From the carrier pigeon to the telegraph, the transistor to the mainframe, technological change has shaped the finance industry for generations. Today we stand at a new inflection point. Decentralized finance, which uses blockchain-based smart contracts to automatically execute a variety of financial transactions without human intervention, has the potential to be the great transformative force.
DeFi, as it’s known, already enables peer-to-peer markets in the crypto-asset industry for borrowing and lending as well as decentralized exchanges for trading cryptocurrencies and non-fungible tokens (NFTs). Those largely unregulated markets have attracted more than $50 billion in investor money so far, but they’ve also experienced high volatility, sudden business failures, and frequent thefts by hackers. To break into the mainstream, DeFi needs to incorporate the same, or higher, level of security standards and safeguards that have been developed over decades in the finance industry.
The Oliver Wyman Forum, in partnership with Singaporean bank DBS, Onyx by J.P. Morgan, and Japan’s SBI Digital Asset Holding, believes the time is ripe for such a breakthrough. In a new paper, Institutional DeFi - The Next Generation of Finance?, we make the case for Institutional DeFi, a system that 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 solutions 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.
The cost savings and new business opportunities of using Institutional DeFi to streamline the world’s trillion-dollar markets in foreign exchange, equities, bonds, and other assets could be significant for issuers and investors, as well as for financial institutions that can adapt their technology and business models.
What Is Institutional DeFi?
Source: Oliver Wyman Forum, DBS, Onyx by J.P. Morgan, SBI Digital Asset Holdings
Many firms are already creating digital representations, or tokens, of such real-world assets to bring them onto the blockchain. The next step – showing how such tokens can be transacted using DeFi protocols on a public blockchain – has been successfully demonstrated by our partner institutions in a recent pilot under the Monetary Authority of Singapore’s Project Guardian, which is testing the feasibility of applying asset tokenization and DeFi protocols while managing financial stability and integrity.
The pilot, led by our co-authors DBS, Onyx by J.P. Morgan, and SBI Digital Asset Holding, carried out transactions involving foreign exchange with tokenized deposits and separate transactions with government bonds, in each case, on a public blockchain network, using digital identity solutions and logic adapted from existing DeFi protocols.*
The pilot demonstrated that DeFi protocols have the potential to be adapted for capital markets activities on a public blockchain. But more work is needed, both by individual financial institutions and by collaboration between the industry, clients, and regulators, to make the leap from proof of concept to real business, and then to scale that business to make an impact on global markets.
The pilot participants identified several priority areas for joint action. These include achieving 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; developing incentives to encourage adoption by institutions and liquidity providers; promoting common industry standards to verify the credentials of market participants and facilitate interoperability, and refining business and operating models to capture the efficiency benefits of DeFi protocols.
We suggest ways in which individual firms can develop their own playbook for Institutional DeFi. Every firm should start by forming a house view on the likely impact of DeFi, which could range from a modest evolution of existing market structures to a parallel development of DeFi and traditional markets 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. Some firms may want to be leaders across a broad range of markets while others may take a more gradual approach. In making those decisions, firms should take into account their clients’ needs and capabilities.
Finally, firms need to get themselves ready by determining 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 answers are needed at both the institution and industry level to move from debates and pilots to scalable, industrialized solutions.
The Institutional DeFi opportunity is here. The time to build the future is now.
* Bond trading scenarios were conducted as a fully simulated exercise only, while demonstrating potential real-world use cases.