“The institutions are coming!” This is one of those perennial arguments we’ve been hearing for years in decentralized finance (DeFi). Despite the evolution in the space and hundreds of billions in total value locked (TVL), institutional presence in DeFi remains relatively low. The lack of KYC-AML capabilities is often cited as the main reason, but that argument is increasingly weak. The reality, more difficult to admit, is that DeFi is missing key building blocks to unlock significant levels of institutional adoption.
DeFi has all the technical foundations to become a parallel financial system for institutions, but unlocking its potential will require two key things. Firstly, DeFi desperately needs first-class primitives for institutions. Additionally, the space must work towards strong validation by meeting the requirements of large institutions in traditional finance. If we consider the impact that the BlackRock BUIDL project has had in validating tokenized securities and real-world assets (RWA), that should be the north star for institutional DeFi.
We are entering a period in global markets with central banks cutting rates, which could be incredibly favorable for DeFi. Not taking advantage of this to catalyze institutional adoption is a wasted opportunity, but we need to address the right challenges instead of oversimplifying the problem.
The limited growth of institutional DeFi is often explained by the lack of KYC and AML capabilities. At the peak of the DeFi market in 2021, several blue-chip DeFi protocols attempted to enable KYC-AML capabilities to attract institutions without any significant success. If KYC-AML was the main hurdle for traditional finance institutions to embrace DeFi, and we were at the peak of the bull cycle, that should have worked, right? What happened?
The reason is that while KYC-AML is required for many institutional DeFi products, it is hardly sufficient to unlock the potential of the market. Today, DeFi is still lacking financial primitives for institutions, so adding KYC-AML just results in the same institutional-less market with validated investors. In the context of large institutional capital, DeFi is still perceived as a second-tier market, not because of the lack of KYC-AML, but due to limited institutional-grade capabilities.
Limited capital efficiency, technical and economic risks, extremely fragmented liquidity, and the lack of institutional-grade investment products are some of the factors that rank higher than KYC-AML for institutions considering DeFi. Even if all protocols in DeFi were to enable KYC-AML features tomorrow, it would only result in a marginal increase in institutional adoption.
Tokenized securities have been hailed as the next-big-thing in crypto since 2018, but the market saw relatively little adoption for years. The value proposition of tokenized securities was obvious, and most platforms had KYC-AML capabilities, but that wasn’t enough to be taken seriously by institutions. During that time, companies like Securitize added institutional-ready capabilities such as broker-dealers, transfer agents, and onboarding institutions, all of which led to BlackRock gaining conviction for the space. BUIDL built on the institutional blocks laid by Securitize, like its transfer agent and broker-dealer capabilities.
The tokenized securities market can effectively be divided into “before BUIDL” and “after BUIDL.” BUIDL legitimized tokenized securities to levels that were previously unthinkable. DeFi needs to work towards a BUIDL moment, and the first step is to enable institutional-grade primitives.
The path to enabling institutional-grade capabilities in DeFi has three main avenues:
The Top-Down Approach: Building financial products that expand the existing foundation of DeFi protocols with institutional-grade capabilities.
The Bottom-Up Approach: Building DeFi protocols or extensions of protocols with native capabilities for institutions.
The Shortcut Approach: Bringing products with significant institutional adoption to DeFi.
A top-down approach refers to the idea of building investment products that mitigate some of the limitations of existing DeFi protocols for institutional adoption.
A classic example of this trend is capital efficiency. In DeFi today, protocols like automated market makers (AMMs) rely on basic linear algorithms to balance liquidity, which remain incredibly inefficient compared to traditional mechanisms such as order books. Similarly, most lending in DeFi is overcollateralized, imposing major limits on scaling. We can envision a new generation of DEXes or lending vehicles that use the current generation of DeFi protocols as a foundation but enable more capital-efficient rails for institutions.
Another example of this trend is capital fragmentation. In today’s version of DeFi, capital is fragmented across hundreds of protocols and different chains with limited interoperability. The launch of new protocols and ecosystems is exacerbating this problem to levels that make it impractical for institutions. Primitives that abstract capital access across different ecosystems are among the simplest and most welcomed solutions to attract institutional capital into DeFi.
As DeFi evolves, we should work towards enabling native institutional-grade capabilities in DeFi protocols. The canonical example of this idea is to enable institutional-first pools or markets in AMMs or lending protocols. This is technically possible today with protocols such as Morpho Blue or the upcoming Uniswap v4 or Aave v4. The blockers are in areas such as liquidity formation, security, and several others.
Another classic example is insurance primitives, which remain very basic in their current form. Native DeFi insurance could be one of the major unlocks for institutional adoption in DeFi.
Until now, we’ve been discussing building capabilities to enable institutions to interact with DeFi, but what about enabling DeFi capabilities for products that already have significant adoption by financial institutions? DeFi has a long history of building derivatives over financial constructs to enable access in DeFi protocols or different ecosystems. wBTC and stETH gained incredible traction in DeFi using these principles. The same idea applies to tokenized treasuries or vehicles like BUIDL, which could be made available in DeFi via derivatives with the right regulatory constructs.
The lack of institutional adoption in DeFi is fundamentally due to capability limitations, not solely regulatory uncertainty. The market is about to enter a low-interest rate cycle that should favor DeFi adoption. Building the right institutional rails in that environment is paramount for the success of DeFi. This might be the best chance DeFi has to capture institutional mindshare in the foreseeable future. The institutions will come to DeFi if the right institutional-grade capabilities exist.
Note: The views expressed in this column are those of the author and do not necessarily reflect those of CoinDesk, Inc. or its owners and affiliates.