This article originally appeared in The Business Times on February 16th, 2023.
From the telegraph to the mainframe, technological change has long shaped the finance industry. Today we stand at a new inflection point. Decentralized finance, or DeFi, which uses blockchain-based smart contracts to automatically execute a variety of financial transactions without human intervention, has the potential to be the next great transformative force – but only if established institutions play a much bigger role.
Trillion of dollars of stocks, bonds, currencies, and other assets are traded around the world every day, but transactions typically go through multiple intermediaries and require the reconciliation of records across numerous institutions and ledgers. That costs time and money – it can take up to four days to settle many cross-border trades.
DeFi technology can cut through much of that inefficiency by presenting transactional and ownership information on a single, shared ledger, enabling trades to be settled almost instantaneously. Automating transactions with DeFi software protocols and smart contracts can generate further efficiency gains. The growing use of tokenization, which creates digital representation of real-world assets on the blockchain, can extend those benefits to the world’s vast markets for stocks, bonds, commodities, and other major assets.
What about risk? It’s true that DeFi technology was developed in a cryptocurrency market that has been shaken by high volatility and a number of costly failures, including the spectacular collapse of the FTX exchange. But those were failures of business models and practices, not the underlying technology. The crisis in crypto demonstrates the need for proper safeguards, not a technological reboot.
Institutions can play a leading role in helping this technology break into mainstream financial markets. A recent paper by the Oliver Wyman Forum, the think tank of global management consultancy Oliver Wyman, and co-authors DBS of Singapore, Onyx by J.P. Morgan, and Japan’s SBI Digital Assets Holding showed the potential for Institutional DeFi to transform global markets.
Institutional DeFi combines the power and efficiency of DeFi software protocols with a level of protections and controls that regulators demand and customers expect. These include identity capabilities to enable financial institutions to comply with anti-money laundering (AML) and know- your-customer (KYC) regulations, strong cybersecurity to minimize the threat of hacking incidents, and recourse mechanisms to make investors whole if something goes wrong.
DBS, Onyx by J.P. Morgan, and SBI Digital Assets Holding recently demonstrated the feasibility of this concept by carrying out foreign exchange and government bond transactions, both live and simulated, in a pilot under the Monetary Authority of Singapore’s Project Guardian. They used a public blockchain network with regulated institutions acting as “trust anchors,” issuing and verifying the credentials of participating entities. The transactions used digital identity solutions and logic adapted from existing DeFi protocols. The pilot showed that “with the appropriate guardrails in place, digital assets and decentralized finance have the potential to transform capital markets,” said Sopnendu Mohanty, MAS’s chief fintech officer.
It’s a big leap to go from proof of concept to real-world applications at scale. To get there, industry participants need to take joint action across several priority areas.
First, they need to achieve greater legal clarity around recourse mechanisms in case of disputes, meeting KYC and AML requirements, and the usage and holding of crypto assets by financial institutions. Firms also should collaborate to develop incentives to encourage adoption by institutions and liquidity providers; promote common industry standards to verify the credentials of market participants and facilitate interoperability; and refine business and operating models to capture the efficiency benefits of DeFi protocols.
As Institutional DeFi transforms how financial markets operate, it will shift the competitive dynamics in the industry, creating opportunities for those who are prepared. Getting all of this right will require not just tech investment but also careful thinking about the firm’s business strategy and organization, as well as its talent profile and partnership network.
That is a daunting task, which is why firms need to start developing their own playbooks now. They should begin by forming a house view on the likely impact of DeFi, which could range from a modest evolution of existing market structures to a complete revolution that leaves DeFi structures triumphant. Then institutions need to decide what their ambition is, where they want to play, and how much they’re willing to invest, taking into account their clients’ needs and capabilities.
Finally, firms need to determine the best organizational structure to fit their ambitions, choosing the right mix of in-house development efforts and partnerships with peers and vendors, and creating a talent environment that attracts and retains the necessary skills and fosters innovation.
There is no single right answer on any of these issues, but firms need to start addressing them now at both the institution and industry level to move from debates and pilots to scalable, real-world applications. The opportunity of Institutional DeFi is too big to wait.