Is Institutional Defi Actually Rebranded CeFi?

Not long ago, decentralised finance (Defi) was just an idea - a grassroots experiment seeking an alternative to Wall Street's institutions. Early Defi pioneers built apps enabling lending, trading, and more without banks or brokers.

As word spread, Defi caught on. By 2021, over $180 billion flowed into Defi apps. This growth caught the attention of the very institutions Defi hoped to displace.

Major financial players were tempted by Defi's efficiency and growth. Yet Defi's decentralised ethos clashed with their oversight needs. Requirements around know-your-customer (KYC) and anti-money laundering (AML) presented hurdles.

And so a vision of "institutional Defi" emerged - one balancing decentralisation with necessary control. Private blockchains, permissioned tokens, and hybrid centralised-decentralised apps could allow institutions to engage deFi on their terms.

But some leaders worry this betrays Defi's open ethos. In their view, excessive centralisation risked undermining Defi's core values.

This article will explore the rise of institutional Defi in more depth, examining the blockchain architectures, token designs, and applications that could bridge the gap between decentralisation and regulation.

An introduction to Defi

Our financial world relies heavily on trust and accurate information. Centralised financial systems, while familiar, rely heavily on trusting intermediaries like banks and brokers. This dependence can lead to frustrations like prolonged settlement times, susceptibility to mismanagement, and a lack of transparency. 

Defi provides a decentralised solution, ensuring higher levels of trust, efficiency, and ownership. Users can manage their funds in self-custodial wallets protected by cryptographic private keys. All transactions are transparently recorded on public permissionless blockchains, such as Ethereum and Solana.

The retail Defi ecosystem has been expanding at a rapid pace, offering financial services such as decentralised borrowing, lending, trading, derivatives, insurance, and asset management. Two notable innovations that have become the backbone and liquidity for these products include decentralised exchanges (DEXs) and automated market makers (AMMs). Decentralised exchanges (DEXs) are open marketplaces for trading digital assets, eliminating the need for a central authority. Automated market makers (AMMs) are a specialised type of DEX that uses mathematical algorithms to manage liquidity pools and facilitate trades. Importantly, these protocols operate in a decentralised fashion, with decisions typically made by the community through governance tokens, not by a centralised team.

Imagine the opportunities unlocked if funds invested in a token representing a real-world-asset, such as a privately-issued company bond, not just for the investment itself, but for the advantages it offers. This token could deliver real-time information, automated compliance checks, an active secondary market, and reduced fees. Funds could then go a step further and stake this token to earn additional yield on a protocol. This additional yield could come from the transaction fees on the protocol, and instead of them going to a centralised entity, like a bank, they are distributed with liquidity providers on the protocol. This provides just a small insight into the potential of market and capital efficiencies presented by the Defi space. 

While the nature of Defi has become an attractive opportunity for institutions, the current characteristics of Defi are not always suited to their needs. For example, the Defi ecosystem is primarily unregulated which provides inherent risks to compliant institutions, who have to interact in a know-your-customer/anti-money laundering (KYC/AML) compliant environment. Privacy is another important factor for institutions, and transacting on a public ledger for everyone to see may not be favourable. These reservations among others, such as cybersecurity, mature governance models, and legal clarity, have stopped many traditional funds from entering the Defi ecosystem.

Therefore, in order for institutions to enter the Defi ecosystem a new field of institutional Defi has to evolve, otherwise, they risk missing out on a massive financial opportunity. 

Institutional DeFi Design

Due to the nature of institutions, they require different rules than retail to enter the Defi game. To best illustrate the building blocks of institutional Defi design, I have broken it down into three layers:

Network Design

Network design refers to the blockchain architecture used for the Defi application. Think of it as the foundations of a building - the foundations you build will influence everything constructed on top of it.

As shown in the diagram, a network can either be permissioned or permissionless, as well as public or private.

A permissioned network or token restricts who can interact with a network based on a set of requirements, such as KYC or AML checks. A permissionless network allows anyone to interact with the network, making it open. Furthermore, a public network means transactions can be viewed publicly, whereas a private network limits transaction data to set participants.

The most used networks, such as Ethereum or Solana, are public permissionless networks - meaning anyone can interact and transactions are publicly visible. In contrast, JPMorgan has developed its own network, JPM Coin, as a private permissioned network with restricted access and data provisions.

However, we have begun to see the rise of public permissioned networks through new token standards like ERC-3643 on Ethereum, which requires compliance checks before executing smart contracts, despite the public network.

As we mentioned before, financial institutions often require heavy compliance, making permissioned networks attractive. Larger institutions may also want transaction privacy, favouring private networks or privacy solutions like ZK proofs on public chains.

Token Design

Token design refers to how the token is structured, which can range from being natively on the blockchain or partially on the blockchain. The spectrum of tokenisation depends on how the token is issued and settled.

A native or on-chain token, such as $ETH or $BTC, is issued on the blockchain with no reliance on real-world infrastructure to operate. Settlement also occurs on-chain as the value transfer occurs through cryptocurrencies.

A hybrid approach often means tokenising a real-world asset, such as real estate. This asset is often owned by a special purpose vehicle (SPV), and then the shares of the SPV are tokenised, representing a share of the underlying asset. Token issuance and settlement can occur on or off chain in varying degrees, creating a hybrid approach.

To illustrate the difference between on-chain and hybrid better, imagine a private company wants to issue a tokenised bond. An on-chain approach could be to tokenise the bond directly on the blockchain, so this is the only way to access it. A hybrid approach could mean issuing the bond off-chain, the way it’s normally done, and then set up an SPV that owns the rights to the bond which is then tokenised. The difference is one is still operating on off-chain or real world infrastructure, whereas the other is fully digitally native.

Institutions will be investing in both hybrid and on-chain tokens for different reasons.

Applications

Once a network and token have been designed, applications lay on top. Applications are the interfaces institutions use to interact with the network and tokens - this ranges from Defi protocols themselves to infrastructure required to safely invest in Defi. This infrastructure includes wallets, custodians, oracles, privacy solutions, and more.

Similar to tokens, institutions can choose applications across a spectrum from centralised (hybrid) to decentralised (on-chain).

Alongside the emergence of Defi, Cefi platforms like Nexo and BlockFi arose. However, due to their centralised nature controlled by owners (similar to current banking), many Cefi platforms fell last year due to mismanagement. For funds uncomfortable with Defi's decentralised governance, centralised solutions remain an option.

Wallets required to execute blockchain transactions also range from centralised to decentralised solutions. Multisig wallets enable improved safety via requiring a set number of accounts to approve transactions, stopping one bad actor from stealing funds. Furthermore, institutional-grade wallets like Fireblocks provide customizable security-focused solutions.

We see this centralisation vs decentralisation spectrum across other infrastructure applications as well.

Institutions can choose network, token, and application designs best suiting their needs and compliance requirements. So I expect a range of hybrid and decentralised solutions to emerge catering to institutional needs moving forward.

Is institutional Defi decentralised?

Defi emerged as a decentralised and open solution to current financial solutions, but we may be heading into an era of private and permissioned blockchains. I can’t help but think that the rise of institutional Defi is bringing us back to centralisation. Vitalik, the co-founder of Ethereum, also raised similar concerns in his recent “Make Ethereum Cypherpunk Again“ post:

“We are not here to just create isolated tools and games, but rather build holistically toward a more free and open society and economy, where the different parts - technological, social and economic - fit into each other.

…

The growing awareness that unchecked centralization and over-financialization cannot be what "crypto is about", and the key technologies mentioned above (Roll-ups, ZK Proofs…) that are finally coming to fruition, together present us with an opportunity to take things in a different direction. 

Namely, to make at least a part of the Ethereum ecosystem actually be the permissionless, decentralised, censorship resistant, open source ecosystem that we originally came to build.”

Defi has opened up financial systems for investors, which have previously only been accessible to the elite. Let’s take market making as an example. Historically, market makers are companies that quote both a buy and a sell price in a tradable asset held in inventory, hoping to make a profit on the bid–ask spread, or turn. Automated market makers (AMMs) allowed participants to join these activities by providing assets to a liquidity pool, which then in turn earn passive fees from the trades they support. So instead of a centralised entity profiting, users in Defi protocols can see the same upside.

However, for DeFi to gain mass adoption, some regulation will likely enter the space. Different jurisdictions will take varying approaches - some embracing innovation while others restrict it. Achieving the right balance will be key. Well-designed regulations developed collaboratively could spur adoption by providing clearer guidelines. Oversight on factors like transparency, audits, dispute resolution, and liquidity requirements could give users and institutions more confidence to participate. The optimal path forward expands access and benefits for everyday users, while upholding decentralisation. 

I believe the future of Defi will range from centralised to decentralised solutions, depending on preferences. Think of all the design components as lego bricks, and you will be able to build a house or structure depending on your preferences.

Conclusion

The emergence of institutional Defi presents both opportunities and risks. On one hand, it could drive mainstream adoption and bring blockchain-based financial services into the norm. Institutional capital and expertise could accelerate innovation and help address issues like security and scalability.

However, excessive centralisation could undermine Defi’s mission of open access and transparency. Private networks and permissioned tokens may recreate the walled gardens of traditional finance. And the outsized influence of Wall Street titans risks crowding out community participation.

Ultimately, a balanced approach is needed - one that thoughtfully blends the best of centralised and decentralised worlds while upholding Defi's core values. With open collaboration between developers, users, and policymakers, solutions may emerge to expand institutional participation without compromising principles.

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