Conversation: Shang, former BitMEX analyst, Lucus, chief analyst of IntoTheBlock
Introduce Into the Block and how to get involved in DeFi?
Into the Block started as a general analytics platform in late 2019, and I joined as the first employee on the research team. We focus on the business development of the early DeFi ecosystem, recognizing its potential as a new financial infrastructure that is different from traditional finance. Our CEO, Susan Rodriguez, with her background in the financial industry, saw an opportunity in innovative DeFi protocols such as Compound V2, Maker, and Synthetix, which were among about 20 protocols in their infancy at the time, This was before DeFi Summer 2020.
As DeFi gains traction, we observe the risks inherent within these emerging financial strategies, which leads us to develop products designed to mitigate these risks for institutional access.
While the challenges of 2022 have impacted many in the DeFi space, we see a fundamental need to focus on risk management to restore market confidence. This realization led us to develop our third product - Risk Radar, a platform designed to transparently track risk indicators within 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 bullish on DeFi. Although DeFi tokens may not perform optimally, I believe their underlying infrastructure has competitive advantages and greater potential than current fintech infrastructure. Although existing fintech looks completely different, it is essentially just a UI layer on top of a banking application. It does not unlock any zero-to-one innovation like DeFi does. DeFi allows permissionless transactions and, in some cases, transaction fees that are significantly lower than those charged by traditional systems. I think over time, its a long process that we knew from the beginning, but in 10 to 20 years, DeFi will surpass the traditional financial system, or at least the fintech companies that we recognize today.
How will institutional participation shape the future of DeFi?
Institutional participation is critical in shaping the future of decentralized finance (DeFi). We are starting to observe that big names in family offices and traditional finance are exploring DeFi and its various strategies despite initial hesitation about market turmoil such as the Terra incident. This growing interest from more traditional sectors over the past two quarters signals preparation for wider institutional participation in DeFi.
Over the next few years, DeFi’s infrastructure is expected to evolve, maintaining its current foundation while incorporating significant advancements. One expected key development is identity verification solutions, which could revolutionize DeFi by making uncollateralized lending possible. Currently, DeFi operates on an over-collateralization basis, but introducing reliable identity verification could allow for credit-based collateralization, mirroring traditional financial mechanisms such as mortgages with minimum down payments.
Identity solutions within DeFi could stem from a variety of innovations, from biometric verification like Worldcoin’s eye scans to sophisticated address tracking systems that assess creditworthiness. Achieving this will speed up the process of bootstrapping companies on-chain, providing numerous advantages such as simplified currency transactions and programmable payments. For example, mortgage payments could be automated and made on the blockchain in real-time directly from someone’s income, reducing risk for lenders and potentially providing better borrowing rates for individuals and businesses.
As identity verification and financial activities transition to blockchain, we can expect a shift toward more efficient and fair capital lending and borrowing rates. Initially, the attraction of high leverage and yield opportunities may draw users to DeFi. However, over time, the emergence of more natural use cases may promote the formation of a more integrated and organic ecosystem within DeFi, a process driven by institutional participation and technological advancements.
How do organizations deploy on new L1 and L2?
How institutions deploy new layer one (L1) and layer two (L2) platforms varies, depending largely on their risk tolerance. Funds seeking higher risk may explore new branches or strands that offer high incentives, in contrast to more conservative institutions that tend to choose lower but stable interest rates that typically exceed Treasury yields but are less than 10% . Such institutions typically deploy on mainnet using well-tested protocols to achieve market-beating yields, favoring capital preservation over aggressive growth.
For new platforms like Eigenlayer, even if the total value locked (TVL) is high, many institutions are choosing to wait for these platforms to become more mature before investing, with a more cautious attitude. This cautious approach stems from a desire to protect wealth and manage risk responsibly, unlike the more speculative strategies employed by individual investors.
A notable trend among institutions is to use Bitcoin holdings to increase leverage while mitigating risk. Strategies that automate liquidation protection, such as rebalancing according to predefined guidelines, are becoming increasingly popular. As market conditions improve, these institutions seek to more actively utilize their substantial capital, preferring to leverage their assets rather than letting them sit idle, highlighting the need for risk management and capital utilization in the evolving landscape of new blockchain platforms. strategic approach.
In the current DeFi environment, how much scale have institutions allocated?
In todays DeFi environment, institutions that are already participating tend to allocate at least 10% of their portfolios to cryptocurrencies. New institutions just starting out in cryptocurrency investing may allocate around 1% to 2%, typically holding only Bitcoin due to its volatility. We primarily work with crypto-native institutions or those making the transition to more crypto-orientation that better understand the risks in DeFi. Especially for institutions new to cryptocurrencies, there is an important educational component involved, requiring patient explanations of strategies and risks. Some very crypto-native companies, already fully allocated to cryptocurrencies, are seeking more risk management strategies and appreciate automated risk management for their investments. New institutions tend to gravitate toward mature, battle-tested platforms like Curve or Aave, which offer stability and are seen as lower risk.
What strategies are institutions most interested in in DeFi?
Institutions are primarily interested in market-neutral strategies in DeFi. They often start with simple methods like earning yield on protocols like Curve or Balancer that provide returns that exceed traditional benchmarks. As they become more comfortable with DeFi, they explore more complex strategies like leveraged staking, which involves depositing staked ETH (stETH), borrowing ETH, and then minting more stETH. This can significantly increase staking returns. Another strategy gaining interest is funding rate arbitrage, which earns funding rates by deploying capital to exploit the difference between long-term staked ETH and short-term ETH positions. These strategies provide a balance between risk management and return optimization and are attractive to institutions seeking to maximize returns in the DeFi space.
How have significant fluctuations in DeFi total value locked (TVL) and various events since 2021 impacted institutional adoption?
The crypto space did face many events that affected short-term sentiment, especially the major breach of approximately $58 billion contributed most by the Terra crash. These events help exacerbate bear market conditions. However, there has been a noticeable decline in the scale of these incidents over time, with only around $1 billion in breaches recorded in the last quarter, the lowest level since 2020. This downward trend indicates improved security measures and risk management within the DeFi ecosystem.
Institutions are gradually realizing that core blockchain technologies like Ethereum are still secure and that major losses are due to high-risk protocol design rather than inherent flaws in the infrastructure. This distinction is critical to restoring confidence in the blockchain and DeFi space.
Crypto market cycles reflect human nature, with capital shifting to riskier investments for higher yields during bull markets, inevitably leading to contraction as leverage is unwound. This pattern is likely to repeat in future cycles, although hopefully the percentage of total DeFi TVL exposed to such high risk will be smaller.
The competitive landscape among centralized lenders, which drives up yields as they compete for returns, mirrors patterns seen in traditional financial markets, such as the build-up to financial crises. Competition for higher yields drives increased risk-taking, which can lead to collapse, underscoring the cyclical nature of financial markets driven by human behavior and the pursuit of profit.
What are your thoughts on the DeFi ecosystem amid a rising interest rate cycle and strategies like Maker integrating U.S. Treasuries and other real assets (RWA)?
These practices do not significantly attract traditional capital at scale because of their direct and easy access to RWA assets like U.S. Treasuries. However, for international clients, allocating capital to such DeFi instruments may be attractive.
The existence of on-chain RWA creates arbitrage opportunities, especially when these assets are new and borrowing rates on platforms like Aave are lower than the yield on U.S. Treasuries. This situation helps improve the overall returns of DeFi and sets a minimum return expectation or bottom line. As market dynamics change and increased demand for leverage pushes borrowing rates higher, the returns from supplying assets like sDAI on DeFi platforms may exceed returns from traditional treasury bonds.
This mechanism could narrow the scope of returns in DeFi, making them 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 a baseline yield (e.g., 5% of sDAI), the protocol can allocate fewer resources to attract and maintain liquidity, increasing efficiency.
Despite these benefits, expecting on-chain RWA to significantly bridge DeFi with traditional finance may be overly optimistic. While they offer certain advantages and help create a more stable yield environment in DeFi, the transformative impact on traditional financial integration has yet to be fully realized. The cautious attitude of traditional institutions towards DeFi, coupled with the need for further maturity and risk management of the DeFi ecosystem, indicates that there is still a lot of work to be done in aligning DeFi products with traditional financial expectations.
"DeFi Summer 2.0"What might be the catalyst?
A key catalyst for DeFi Summer 2.0 could be a shift in market conditions. As capital grows within the ecosystem, demand for financial services within DeFi tends to increase. An example of this observed in Q4 was that Aaves leverage usage rose significantly, indicating increased activity. For example, Aaves outstanding loans jumped from $4 billion to nearly $7.6 billion in the fourth quarter, largely driven by stablecoin loans, indicating new organic demand. This wealth effect encourages more borrowing and can start a cycle of new capital influxes in DeFi.
Parallel to institutional interest, retail user participation in points systems, similar to gamification strategies, has the potential to attract users back to the DeFi space. Despite their controversial nature and institutional caution about them, these systems could play a key role in attracting retail players. Over the next six months, it is expected that a larger points system may emerge, further boosting 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 towards the innovative financial services provided, driving the growth and evolution of DeFi 2.0. Overall, the combination of rising markets, innovative engagement strategies for retail users, and increased institutional capital flows may combine to serve as a catalyst for the next phase of DeFi’s 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 are quite attractive to traditional financial institutions, mainly because of their competitive metrics and advantages compared to fintech companies, especially in terms of lower expenses and capital charges. As more traditional institutions transition to DeFi, these established DeFi entities are expected to benefit significantly. However, this transition tends to be gradual, with institutions typically starting with Bitcoin, moving to Ethereum, and eventually participating in DeFi, focusing on the most reputable projects like Maker and Aave.
These blue-chip DeFi tokens are considered more reasonably priced and have less frenzy than newer, more speculative tokens. This stability, while perhaps less exciting for retail players, aligns well with institutional preferences for predictability and manageable risk. The massive growth in loans and revenue in a single quarter has been considered considerable by institutions, taking away the need for explosive growth seen on some new protocols sitting on emerging layer 2 platforms.
Institutions prefer the predictability of yield farming in established protocols like Curve, where expected returns are relatively stable, to the speculative nature of new points systems, which carry uncertain valuations. Therefore, they often choose a safe 7% annualized return rather than the speculative 25% annualized return that a new token may 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 shift toward targeting prediction markets, highlighting its ability to attract users and generate revenue through derivatives such as perpetual contracts and options. Their flexibility in innovating and deploying their own second-layer solutions underscores their potential to gain first-mover advantage in derivatives. As market dynamics shift towards a more speculative environment, derivatives protocols are expected to see significant success.
Additionally, Aave is recognized for its effective multi-chain strategy and its position as a central liquidity hub for integrating lending and borrowing liquidity across the ecosystem. Despite facing competition from Compound in the past, Aaves strategic alignment has positioned it for a potential recovery and continued dominance in the lending space.
Mention of Uniswap V4 and the “hook” functionality it introduces points to an evolution towards so-called “micro-primitives” – specialized, customizable layers within DeFi protocols that enable a wide range of new functionality. Such innovations are expected to introduce new opportunities in the DeFi space.
There is a broader trend towards customization and innovation within DeFi. However, it is emphasized that these observations are not financial advice, but rather an expression of interest in the continued evolution and potential renaissance of the DeFi space.
Will the collapse of FTX push institutions towards on-chain trading or on-chain perpetual contracts?
The collapse of FTX is likely to accelerate the transition of institutions to on-chain trading and the use of on-chain perpetual contracts. While liquidity remains a concern, with centralized exchanges like Binance significantly ahead of decentralized platforms like dYdX in terms of liquidity, the gap is closing. Predictions that there may be days over the next year when DeFi trading volume exceeds the trading volume of centralized exchanges (CEX), underscoring the growing confidence in self-custody and the security advantages of holding your own keys.
Institutions are increasingly participating in DeFi, especially on second-layer solutions like Arbitrum, which has seen a lot of institutional activity. This trend is expected to continue as infrastructure develops to support more efficient and cost-effective on-chain activities.
New developments such as Eigenlayer and platforms like Dymension offer the potential to quickly deploy 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 the 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 last cycle revealed some limitations, such as the necessity to trade derivatives on the first layer or subsidized and centralized order books. However, the current wave of infrastructure development promises decentralized alternatives that can match or exceed the performance and user experience of centralized platforms.
This evolving landscape shows that a significant shift toward DeFi is occurring due to innovations that reduce costs, enhance security, and improve user experience, making on-chain trading and perpetual contracts more accessible to a wider range of market participants, including institutions. Attractive.
How do institutions feel about liquidity fragmentation?
When it comes to dealing with liquidity fragmentation, institutions often prefer a modular approach to a single architecture. This preference stems from a background where financial systems have historically been 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 constantly bridging assets across different environments may pose challenges, infrastructure advancements that make these processes more efficient are shifting preferences toward more modular financial ecosystems.
A modular approach is seen as more resilient, allowing parts of the system, such as the second or third tier, to experience issues without affecting the integrity of the core layer, which is typically where most capital is stored. This resilience is an important factor in favoring a modular setup, as it ensures that the wider system can run smoothly despite local disruptions.
However, there is also a recognition that this preference may evolve as the DeFi ecosystem grows and comes under greater pressure. One potential future concern is that if a certain second layer exceeds the liquidity of the Ethereum mainnet, it could pose new challenges to the modularity argument. Although 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 a modular approach is currently preferred due to its resilience and ability to easily integrate different parts of the DeFi ecosystem, continued developments and the dynamic nature of the market may impact institutions’ views on liquidity fragmentation and infrastructure design. Future Views.
What are the biggest risks currently preventing institutions from entering DeFi?
Based on discussions with traditional finance professionals outside the crypto space, the main barriers preventing institutions from entering DeFi revolve around the learning curve and the perceived novelty and risk of the space. The approval and launch of the Bitcoin ETF played an important role in legitimizing the cryptocurrency in the eyes of the traditional financial community, with some viewing such regulatory milestones as the “legalization” of Bitcoin, even though Bitcoin was not previously illegal. This marks a step towards overcoming the taboo surrounding cryptocurrencies and blockchain technology.
However, the process of familiarity and acceptance is gradual, and younger generations within banks and financial institutions are likely to drive the shift toward blockchain acceptance as they understand and appreciate the technology’s potential to streamline operations and reduce intermediation costs.
The hesitancy of traditional institutions to dive deeper into DeFi is not necessarily due to a direct assessment of its risks, but rather due to a lack of in-depth assessment and an inherent conservative attitude towards new financial technologies. While some banks, such as JPMorgan Chase, have shown both a critical and engaged stance on blockchain initiatives, not all traditional financial institutions will embrace cryptocurrencies. Skepticism about new technology is not unusual, and the crypto industry may not need widespread adoption by traditional banks to thrive.
Rather, the current growth and evolution of crypto-native institutions that are better able to understand and leverage blockchain technology hints at a future in which these entities may compete with or even surpass traditional financial giants. This view is consistent with historical patterns in which innovative startups eventually overtake established industry giants as the technology landscape and market preferences evolve. Optimism about DeFi, therefore, lies in its potential to facilitate the rise of new financial powers that could redefine the industry.
