This insight was originally published as a guest article in TabbFORUM. Click here to view.
With investors across the world now facing billions of dollars of losses from the FTX blowup, there has been a surge in interest in DeFi platforms as users look to take control of their digital assets, writes Yuvraj Sidhu, Principal Consultant at Lab49, in the last segment of his three-part series on DeFi. Some industry reports suggest decentralized exchanges gained as much 24 per cent in volume – further confirmation of the importance of a strong technology-driven approach to DeFi, he explains. In this article, Mr. Sidhu highlights three areas that banks and institutional players should focus on to realize the potentially game-changing opportunities in DeFi.
‘Crypto winter’ notwithstanding, the evolution of DeFi technology, infrastructure, and applications continued to accelerate throughout 2022. While this gave optimism to many sector commentators, the market turmoil created by the collapse of FTX in November highlighted the immaturity and volatility of the sector as well as the risks this has created – in particular around liquidity. With investors across the world now facing billions of dollars of losses, there has been a surge in interest in DeFi platforms as users look to take control of their digital assets. Some industry reports suggest decentralized exchanges gained as much 24 per cent in volume – further confirmation of the importance of the need for a strong technology-driven approach to DeFi.
In the first article of the Institutional DeFi series we explored the paradox of institutions incorporating decentralized technology. In the second article we addressed the new types of risk that DeFi introduces, along with emerging mitigation strategies. In this third installment, we delve deeper into the opportunities presented by DeFi as banks look to unlock new markets and value streams.
Investments should focus on building the foundational capabilities needed to support a variety of use cases and asset classes. Similarly, optionality should be a key component of the strategy – initiatives should be undertaken when they have clear two-way doors at multiple phases.
Opportunities exist at multiple layers of the value chain, from use cases and applications to services and infrastructure. However, there are barriers to entry that will need to be navigated with care. Regulatory uncertainty, the relative illiquidity of the market, persistent financial engineering hacks and counterparty risk being the most significant. So, how can banks strategically leverage DeFi?
While participants such as corporates, sell-side firms and buy-side asset managers differentiate at the Application Layer, the overall DeFi context is similar across the board. For example, asset custody and settlement are of interest no matter the type of business institution due to universal concerns around regulatory compliance (KYC/AML) and privacy.
Stablecoins, CBDCs, and other tokenized assets provide a seamless way to store and transfer value across the stack while minimizing friction. Facilitating investments and payments using these new assets are how most institutions begin their DeFi journey, treading a careful path at the periphery of the ecosystem to ensure compliance with emerging regulations. The past year has seen a host of new asset managers enter this space. While BlackRock became the primary asset manager of USDC stablecoin cash reserves, Fidelity launched Bitcoin and Ethereum Index Funds. Also in Europe, SWIFT led the way in successfully piloting CBDC-to-CBDC transactions between different DLT networks.
But once organizations have taken these initial steps, what’s next? Due to the obstacles mentioned earlier, at the meta-level there is a certain set of characteristics and guardrails any DeFi strategy should have.
Investments should focus on building the foundational capabilities needed to support a variety of use cases and asset classes. Similarly, optionality should be a key component of the strategy – initiatives should be undertaken when they have clear two-way doors at multiple phases. This will minimize wasted effort and operational risk and place institutions in a more favorable position.
To meet these objectives, there are three foundational areas that banks should investigate.
Traditionally, security issuance has been limited to conventional assets and their derivatives. One major goal of securitization is to transform non-fungible entities such as corporations or residential mortgages into fungible assets for capital formation in the primary market, and to be tradable on secondary markets. The primary benefits are greater liquidity for issuers, and risk diversification for investors. However, the current securitization process is not only inefficient, but the resulting securities often lack transparency into the makeup and performance of underlying assets.
Asset tokenization may be viewed as an evolution of securitization. Distributed ledgers and smart contracts provide a simple, low-cost, and transparent way to tokenize virtually any asset class. Emerging tokenization platforms such as Onyx (JP Morgan) and Toko (DLA Piper) provide facilities to tokenize and trade niche assets such as intraday repos, intellectual property, and commercial real estate. As regulatory clarity improves, these types of platforms will be able to support the tokenization of more mainstream assets such as equities and corporate bonds.
As all assets require tokenized representations in DeFi, this is clearly a foundational capability that will be required for banks – especially sell-side firms – looking to evolve their strategies.
Tokenization is also more efficient than existing securitization processes. It opens up new asset classes and brings greater liquidity to niche markets – all at a lower cost. But the biggest opportunity is programmability. Once assets are tokenized, the next generation of financial applications can be developed utilizing DLT and smart contracts.
As all assets require tokenized representations in DeFi, this is clearly a foundational capability that will be required for banks – especially sell-side firms – looking to evolve their strategies. Once these capabilities are developed, either internally or integrated with a third-party service, banks can then focus on aligning tokenized assets with their corporate strategy and evolving regulatory requirements.
Clearing & Settlement
Post-trade clearing and settlement is a highly inefficient and fragmented process. With DTCC average daily volume at roughly $300B in 2021, the smallest of improvements can have a huge impact. In an industry that currently spends over $130B annually on post-trade processes, it is no wonder that organizations such as the Fed, DTCC, and Bank of England are looking for ways to streamline their operations.
One of the options being studied is the use of Distributed Ledger Technology (DLT). Allowing simultaneous access, validation and record updates across multiple entities, this technology could transform the way institutions operate. Some estimates suggest DLT could automate up to 95% of trade processing and settlement.
However, banks need to tread carefully. While the very nature of DLTs insulates them from hackers – an issue top of mind for the industry following an unprecedented attack on the Binance blockchain ecosystem last month is the security of cross-chain bridges. These bridges have historically been fertile entry points for hackers, and will need to be addressed in the context of post-trade settlement, as banks will likely utilize different blockchain implementations.
To ensure they get off on the right foot, banks should study the various efforts underway around the use of DLT in middle- and back-office Netting, Clearing and Settlement processes. These offer a low-risk, high-reward starting point for institutions looking to experiment with these technologies in their banking infrastructures.
One fundamental blocker for institutional DeFi adoption is the transparency of blockchains. Transaction data is publicly viewable on the blockchains that power decentralized applications – an obvious non-starter for banks. However, public blockchains are a necessary component of DeFi to ensure network security. How do we address these seemingly contradictory goals? Enter Zero Knowledge Proofs (ZK Proofs).
ZK Proofs can transform the way banks handle sensitive data by preserving transaction privacy while ensuring network security. They allow information to be verified without disclosing the underlying contents, providing both value and protection. A further benefit of many ZK implementations is scalability – various methods such as rollups, parallelization, and sidechains are utilized to increase performance while improving transaction economics.
For institutions not only seeking resilience now, but also looking to insulate themselves from future challenges, a strong DeFi strategy is more important than ever.
This approach has already been adopted by individual blockchains such as Zcash and platforms such as StarkNet. However, only a limited number of banks, for instance ING in the Netherlands, have followed suit. These tools will be a key component of banks’ strategies when DeFi becomes mainstream. Banks investing in privacy-preserving technologies today will be positioned to lead the DeFi space in the future.
What’s next for DeFi
The collapse of FTX earlier this month sent shockwaves across the industry, and further dominoes will likely fall as a result. However, the DeFi segment has proved resilient in the face of a potential “contagion”. Following the collapse, DeFi trading volumes reached $32 billion as participants looked to the industry’s founding ethos of decentralization and self-custody.
For institutions not only seeking resilience now, but also looking to insulate themselves from future challenges, a strong DeFi strategy is more important than ever. While the three areas mentioned above should be prioritized, banks should also consider how they can apply their particular strengths to DeFi – especially in the areas of risk analytics and user experience. By combining traditional and modern learnings, banks should be well positioned to realize the potentially game-changing opportunities of this space.