When will DeFi Summer 2.0 arrive? Institutional DeFi Strategy Handbook

Source: Wu Says

Introduction to Into the Block and How to Get Involved in DeFi?

Into the Block started as a general analytics platform at the end of 2019, and I joined as the first employee of the research team. We focused on business development in the early DeFi ecosystem, recognizing its potential as a new financial infrastructure that differs from traditional finance. Our CEO, Susan Rodriguez, saw opportunities in DeFi innovative protocols (such as Compound V2, Maker, and Synthetix), which were among about 20 protocols that were still in their infancy before the summer of DeFi in 2020.

As DeFi gained attention, we observed the inherent risks of these emerging financial strategies, which prompted us to develop products aimed at mitigating these risks for institutional access.

Despite the challenges of 2022 affecting many in the DeFi space, we saw a fundamental need focused on risk management to restore market confidence. This realization led us to develop our third product—Risk Radar, a platform designed to transparently track internal risk indicators of DeFi protocols, addressing the critical need for enhanced risk assessment and management in the DeFi ecosystem.

What Types of Institutions Are Participating in the DeFi Market?

I am very optimistic about DeFi. Although the performance of DeFi tokens may not be the best, I believe their underlying infrastructure has a competitive advantage and greater potential compared to current fintech infrastructures. Existing fintech, while appearing completely different, is essentially just a UI layer on top of banking applications, and it has not unlocked any zero-to-one innovations like DeFi has. DeFi allows permissionless transactions, and in some cases, transaction fees are significantly lower than those charged by traditional systems. I believe this is a long process that we have known from the beginning, but within 10 to 20 years, DeFi will surpass traditional financial systems, or at least the fintech companies we know today.

How Will Institutional Participation Shape the Future of DeFi?

Institutional participation is crucial in shaping the future of decentralized finance (DeFi). We are beginning to observe family offices and well-known figures from traditional finance exploring DeFi and its various strategies, despite initial hesitations due to market turmoil like the Terra incident. This growing interest from more traditional sectors over the past two quarters marks a readiness for broader institutional participation in DeFi.

In the coming years, the infrastructure of DeFi is expected to evolve, maintaining its current foundation while integrating significant advancements. A key anticipated development is identity verification solutions, which could revolutionize DeFi by enabling uncollateralized loans. Currently, DeFi operates on an over-collateralized basis, but introducing reliable identity verification could allow for credit-based collateral, reflecting traditional financial mechanisms, such as mortgages with minimum down payments.

Identity solutions within DeFi could stem from various innovations, ranging from biometric verification like Worldcoin's eye scans to complex address tracking systems that assess creditworthiness. Achieving this would accelerate the onboarding of companies on-chain, providing numerous advantages such as streamlined monetary transactions and programmable payments. For example, mortgage payments could be automated in real-time directly from someone's income on the blockchain, reducing lender risk and potentially offering better borrowing rates for individuals and businesses.

As identity verification and financial activities transition to the blockchain, we can expect a shift toward more efficient and equitable capital borrowing rates. Initially, the allure of high leverage and yield opportunities may attract users to DeFi. However, over time, the emergence of more natural use cases may foster a more integrated and organic ecosystem within DeFi, driven by institutional participation and technological advancements.

How Are Institutions Deploying on New L1 and L2?

Institutions deploy on new Layer 1 (L1) and Layer 2 (L2) platforms in various ways, largely depending on their risk tolerance. Funds seeking high risk may explore new branches or chains that offer high incentives, while more conservative institutions tend to opt for lower but stable yields, which typically exceed treasury yields but are below 10%. Such institutions usually deploy on mainnets using well-tested protocols to achieve yields that surpass the market, preferring capital preservation over aggressive growth.

For new platforms like Eigenlayer, many institutions choose to wait until these platforms mature before investing, reflecting a cautious attitude. This caution stems from a desire to protect wealth and manage risk responsibly, contrasting with the more speculative strategies adopted by individual investors.

A notable trend among institutions is leveraging increased Bitcoin holdings while mitigating risk. Strategies involving automated liquidation protection, such as rebalancing according to predefined guidelines, are becoming increasingly popular. As market conditions improve, these institutions seek to utilize their substantial capital more aggressively, preferring to leverage their assets rather than let them sit idle, highlighting a strategic approach to risk management and capital utilization in the ever-evolving landscape of new blockchain platforms.

What Scale Are Institutions Allocating in the Current DeFi Environment?

In today's DeFi environment, participating institutions tend to allocate at least 10% of their portfolios to cryptocurrencies. New institutions starting to invest in cryptocurrencies may allocate around 1% to 2%, typically holding only Bitcoin due to its volatility. We primarily work with crypto-native institutions or those transitioning toward a more crypto-oriented approach, which have a better understanding of the risks in DeFi. Especially for institutions new to cryptocurrencies, there is a significant educational component involved, requiring patience to explain strategies and risks. Some highly crypto-native companies have fully allocated to cryptocurrencies, seeking more risk management strategies and appreciating the automated risk management layers of their investments. New institutions tend to lean toward mature, battle-tested platforms like Curve or Aave, which offer stability and are viewed as lower risk.

What Strategies Are Institutions Most Interested in Within DeFi?

Institutions are primarily interested in market-neutral strategies within DeFi. They typically start with simple approaches, such as earning yields on protocols like Curve or Balancer, which provide returns above traditional benchmarks. As they become more accustomed to DeFi, they explore more complex strategies, such as leveraged staking, which involves depositing staked ETH (stETH), borrowing ETH, and then minting more stETH. This can significantly increase staking yields. Another strategy gaining interest is funding rate arbitrage, which involves deploying capital to take advantage of the differences between long-staked ETH and short-term ETH positions to earn funding rates. These strategies offer a balance between risk management and yield optimization, making them attractive to institutions seeking to maximize returns in the DeFi space.

What Impact Have Significant Fluctuations in Total Locked Value (TVL) in DeFi Since 2021 and Various Events Had on Institutional Adoption?

The crypto space has indeed faced many events that have affected short-term sentiment, particularly the significant vulnerabilities contributing to the approximately $58 billion loss primarily from the Terra collapse. These events have exacerbated bear market conditions. However, over time, the scale of these events has noticeably decreased, with only about $1 billion in vulnerabilities recorded in the last quarter, the lowest level since 2020. This downward trend indicates improvements in security measures and risk management within the DeFi ecosystem.

Institutions are gradually recognizing that core blockchain technologies like Ethereum remain secure, with major losses stemming from high-risk protocol designs rather than inherent flaws in the infrastructure. This distinction is crucial for restoring confidence in the blockchain and DeFi space.

The cycles of the crypto market reflect human nature, with capital shifting toward higher-risk investments for greater returns during bull markets, inevitably leading to contractions as leverage unwinds. This pattern may repeat in future cycles, although it is hoped that the percentage of total TVL exposed to such high-risk DeFi will be smaller.

The competitive landscape among centralized lending institutions, driven by competition for returns, has pushed yields higher, reflecting patterns seen in traditional financial markets, such as the accumulation of financial crises. The competition for higher yields drives increased risk-taking, which could lead to collapses, emphasizing the cyclical nature of financial markets driven by human behavior and the pursuit of profit.

What Is Your View on the DeFi Ecosystem in the Context of Rising Interest Rates and Strategies Like Maker Integrating Real-World Assets (RWA)?

These practices have not significantly attracted traditional capital at scale, as they can directly and easily access RWA assets like U.S. treasuries. However, for international clients, allocating capital to such DeFi tools may be appealing.

The existence of on-chain RWAs creates arbitrage opportunities, especially when these assets are newly launched, and borrowing rates on platforms like Aave are lower than the yields on U.S. treasuries. This situation helps enhance the overall yields of DeFi, setting a minimum yield expectation or floor. As market dynamics shift, the increased demand for leverage pushes borrowing rates higher, and the supply of assets like sDAI on DeFi platforms may yield more than traditional treasury yields.

This mechanism may narrow the yield range in DeFi, making it more predictable and slightly more attractive to cautious investors. Additionally, integrating these assets into liquidity pools reduces the incentive costs of DeFi protocols. Since a portion of the pool inherently earns baseline yields (e.g., 5% for sDAI), protocols can allocate fewer resources to attract and maintain liquidity, improving efficiency.

Despite these benefits, expecting on-chain RWAs to significantly bridge DeFi with traditional finance may be overly optimistic. While they offer certain advantages and contribute to creating a more stable yield environment in DeFi, the transformative impact of integrating with traditional finance has yet to be fully realized. The cautious stance of traditional institutions toward DeFi, combined with the need for further maturation and risk management within the DeFi ecosystem, indicates that there is still much work to be done in aligning DeFi products with traditional financial expectations.

What Could Be the Catalysts for "DeFi Summer 2.0"?

A key catalyst for DeFi Summer 2.0 could be a shift in market conditions. As capital within the ecosystem grows, the demand for financial services within DeFi tends to increase. An example observed in the fourth quarter is the significant rise in leverage usage on Aave, indicating increased activity. For instance, Aave's outstanding loans jumped from $4 billion to nearly $7.6 billion in the fourth quarter, primarily driven by stablecoin loans, reflecting new organic demand. This wealth effect encourages more borrowing and could initiate a new cycle of capital inflow into DeFi.

Parallel to institutional interest is retail user participation in incentive systems, similar to gamification strategies, which have the potential to re-engage users in the DeFi space. Although the nature of these systems is controversial and institutions are cautious about them, they may play a key role in attracting retail participants. Larger incentive systems are expected to emerge in the next six months, further promoting retail user interest in DeFi.

For institutional clients, bringing more capital into the ecosystem is seen as a crucial step. As more capital flows into DeFi, it will naturally tilt toward the innovative financial services offered, driving the growth and evolution of DeFi 2.0. Overall, the combination of a market upturn, innovative participation strategies targeting retail users, and increased institutional capital flow could collectively act as catalysts for the next phase of DeFi evolution.

How Do You View the Prospects and Value of Existing Blue-Chip DeFi Projects and Their Tokens?

Blue-chip DeFi projects and their tokens hold considerable appeal for traditional financial institutions, primarily due to their competitive metrics and advantages compared to fintech companies, especially in terms of lower expenses and capital costs. As more traditional institutions transition to DeFi, these established DeFi entities are expected to benefit significantly. However, this transition is often gradual, with institutions typically starting with Bitcoin, moving to Ethereum, and eventually engaging in DeFi, focusing on the most reputable projects like Maker and Aave.

These blue-chip DeFi tokens are considered more reasonably priced, with less frenzy compared to newer, more speculative tokens. This stability, while perhaps less exciting for retail participants, aligns well with institutions' preferences for predictability and manageable risk. Significant growth in loans and revenues within a single quarter has been viewed as quite substantial by institutions, alleviating the demand for explosive growth seen in some new protocols on emerging Layer 2 platforms.

Institutions prefer the predictability of yield farming conducted on mature protocols like Curve, where expected yields are relatively stable, rather than the speculation of new incentive systems with uncertain valuations. Thus, they often opt for a safe 7% annual yield rather than the speculative 25% annual yield that new tokens might promise. This preference underscores a broader institutional approach to DeFi: seeking reliable returns within a framework that reduces volatility and speculative risk.

What DeFi Projects Are You Particularly Interested In?

AEVO stands out for its innovative approach to options products and its pivot toward target prediction markets, highlighting its ability to attract users and generate revenue through derivatives like perpetual contracts and options. Its innovative flexibility and deployment of its own Layer 2 solution emphasize its potential to gain a first-mover advantage in the derivatives space. As market dynamics shift toward a more speculative environment, significant success is expected for derivatives protocols.

Additionally, Aave's effective multi-chain strategy and its position as a central liquidity hub have been recognized for integrating lending liquidity within the ecosystem. Despite facing competition from Compound in the past, Aave's strategic adjustments have prepared it for potential recovery and continued dominance in the lending space.

The mention of Uniswap V4 and its introduction of "hooks" points to a trend toward the evolution of so-called "micro-primitive" layers within DeFi protocols, allowing for a wide range of new functionalities. Such innovations are expected to introduce new opportunities within the DeFi space.

There is a broader trend of customization and innovation within DeFi. However, it is emphasized that these observations are not financial advice but rather an expression of interest in the ongoing evolution and potential resurgence of the DeFi space.

Will the Collapse of FTX Accelerate Institutions' Shift to On-Chain Trading or On-Chain Perpetual Contracts?

The collapse of FTX is likely to accelerate institutions' shift toward on-chain trading and the use of on-chain perpetual contracts. While liquidity remains a concern, centralized exchanges like Binance significantly lead in liquidity compared to decentralized platforms like dYdX, the gap is narrowing. It is predicted that within the next year, there may be days when DeFi trading volume exceeds that of centralized exchanges (CEX), highlighting the growing confidence in self-custody and the security advantages of holding one's own keys.

Institutions are increasingly engaging in DeFi, particularly on Layer 2 solutions like Arbitrum, where substantial institutional activity has already been observed. As infrastructure develops to support more efficient and cost-effective on-chain activities, this trend is expected to continue.

New developments, such as Eigenlayer and platforms like Dymension, offer the potential for rapid deployment of application-specific chains or more general solutions. This flexibility may be particularly beneficial for derivatives exchanges, while lending platforms may benefit more from integration into a broader ecosystem due to their collaborative nature.

The emergence of these infrastructure solutions provides opportunities for DeFi applications to compete with their centralized counterparts in terms of cost and user experience. The previous cycle revealed some limitations, such as the necessity of trading derivatives on Layer 1 or the subsidies and centralized order books. However, the current wave of infrastructure development promises to provide decentralized alternatives that can match or exceed the performance and user experience of centralized platforms.

The evolving landscape of this transformation indicates that a significant shift toward DeFi is occurring, driven by innovations that lower costs, enhance security, and improve user experience, making on-chain trading and perpetual contracts more attractive to a broader range of market participants, including institutions.

What Is the Institutional Perspective on Liquidity Fragmentation?

In dealing with liquidity fragmentation, institutions typically prefer a modular approach rather than a monolithic architecture. This preference stems from the historical context of financial systems composed of interconnected parts, with the expectation that bridging across different platforms and layers should be seamless and user-friendly. While liquidity fragmentation and the friction of continuously bridging assets across different environments may pose challenges, advancements in infrastructure that make these processes more efficient are shifting preferences toward a more modular financial ecosystem.

The modular approach is seen as more resilient, allowing parts of the system, such as Layer 2 or Layer 3, to experience issues without affecting the integrity of the core layer, where most capital is typically stored. This resilience is a significant factor in the preference for modular setups, as it ensures that the broader system can continue to operate smoothly despite localized disruptions.

However, there is also recognition that as the DeFi ecosystem grows and faces greater pressures, this preference may evolve. A potential future concern is that if a particular Layer 2 surpasses the liquidity of the Ethereum mainnet, it could pose new challenges to the modularity argument. While this is considered unlikely in the short term, it is a possibility that institutions and developers need to consider when building and investing in the DeFi space.

Overall, while the current preference is for a modular approach due to its resilience and ability to easily integrate different parts of the DeFi ecosystem, ongoing developments and the dynamic nature of the market may influence institutions' future views on liquidity fragmentation and infrastructure design.

What Are the Biggest Risks Preventing Institutions from Entering DeFi?

Based on discussions with traditional finance professionals outside of crypto, the primary barriers preventing institutions from entering DeFi revolve around the learning curve and the perceived novelty and riskiness of the space. The approval and launch of Bitcoin ETFs have played a significant role in legitimizing cryptocurrencies in the eyes of traditional finance, with some viewing such regulatory milestones as a "legalization" of Bitcoin, even though Bitcoin was not illegal before. This marks a step toward overcoming the taboos surrounding cryptocurrencies and blockchain technology.

However, the process of becoming familiar and accepting is gradual, and the younger generation within banks and financial institutions may drive the shift toward blockchain acceptance as they understand and appreciate the technology's potential to streamline operations and reduce intermediary costs.

The hesitance of traditional institutions to delve deeply into DeFi is not necessarily due to a direct assessment of its risks but rather a lack of thorough evaluation and an inherent conservatism toward new financial technologies. While some banks, like JPMorgan, exhibit a dual stance of criticism and participation in blockchain initiatives, not all traditional financial institutions will embrace cryptocurrencies. Skepticism toward new technologies is not uncommon, and the crypto industry may thrive without widespread adoption by traditional banks.

Conversely, the growth and evolution of current crypto-native institutions, which better understand and leverage blockchain technology, suggest a future where these entities may compete with or even surpass traditional financial giants. This perspective aligns with historical patterns where innovative startups eventually outpace established industry leaders as the technological landscape and market preferences evolve. Thus, the optimism surrounding DeFi lies in its potential to facilitate the rise of new financial powerhouses that may redefine the industry.