine the cost of complying with regulatory obligations. Will the weight of this cost be transferred to end consumers? Obviously. The SEC collected over $5B in fines alone from crypto institutions for failing to comply with the regulations. These are numbers from just one country. Last year, BlockFi paid over $100M in fines alone.
With wider acceptance, these numbers could skyrocket. The impact of these challenges presents a strong case for custody solutions, interoperability, self-custody, and transparency.
Other Challenges For Institutions Adopting DeFi
Ambiguous Legal Framework: Various regulatory and legal entities worldwide have issued fragmented guidelines on the use of smart contracts. A comprehensive and universally accepted legal framework is a prerequisite for wider acceptance. This broader framework would facilitate the establishment of robust legal foundations for financial services leveraging programmable money, ensuring consistency and clarity across different nation-states.
AML/KYC: Around $10 billion worth of cryptocurrencies were held by illicit addresses, according to a report by Chainalysis. Cybercriminals are aggressively using crypto assets to launder money and thus far, stakeholders in DeFi have failed to enforce bank-level checks. Until that happens, mass adoption is a far-fetched thought.
The bottom line is that retail users hate KYC, but institutions can’t escape it. The solution lies in finding a middle ground where onboarding is seamless, and institutions take care of the regulatory obligations instead of users.
The Next Logical Step For Institutions
Clearly, DeFi is fraught with operational and regulatory challenges, and institutions must take some serious steps to navigate the deep waters. Here are a few considerations for DeFi institutions to trigger mass adoption:
On-Chain and Off-chain Interoperability: Retail adoption tells a different story but for businesses to embrace DeFi could take decades in the current environment. There’s a greater need for interoperability between on-chain and off-chain assets. This can only happen through an open dialogue between banks and DeFi institutions.
Traditional financial institutions should be open to participating in liquidity provision on decentralized platforms. This involves providing funds to decentralized exchanges or lending protocols to earn interest and facilitate trading.
Self-Custody: Self-custody, rather institutional-grade self custody, is the way forward. Increased security and regulatory compliance are prerequisites for institutional DeFi to achieve mainstream adoption. Custody solution platforms like Liminal are actively involved in helping DeFi institutions achieve wider acceptance through robust MPC wallet, KYC, AML, CFT, travel rule compliance, and institution-grade interoperability.
Customization: One size fits all seldom works in an organizational structure. Businesses operate on a hierarchical model and control levels may vary from position to position. This is again an area where custody solutions can play a critical role by offering customizable wallet infrastructure with features like account abstraction.
Final Word
Retail DeFi and Institutional DeFi and two different worlds altogether. Retail adoption is easier to achieve due to relaxed regulatory obligations and limited operational expenses. Institutional adoption comes with many challenges, including regulatory obligations, KYC/AML requirements, and security challenges. This explains the expanding scope of work for custody solutions ready to offer much more than just safeguarding private keys.
Institutional custody solution providers like Liminal are set to play a key role in mainstreaming DeFi. Innovation and adapting to the changing regulatory environment are key as more challenges unfold.