In-depth丨How can institutions achieve innovation in DeFi2.0?

We have entered a five-year long "DeFi hype cycle" that will likely consist of several mini-cycles, with the total effect of quadrupling today's total market cap and doubling the 2017 high of $600 billion, based on the industry's continued "mainstreaming".

By Jamie Burke

In this series, I proposed that we have entered a 5-year long "DeFi hype cycle" that is likely composed of several mini-cycles, with the total effect of quadrupling today's total market capitalization and doubling the 2017 high of $600 billion based on the continued "mainstreaming" of the industry.

Defining institutions in DeFi

First, for the purposes of this series, I will define institutions in DeFi as:

A. Crypto Native Companies

Institutions/corporates that have entered the crypto space are organizations that are exposed to large amounts of money and have close contact with the market, which is not a bank in the traditional sense. Due to their crypto-native nature, they are excluded from traditional banking and financial services such as lending/borrowing and are navigating a challenging currency/crypto world.

For example, DApp startups, intermediary service providers, crypto day traders, venture capital firms or foundations.

B. Financial companies

Sophisticated and professional investors, from traders to mid- to large-scale financial institutions, who are not interested in "crypto" as an alternative asset class, especially its subset "DeFi", can invest directly through custody or indirectly through derivatives and ETFs.

For example, professional traders, family businesses, hedge funds, banks, pension funds, etc.

C. Fintech companies

It makes it easy for verified DeFi financial products to be integrated into the fintech system, bringing a B2B2C approach to meet new needs through standardized online and offline operations. However, most fintech companies are loss-making, and their operating logic is to heavily subsidize users and increase user usage, thereby providing the product variety and yield seen in DeFi (even if it drops from 7-10% of today's stablecoins to normal levels), which can not only make them profitable, but also further incentivize new users.

Fintech startups like Square

D. General business company

There is an argument to be made that today, there is arguably a DeFi market for first, second and third world economic sectors that are underbanked for their own particular reasons, typically the self-employed/SME, and especially those who cannot otherwise access affordable debt.

For example, self-employed individuals, small and medium-sized enterprises, entrepreneurs, and gambling/adult industries.

The order of institutional adoption of DeFi

All the stakeholders outlined above are operating on a spectrum, and DeFi is more likely to be adopted by experienced crypto retail investors and small day traders, followed by SMEs, and ultimately large financial institutions in the next decade. However, 95% of institutions in the crypto space are not involved in DeFi right now.

The wider application of DeFi will be driven by financial services that cannot be provided by centralized banks, leading to their high risk appetite or aversion. But this also comes down to its own development and the ability of the DeFi industry to lower barriers to entry and be able to handle the typical transaction size and volume required by institutions and their counterparties.

This is natural, DeFi and crypto in general are too small today for most institutions to even bother upgrading their knowledge and understanding, let alone IT systems, and even if they can, the market depth is not enough to deploy meaningful funds into it. That said, for DeFi adoption to increase, there are some issues that must be addressed in one of the most innovative and fast-paced areas of financial technology. Importantly, you simply cannot underestimate the superpower of DeFi's composability, which means that no single entity alone needs to solve all of these problems, but each problem can be solved by a specialized protocol that quickly combines into a stack to create a powerful form of open finance together .

Here are several innovations that, when applied to DeFi, have the potential to launch what I call DeFi 2.0.

Innovation

As discussed in the previous article (linked above), each hype cycle is usually the result of a combination of innovations in a timely manner. I propose that the innovations that will drive demand for institutional DeFi in the context of DeFi 2.0 are as follows:

NFTs, Confidentiality Solutions, DIDs and Verifiable Claims, AEA + (Demand) dPrime Brokerage and ETFs.

Non-fungible Token (NFT)

Also known as 'nifty', it is a special type of cryptographic token that represents something unique; therefore, non-fungible tokens cannot be interchanged in the same way as ordinary tokens.

The two NFT standards on Ethereum allow for a variety of unique programmable digital goods with various properties that go beyond the use case of currency . In previous Retail DeFi articles, we discussed them in the context of “Consumerization of Crypto”, including.

Social currencies, rewards, collectibles, access tokens, digital art, loyalty points, and digital-to-physical goods redemption.

But in an institutional context; it is mostly a digital representation of/or access to/ownership of something unique, either completely digital or as a twin to a physical asset (like property like a car or real estate).

The most important question is when an NFT is a security, then it becomes a " security token" , which raises considerations around custody and activities, and may make intermediaries regulated counterparties. All of this places a burden on the operators of the protocol to comply, no matter how they claim to be decentralized. This process will inevitably make it more centralized.

Confidentiality Solutions: Private Data, Transactions, and Computations

Until now, DeFi protocols have been radically open, just like the public and permissionless platforms they are built on. Pseudonymous at best, all transactions and balances are visible and traceable to the public. This is partly due to the characteristics of the blockchain and partly due to pure necessity: there was no technology available at the time for on-chain confidentiality.

However, there are several tools available today for confidential transactions, some already on mainnet and others getting closer. Where there is a business requirement for that level of privacy, on-chain confidentiality will remove another barrier for institutional players to come on board .

• Privacy protection is more perfect

Various forms of privacy such as zero-knowledge proofs (ZKP) have gone from theory to practical use on-chain and off-chain, and have been deployed in DeFi. From the enterprise camp is EY Nightfall, which enables standard fungible and non-fungible tokens to be traded with complete privacy on the Ethereum blockchain. The drive for privacy and expansion has accelerated innovation in cryptography, which has led to different forms of ZKP and similar technologies such as "bulletproofs" with ever-increasing performance. ZKPs are now finding their way into DeFi projects such as Loopring and indirectly through scaling solutions using zero-knowledge proofs.

• Transaction Mix

Transaction mixing techniques can be used to hide the history of a specific token.

• Layer2 Scaling Solution

Layer2 scaling solutions can provide higher privacy than layer 1 networks by design: transactions do not end up on the layer 1 blockchain. Some methods enable significant confidentiality. It is worth noting that Aztec recently released their v2 testnet, which implements private transactions with significantly lower gas costs than ordinary transactions and is compatible with the current Ethereum mainnet.

• General confidential computing

In addition to keeping some data confidential at times, new crypto networks are able to keep all data on-chain confidential through built-in privacy features. The Secret Network (formerly Enigma) has general confidential computations called "secret contracts" on its mainnet today, and the Oasis Network is also about to launch its mainnet with many privacy features at its core.

Decentralized Identifiers (DIDs) and Verifiable Credentials

DID is a new type of identifier that enables verifiable, decentralized digital identity . DID can identify any subject (such as individuals, organizations, things, data models, abstract entities, etc.) determined by the DID controller. DID is designed so that it can be decoupled from centralized registries, identity providers, and certificate authorities. This design enables the controller of the DID to prove control over it without the permission of any other party, which is also a standard that the World Wide Web Foundation W3C is launching.

When combined with DIDs, verifiable credentials allow for the exchange of information whose provenance and integrity can be verified (i.e. the information can be traced back to the issuer (via their DID)) and verified to be immutable (i.e. proving that the DID’s private key signed it).

For example, the Sovrin Foundation and Evernym have been researching DIDs in a public/permissioned context for several years along with IBM/Hyperledger and Microsoft, and now there is a token-optimized network called P-DIDI launching with an open RFP for founders.

Autonomous Economic Agents (AEAs)

An intelligent agent that acts on behalf of its owner with limited hands-off control by that owner entity, with the goal of creating economic value for that owner. In the context of blockchain, AEAs can be thought of as allowing for an order of magnitude more complexity on top of DeFi’s smart contract logic and execution layer.

In the same way that ERC20 and smart contracts allow a composable stack of specialized DeFi protocols to exist and interact on top of Ethereum to form a kind of "money Lego" AEAs can be thought of as an overlay of "AI Lego". In this, they complement Ethereum and other layer 1 protocols as layer 2 technologies that can:

a) Simplify the user experience through automation

b) Support modularization and off-chain reuse of complex decision-making and machine learning capabilities (optional on-chain components).

c) Allows for proactive behavior, promoting autonomy (compared to smart contracts, which are purely passive acceptors of TX inputs/contract calls).

This is highly relevant to DeFi, where in addition to all the on-chain smart contract logic, there is an increasing requirement for complex off-chain logic, and you need to actively "do stuff" in response to events outside the blockchain, usually through oracles. We already have on-chain smart contracts in the form of these now, and as DeFi matures, we may see it look more and more like CeFi.

The Power and Limitations of DeFi

I have described DeFi as an aggressively “hyper-competitive” game, with a distributed system of participants seeking a balance between yield and efficiency, in direct contrast to the existing financial system, ruthlessly removing inefficiencies and actively seeking yield in a very volatile market environment.

Clearly, such a new financial system not only offers the potential for significant efficiency gains, but also new possibilities for an increasingly digital economy. However, one person’s inefficiency is another person’s business or job, and therefore, DeFi is and should be seen as both transformative and disruptive.

Likewise, the relentless and fast-paced nature of DeFi innovation occurs precisely because of its permissionless and open-source nature. Anyone with the technical ability can launch or copy and fork a new unaudited, unregulated smart contract or protocol as a financial product or service on a global scale, which (at least in principle) can subsequently act somewhat independently of its creator.

The question is to what extent regulators will allow this to continue, which remains to be seen. But the question is to what extent they can prevent it, or at least find ways to contain it rather than actively participate in it, or more simply: is there a threshold at which its net benefits become irresistibly superior to the current system that encourages innovation, competition, and economic expansion?

Many would view DeFi as a fringe case, like Bitcoin or Ethereum, but regulators have come around to viewing both as net benefits, even declaring them to operate outside their jurisdictions. In fact, they have used them as inspiration for a more centralized approach in developing CBDCs (Central Bank Digital Currencies).

So, in fact, when we talk about DeFi, we are talking about how today's dominant top-down fiat system interacts and merges with the bottom-up cryptocurrency. The question will be whether there will be bridges in and out of their jurisdictions, allowing capital to flow freely.

And clearly, a degree of decentralization is seen as not only beneficial but desirable compared to approaches such as Facebook.

The question is: How can DeFi allow new institutional users to benefit from its innovations without becoming too centralized?

Below I have listed a range of opportunities in DeFi that leverage a combination of the key technological innovations listed above and are expected to increase liquidity, institutional demand, and usage of DeFi, but in a way that is sufficiently decentralized to avoid censorship and still be called "DeFi" within reasonable limits.

Lowering the barrier to participation

Generally speaking, institutions reported that they did not join DeFi due to lack of compliance, institutional experience, and security/risk controls .

But also because of (lack of) accessibility and unfamiliarity with a newly available asset class. So I will use these thresholds as a starting point to categorize each opportunity.

These are all opportunities we are actively investing in or would like to invest in. If you are building a startup in any of these areas, please contact us, we would like to invest.

(1) Compliance

KYC & AML Passive Participation

The main concern of institutions is that they want to ensure that their counterparts in DeFi are legitimate and compliant actors. This is reflected on two levels.

1. KYC/AML of the parties to the agreement

1. KYC/AML for Sales Execution

Unless this problem is addressed, there will be two extremes; one where a regulated central entity enforces compliance, and the other where there is no compliance. The former loses many of the benefits of the permissionless nature of DeFi, while the latter is not something institutions can or want to participate in. Our goal should be a single system and pool of liquidity (capital and assets) that automatically identifies the status of wallet owners and suggests recommended permissions to their counterparties.

Currently, if you are building a decentralized protocol and want to perform KYC and AML on your users and their funds, you run the risk of becoming a party to the transaction yourself, which would force you to become a regulated central party .

One approach is for DeFi users to use DIDs and verifiable credentials to prove things about themselves, such as KYC and AML. Using zero-knowledge proofs, user privacy is protected, but DeFi protocols and applications can prove that all users are compliant by adopting standards without performing compliance functions directly by themselves. Through the credential market, DeFi users can choose issuers they trust to perform KYC/AML checks for them. Institutions can choose to only trade with those counterparties that meet their standards without exposing the details of those counterparties.

However, a big factor in the financialization of assets and the rise of DeFi will be the provision of new mechanisms around the transfer of responsibility around third-party reliance from a compliance context. The challenge is that the ultimate responsibility for customer due diligence still lies with financial institutions (FIs) who rely on third parties (authenticators and certificate issuers who provide insights about identity holders, not data). If the third party makes a mistake, the financial institution will still be subject to criminal and civil liability. This may require the third party to be a regulated FIU itself (reducing or eliminating criminal liability) and selling the civil risk to insurance companies (which rely on regulatory and possible audit oversight).

Therefore, it essentially enables risk transfer, making it simple and seamless to rely on third-party identity providers. This will allow people to verify their identity once and use it in many places, greatly reducing the friction caused by global compliance requirements .

(2) Risk Management

NFT Insurance

DeFi is extremely risky from a custody and security perspective, with many layers of unaudited code and opportunities for malicious actors to exploit the financial system in entirely new ways, such as “flash attacks.” DeFi needs a native form of insurance contracts to help its participants minimize their financial risk when it is technically impossible to eliminate the risk.

Like most emerging industries, the existing insurance industry will have difficulty pricing the risk and will not initially scale enough to justify investing time and money into developing specialized technology. Historically, in these cases, communities have insured themselves through mutual aid organizations, and we are starting to see projects like Nexus Mutual, whose policies include: smart contract risks, hacks, etc.

One of the more useful areas to explore here is parametric insurance, which maps nicely onto smart contracts and greatly simplifies the process. Basically, there are parameters for specific payouts based on triggering events.

This fixed-payout contract allows people to buy the risk of an event happening at any time. The key question is, if the data source itself is not contract-driven, how can governance, such as oracle control, verify the occurrence of an event?

However, these can also be issued as NFTs that can be underwritten, bought and sold in protocols based on open reinsurance markets, and potentially collateralized by loans, with insurance (preferably using a betting-like approach through multi-asset baskets) to back the risk.

This not only solves a problem for crypto and DeFi, but could become an asset that attracts institutional investors and finance, and lead to a transformation of insurance and reinsurance more broadly.

Administration/custody

Currently, custody is either done in-house as an organization or outsourced to a third party. This is one of the main barriers to institutional adoption. The more sophisticated the institution, and the more fiat-based it is, the more complex the permissions on the wallets. Self-custody allows for full control and use of funds in DeFi and other on-chain protocols, but requires significant ongoing internal resources. Over the past few years, numerous centralized custody providers have been established, some of which are institutional-grade, which can provide access to insurance but only a limited number of yield-generating opportunities supported by the custody provider, such as simple staking.

It is possible to leverage DIDs to license “organization wallets” that contain digital portable credentials that confirm the identity of the organization and verify the authority of employees and other representatives to act on behalf of the organization . These credentials can be used to securely identify authorized representatives as they perform an increasing number of digital business activities, such as the movement of crypto assets, but can also be used to approve business transactions and contracts.

Trusted Oracles

In order for institutions to entrust more of their capital to DeFi, and thus automation through smart contracts, they will need to increase their reporting levels on oracles and their authenticity to achieve compliance when they become/become regulated entities, but more generally around security and oracle manipulation.

For example, the most likely way for asset managers to bring trillions of dollars into DeFi is through ETFs (Exchange Traded Funds), which allow institutions to not have to directly custody the underlying assets, but instead trade them through management tools such as indices, which can be built on protocols like Set Protocol.

And while there are a handful of regulated crypto indices, regulators need to ensure the quality and integrity of the data that informs them, and in the context of DeFi, access to oracles that will inform them. Innovations in data markets can harness the power of the crowd to curate and verify the provenance and integrity of datasets, secured through game theory.

For example, DIA is building authenticity for institutional-grade oracles by leveraging crowdsourcing for data sources and ensuring integrity through crowd verification.

Native credit score

If users can prove themselves and their assets or the assets of their organization through verifiable credentials linked to a DID as an NFT, native on-chain credit profiles can be established, and even credit scores can be generated by staking from their network to allow risk-adjusted credit profiles. These can be further enhanced by oracles to prove things off-chain.

Analysis and fundamental analysis

As the complexity of DeFi tokens increases, performing fundamental analysis becomes more difficult, requiring new analytical approaches that leverage the decentralized nature of crypto networks and the power of automation and artificial intelligence.

To be adopted by CeFi, financial security services within major private and public banking institutions need innovative monitoring solutions to manage the structural financial and compliance risks around DeFi. To adapt to the complexity of DeFi Tokens, they need modeling tools to understand, analyze and monitor activities around major dApps and related assets.

Sophisticated cryptoasset analytics like Nyctale’s are needed to monitor investment and usage behavior and on-chain activity patterns around DeFi services where institutional adoption requires both qualitative and quantitative understanding of the economic and business mechanisms.

(3) Mortgage

Commodities/Derivatives

Most institutions will only enter DeFi when there are assets they know, understand, and can price, such as real-world commodities, derivatives, or real estate. Projects that can create synthetics of these assets that can be freely traded in DeFi and benefit from its efficiency will bring new demand.

NFTs with income

The problem with DeFi yields is that they are not tied to actual income, but rather a form of subsidy to users, and therefore unsustainable. However, there are new forms of yield-based instruments that are packaged as NFTs and enter the market, such as invoice factoring or SME packaged bonds.

For long-term compliance, NFTs with income themselves may require that a wallet has been whitelisted, linked or signed with a verifiable identity, in order to establish more liquidity compliance management systems through decentralized compliance based on relevant risks and thresholds.

Multi-asset swap

How can we exchange STOs, CBDCs, and cryptocurrencies, and vice versa? If NFTs can each carry a license for who can use it, such as a wallet, unless the owner has proven to have passed KYC, they can exist in the same decentralized environment and can be freely exchanged in pairs and traded with each other.

Likewise, the ability to create investment pools and fund structures will allow for holding of a wider range of underlying assets and enable algorithmic market making between them, providing liquidity for swaps, including managed (mutual funds, investment funds) structures, whether managed by an individual, entity or through collective governance, and unmanaged (ETFs, ETNs) that track the value of an index and underlying assets.

Access Token

Access tokens give people access to a digital vault that holds collateral. NFTs are not digital representations or rights to collateral (which might be considered a security), but rather access tokens that can be used as underlying collateral and are burned/consumed when used. The legal corollary is a lease arrangement (temporary ownership) or a trust arrangement (separating legal and beneficial ownership). Access tokens therefore allow the holder to rent the collateral for a certain period (with subsequent mandatory return); or grant temporary legal ownership (with beneficial ownership remaining with the original owner).

(4) Ease of use

Administration: Accounting and Taxation

Because today’s institutional users of DeFi are likely to be crypto-native companies or small individual day traders using increasingly complex multi-protocol products, the administrative burden of year-end tax filings alone will discourage many people or limit their trading activities and frequency.

CeFi to DeFi Bridge

Traditional finance has accumulated decades of complex legacy IT systems that are often outdated and difficult for newer external technologies to integrate directly with. A new bridge needs to be built between CeFi and DeFi. Open source BaaS solutions for banking like Corda have been customized with financial institutions for several years through alliance programs like R3, and new institutional-grade DLT connectors are now available to simplify integration between traditional systems and newer DeFi protocols.

Projects such as Bond180 and Alkemi allow CeFi to bring liquidity to DeFi and provide financial products.

User Experience/Prime Brokerage

A lot of what has been discussed needs to be rolled up into a UX that abstracts complexity to some extent. This is especially true in so-called "deep defi", where a financial product relies on multiple defi protocols, bringing higher complexity and risk, especially if you consider the small institutions described at the beginning, including smaller teams of traders.

(5) Market efficiency

Liquidity and Automated Market Makers (AMMs)

DeFi emerged after the development of crypto technology. As a new capital market, it is still inefficient overall, and the liquidity level is too low for most institutions. However, innovations to solve this problem can aggregate liquidity in wallets, centralized exchanges, and DEXs in a non-custodial manner, making the "liquidity superhighway" expected to catalyze the growth of DeFi and tap into dormant asset pools in crypto.

For example, Alkemi has built a liquidity superhighway to connect CeFi and DeFi.

There are some inefficiencies in order book matching currently seen with AMMs (Automated Market Makers), a decentralized DEX (Decentralized Exchange) alternative to centralized exchanges. The most notable is the problem of unfixed losses. Simply put, if the price of a trading pair changes significantly, liquidity providers will often suffer losses. This can be recouped through fees and in some cases subsidized by issuing rewards, but it is a factor that needs to be actively monitored and managed by liquidity providers through risk controls.

Another issue that is often overlooked is that price discovery in AMMs is often done through arbitrage between centralized exchanges with higher liquidity and DEXs with lower liquidity. Traders profit from this arbitrage, so the cost of price discovery can be seen as an inefficiency. There are innovative AMM algorithms being tried, but this is an experiment that is still in its infancy.

Likewise, the maturation of derivatives markets and fund structures will bring more liquidity to the market. The market itself also has the potential to drive market making through "liquidity mining-like" activities, which reward participants based on the amount, frequency and scope of their buys/sells as a mechanism to increase liquidity in illiquid assets.

There’s also the growth of so-called “trade-wide credit” — the ability to use flash loans to back trades, which can help arbitrage price differences between different assets and increase liquidity.

Privacy Pool

With most institutional interest today focused on acquiring assets to diversify their portfolios, there isn’t a huge demand for dark pools right now, especially given the limited size of the market and the lack of widely held assets.

As the market matures and more widely traded assets emerge, the need for the ability to swap assets over the counter will increase, particularly as there are larger fund structures that need to quietly move large amounts in and out of positions without disclosing their intentions.

Another example is Secret Network, a privacy-preserving smart contract platform that can use synthetic assets such as ETH as privacy tokens. Privacy tokens (SNIP-20), combined with privacy-preserving AMMs, order book transactions, and auction tools, build the foundation for decentralized dark pools.

in conclusion

This is not a new thesis, but rather one that evolved from a strong feedback loop, with a mature portfolio of 30+ startups. This is also by no means a comprehensive list, just thoughts and observations from across the Outlier ecosystem as we collectively seek to build this bottom-up permissionless capital market. There are almost certainly many themes and opportunities we’ve missed.