Institutional players shape the future of DeFi

Opinion by: Michael Egorov, founder of Curve Finance

Decentralized finance (DeFi) is rapidly becoming one of the most important trends influencing the financial world. With DeFi activity constantly increasing and the total value locked exceeding $100 billion, this sector is gaining much traction among institutional investors. 

This growing institutional interest in DeFi, however, inevitably raises questions about the future of this sector. Can DeFi maintain its principles of decentralization and democracy while ensuring security for all participants? Or will the need to meet the demands of large players change the essence of “decentralized” finance, compromising it?

Institutionalization of DeFi

We can see many cases of institutional players’ growing interest in DeFi, such as BlackRock’s BUIDL fund, which manages assets exceeding $550 million. That, in turn, signals a transformation in this sector, where tokenized securities, once seen as a niche concept, are now being viewed as bridges between TradFi and blockchain ecosystems. 

Even companies like Securitize are working to ensure that these tokenized assets are aligned with proper regulations. The agents will also play a significant role in driving more capital into the DeFi space.

It’s not all smooth sailing from here — properly integrating institutional investors into decentralized finance comes with challenges. Regulatory and legal uncertainty, as is compliance with Know Your Customer (KYC) and Anti-Money Laundering (AML) standards, is still a factor. Beyond that, we have issues that involve liquidity and transparency of transactions, technical security and economic risks. All these obstacles make it difficult for institutional players to navigate this environment, thus slowing down the DeFi adoption.

Despite the promise of decentralized finance, large-scale players are cautious regarding the safety of their money. The key issue is balancing the core tenets of decentralization with the security requirements that would satisfy institutional investors.

Recent: How validator compromises threaten DeFi security

Market reports from the likes of Blockworks and JPMorgan speak in favor of institutional presence in DeFi, stating that this sector needs to support these players and adopt the necessary infrastructure to scale effectively. But the reality is more complicated than that. 

Institutional involvement can increase trust in the DeFi ecosystem, driving its growth to new heights. It also, however, carries the risk of more centralization, causing the very nature of this system to step away from what it was devised to be and what made it so attractive to many people.

The risks of RWA tokenization

A significant development in the DeFi space is the tokenization of real-world assets (RWAs), which includes everything from tokenized commodities to tokenized stocks. According to McKinsey, the market for these assets could reach $2 trillion by 2030.

While RWAs mark a considerable step forward for DeFi, they have security risks that must be addressed. One of the most pressing challenges is “custody” risk — when assets are tokenized and moved into DeFi. In such cases, the security of these assets being “backed” relies on legal agreements rather than the automated nature of smart contracts. 

For example, the two most widely used stablecoins, USD Coin (USDC) and Tether’s USDt (USDT), are backed by traditional banking institutions, not decentralized protocols. And because their backing depends on centralized entities, they are vulnerable to manipulation and errors.

Assets that require compliance with AML and KYC rules are trickier. Tokens like the Short-term Treasury Bill Token (STBT), for example, can work in the permissionless DeFi environment as long as they are accepted. Accepting these assets appears to be limited as users are reluctant to go through the KYC requirements that come with them. Adoption hurdles stem from compliance rather than the necessity of changing up DeFi smart contracts to integrate the assets themselves.

If TradFi giants can apply their infrastructures to safeguard RWAs, this could help to address the security concerns tied to tokenization. If done professionally, a stablecoin with proper backing from a big-time traditional financial institution could become very popular in theory, leading to greater trust and adoption. Tokenized stocks and commodities could also gain traction, offering new investment opportunities that mix TradFi structures and blockchain.

The future of DeFi 

Looking ahead, the future of DeFi will likely be a hybrid model that blends decentralization principles with regulated elements of centralization. This approach could help enhance security while preserving the essence and advantages of DeFi: reducing intermediaries and increasing transparency.

Very often, the future comes not as the result of an old or a new paradigm winning but rather from finding a compromise. True DeFi has legs it can firmly stand on even without large institutional players. Still, some areas within DeFi will likely need to accommodate elements of centralization to ensure better security and regulatory compliance.

One way or another, the result will be a financial ecosystem with fewer intermediaries than today’s TradFi systems. And this hybrid model will likely become the basis for how the world’s future financial systems operate.

Opinion by: Michael Egorov, founder of Curve Finance.

This article is for general information purposes and is not intended to be and should not be taken as legal or investment advice. The views, thoughts, and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.