DALI It’s Time to Explore Institutional DeFi

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.

Decentralized finance (DeFi), which uses blockchain-based smart contracts to execute a variety of financial services activities, has seized the attention of technology developers, investors, and financial institutions. DeFi protocols have already enabled nascent markets in the crypto-asset industry on public blockchains, such as borrowing and lending as well as decentralized exchanges. Imagine the potential if the technology were to be applied to streamline transactions in foreign exchange, equities, bonds, and other real-world assets. This will require the creation of digital representations, or tokens, of real-world assets to bring them onto the blockchain.

The basics of Institutional DeFiMature governance and conduct models

Distributed ledger technology (DLT), such as blockchain, has the potential to resolve some of those inefficiencies by presenting transactional and ownership information on a single shared ledger. The growing acceptance of tokenization, which creates digital representations of assets such as a stocks and bonds on a blockchain, can extend the benefits of DLT to enable exchange and settlement of a wide range of asset classes.

Institutions can generate further efficiency by adopting DeFi protocols, which use software code to automatically execute a range of financial transactions pursuant to present rules and conditions.

We define Institutional DeFi as the application of DeFi protocols to tokenized real-world assets, combined with appropriate safeguards to ensure financial integrity, regulatory compliance, and customer protection. (It is important to note that in this joint paper we do not refer to Institutional DeFi as institutional players participating in crypto DeFi.) The prize for innovators who hone this model for use in the world’s trillion-dollar finance industry could be substantial.

To create viable Institutional DeFi solutions that fit their purpose and ambitions, we believe financial institutions need to make several key design choices to implement appropriate safeguards and drive innovation.

These design choices will influence everything from the level of privacy and efficiency in transactions to the pace of user adoption and the extent of interoperability with other tokenized assets. Learn more from Exhibit 4: The Three Key Design Choices.

Given the transformative potential of Institutional DeFi, financial institutions need to develop a playbook (refer to Play Book for Financial Institution) for getting the most value out of it. Institutional DeFi will likely vary by jurisdiction and market structure.

Financial services are built on trust and empowered by information. This trust rests on financial intermediaries who maintain the integrity of records covering ownership, liabilities, conditions, and covenants, among other areas, across a variety of siloed ledgers that are separate from the means they use to communicate. As each intermediary has a different piece of the puzzle, the system requires much post-transaction coordination to reconcile the various ledgers and settle transactions. For example, many securities transactions, particularly cross-border ones, can take anywhere from one to four days to settle.

Technology continually evolves and modernizes financial services by creating new ways of executing and recording transactions. Each step in this evolution brings new business opportunities. For example, dematerialization replaced paper certificates with digital ones in the form of electronic book-entries, fostering the rise of electronic payments and trading. That, in turn, made securitization possible, which added value to previously illiquid assets such as mortgages.

In the process of adopting blockchain technology, financial firms are exploring representing real-world assets as tokens on a blockchain. Such tokenization can reduce settlement risk and decrease settlement times, which typically takes one to two days even for low-risk assets such as G10 government bonds, by enabling so-called “atomic” settlement – the instant exchange of two assets on the condition that assets are simultaneously transferred. No party to a transaction is then left waiting for delivery.

The application of smart contracts in asset tokenization also has delivered a number of benefits, including enhanced and new offerings. For example, J.P. Morgan leverages tokenization to offer intra-day repo solutions for clients on its Onyx Digital Assets platform, and DBS Digital Exchange offers corporates a platform to raise capital through the digitization of their securities and assets, with options to offer smaller denominations.

These tokenization benefits are also welcomed by asset managers, as 70% of institutional investors expressed willingness to pay extra for increased liquidity and faster asset turnover, according to a recent survey conducted by Celent.

Tokenization efforts in the industry are well under way covering both payment instruments and assets, which creates the potential for end-to-end asset exchange on blockchain.

Tokenized assets are growing as multiple pilots have validated their feasibility and value

91%

Of institutional investors are interested in investing in tokenized assets, according to a 2022 Celent survey

Tokenized payment instruments are gaining scale through public- and private-sector efforts

88%

Of global institutional investors are comfortable with digital representations of cash using blockchain-based technology, according to a 2022 Celent survey

Some noteworthy innovations in the DeFi space involve crypto lending/borrowing protocols and decentralized exchanges:

Liquidity pools, for instance, create all-to-all markets. These pools link buyers and sellers along with liquidity providers in decentralized exchanges, or DEXes, and lenders and borrowers in lending protocols. Aave and Compound are examples of large crypto lending and borrowing protocols in terms of total value locked,17 whose operations involve liquidity pools. Both retail and institutional investors can deposit, borrow, or trade crypto from the pool using business logic that is governed by smart contracts. If pools are on the same chain or made interoperable, this aggregates liquidity by attracting more investors.
Automated market markers (AMM) provide a new method of price discovery. An AMM facilitates buy and sell orders in a selfexecuting manner, always standing ready to provide quotes and setting a price based on a predefined, transparent formula considering supply and demand. Uniswap and Curve are examples of a decentralized crypto exchange that uses an AMM. When a user wants to swap crypto A for crypto B, the AMM automatically calculates how much crypto B the user can get and at what price rather than relying on a market maker to quote a price or to match a buyer and a seller.

Here are some of the key safeguards needed to build DeFi-based solutions for institutions:

AML/KYC risk controls

Mechanisms that ensure AML/KYC compliance for participants can avert the potential legal liability of dealing with sanctioned parties or unqualified investors, and also prevent inadvertently enabling or participating in money laundering. Designing appropriate risk controls however are not easy.

In 2021, financial institutions were fined $2.7 billion for their deficiencies and failures in AML compliance policies, procedures, and processes. To avoid the severe consequences that could arise from control failures, the average mid-size to large organization spends $22.7 million annually on financial crime compliance operations to build up effective standards. Appropriate controls are needed if regulated financial activity is to take place through DeFi protocols, and regulators have begun to set expectations.

In August 2022, the U.S. Department of the Treasury’s Office of Foreign Assets Control ( OFAC) imposed sanctions on Tornado Cash, a cryptocurrency mixer that facilitates anonymous transactions by obfuscating their origin, destination, and counterparties, alleging that it had facilitated the laundering of more than $7 billion worth of cryptocurrency.

Blockchain technologies may offer novel ways of ensuring appropriate controls at lower cost. For example, there are methods for ensuring compliance with AML/KYC without necessarily revealing one’s personal information, such as using zero-knowledge proofs combined with pseudonymous identity mechanisms.

Data privacy

Data privacy is crucial for clients in certain segments, in particular to protect their trading history and positions for certain asset markets. Information on public blockchains is permanently visible to all by default, and investor orders can at times be inferred from publicly available data, something that becomes increasingly more likely as time goes on and data is accumulated.

For example, whale tracking tools on Twitter and Telegram are widely used by the public to track large crypto-asset transactions done via decentralized exchanges and other DeFi protocols, whereby people have strong assumptions or hypotheses on who these whales (investors holding a vast number of crypto-assets). In the finance industry, client information in respective transactions is masked and protected through brokers, without being revealed to the market. Appropriate privacy protections will be necessary.

Cybersecurity protections

While almost anything digital can be vulnerable to hackers, cybersecurity protections are especially important for digital assets and DeFi protocols due to the nature of blockchain. Although the underlying blockchain technology makes it difficult to alter data, firms seeking to develop Institutional DeFi solutions must address cybersecurity vulnerabilities in cross-chain bridges, private digital keys, and on-chain price oracles, as well as guarding against market manipulation.

Such controls are needed to enhance client trust and protect the safe ownership of digital assets. A rise in thefts from DeFi protocols led to a 58% increase in crypto hacking losses, to $1.9 billion, in the first seven months of 2022.22 Bridges connecting different networks are particularly vulnerable, as hackers demonstrated in July 2021 by attacking the cross-chain DeFi platform Poly Network, and causing roughly $600 million in losses in Ethereum and other tokens.

Users manage their own private keys to access their crypto assets, which can also compromise security. Losses due to compromised private keys have totaled $274 million in the first eight months of 2022 alone.

Mature governance and conduct models

Reliable DeFi protocol governance and stakeholder conduct standards are needed to ensure that the quality of Institutional DeFi solutions offered are in alignment with financial services professional standards. Financial institutions are highly regulated with mature quality assurance processes.

For example, there are more than nine different federal financial regulators in the United States on top of multiple regulators in each of the 50 states.25 Multilateral organizations help coordinate financial regulation internationally. Banks invest over $270 billion a year and dedicate an average of 10% to 15% of their staff to comply with regulatory obligations. 26 Standards for conduct exist for both institutions and individuals. Existing DeFi protocols are based on different governance and conduct assurance mechanisms, most often done through governance tokens that bestow holders with voting rights. This is similar to most common equity structures but without the same level of corporate governance.

Also, many DeFi protocols have a very high concentration of voting control: Research by Chainalysis into 10 major governance tokens found that fewer than 1% of token holders held 90% of the voting rights.27 Indeed, participants could consider whether to and how to cover DeFi protocols under a corporation construct – such as trusts, special purpose vehicles, or other limited purpose corporations – to allow for structured governance and liability recourse.

Proper recourse mechanisms

Recourse and dispute management should be properly established upfront. Incidents such as theft or loss due to operational errors can occur in any financial system.

The finance industry today is built with robust recourse mechanisms or legal remedies to protect users and investors in most cases. For instance, the London Court of International Arbitration, one of the world’s leading arbitral institutions, managed 86 international dispute cases from the banking and finance industry in 2021. Such mechanisms are lacking in public DeFi solutions, giving rise to uncertainty in arbitration procedures.

When a hacker stole $130 million in crypto assets from users of DeFi platform BadgerDAO, they were unable to afford full restitution immediately with a mere $53 million in their treasury and no insurance coverage. Without an available legal recourse mechanism, this left a handful of affected users uncompensated.

Legal clarity around smart contract based business activity

The legal status of financial business activity has been continuously clarified by countless acts of legislation and major litigation efforts over past decades. The UK High Court, for example, typically hears 80 to 100 important banking and finance cases annually. That level of clarity does not yet exist for smart contract-based DeFi activity.

According to international law firm Norton Rose Fulbright, it remains unclear which smart contracts are legally enforceable, which could depend on the intentions of contracting parties or local jurisdictions. In the United States, the enforceability and interpretation of contracts in the United States is commonly governed by state law. Some states such as Arizona and Nevada have amended their respective laws (such as the Uniform Electronic Transactions Act) to explicitly incorporate blockchains and smart contracts. Some code-only smart contracts would be enforceable under state laws governing contracts.

The International Swaps and Derivatives Association (ISDA) also developed legal guidelines for smart derivatives contracts to provide general guidance for different jurisdictions.33 More legal clarity in commercial law is necessary to reinforce these requirements and foster a trusted environment for smart contractbased business.

Now is the time to actively explore Institutional DeFi

The foundation for Institutional DeFi is being established by the growth of real-world asset tokenization and the innovations observed in DeFi. Financial institutions have the opportunity to transform parts of their business by adapting DeFi protocols and combining them with the level of safeguards that regulators and clients expect. Institutional investors’ appetite for digital assets is growing and they are willing to pay extra for increased liquidity and faster transactions. 88% said they are still planning to move forward with current plans around digital assets despite market downturn.

While Institutional DeFi has potential, financial institutions need to consider areas where tokenization and programmability are most valuable, and tailor DeFi protocols for their purposes accordingly instead of simply reusing what works in the cryptoasset industry.

Institutions interested in exploring Institutional DeFi solutions should start by asking themselves, “why DeFi?” The answer will depend on the commercial viability, adoption feasibility, and competitive advantage of such a solution. Objectives could range from creating new products and reducing data reconciliation tasks, to cutting costs and speeding up settlement times.

Firms also need to consider a number of broader objectives when designing Institutional DeFi solutions. These should include:

Ecosystem objectives, such as encouraging widespread adoption by providing seamless interconnectivity to and compatibility with existing trading systems, preparing for interactions with upcoming CBDC frameworks, and fostering an open innovation environment that encourages the development of market-driven solutions.
Protection objectives, such as ensuring compliance with the existing legal and regulatory frameworks, allowing access to only qualified users, and mitigating various financial and operational risks, including cybersecurity risks.

After firms have established their objectives, they need to make choices in three key areas: Blockchain, Participation and Token Design. It is critical that firms weigh the options and their associated trade-offs carefully, as these design choices are paramount in influencing how the offerings achieve their objectives.

Blockchain – Which underlying network to build on and what information is visible to whom

Exhibit 5: The Three Key Design Choices - Blockchain

Source: Oliver Wyman Forum, DBS, Onyx by J.P. Morgan, SBI Digital Asset Holdings

Network type – Network type refers to the underlying network and database used to deploy an Institutional DeFi solution with asset tokens.
Data security and visibility – This informs the level of data transparency of the solution, and its implied level of data security. Data transparency is itself a multifaceted concept and the choices vary along a spectrum. On one end of the spectrum, all transaction data is transparent and available for all participants to view, as is common with many public blockchains today. On the other end of the spectrum, participants may access only data relating to their own transactions. Function-level access management can provide different levels of access to users, while encrypting data and providing a viewing key to selected participants can enable authorized viewership. Moreover, different techniques, such as zero-knowledge proofs (ZKP) and ensuring DeFi protocol uses only private messages, can be implemented for data privacy on public blockchains.

Participation – The mechanisms that determine who can develop and access solutions

Exhibit 6: The Three Key Design Choices - Participation

Source: Oliver Wyman Forum, DBS, Onyx by J.P. Morgan, SBI Digital Asset Holdings

Deployment – This choice governs how new smart contracts and protocols are developed and deployed, and embodies different approaches to innovation and risk. On one end of the spectrum, in a fully open model, anyone can develop and deploy smart contracts. This lowers barriers for application development and encourages competition, but it also entails risk as there are fewer checks and balances before protocols are deployed. This is not to say that assurance standards are not used. For example, some DeFi protocols today make use of code audits. But such standards are not mandated nor instituted for deployment.
Access and usage – This design choice relates to how controls are put in place to manage user access and usage. Restrictions can be imposed at the service level (such as by controlling who can access a liquidity pool) or at the level of underlying functions (for example, by controlling trading permissions, such as instrument types and ticket size).

Token Design – How tokens are issued, transacted, settled, and standardized

Exhibit 7: The Three Key Design Choices - Token Design

Source: Oliver Wyman Forum, DBS, Onyx by J.P. Morgan, SBI Digital Asset Holdings

Token issuance – Non-native tokens are issued to represent existing real-world assets. These non-native tokens are bound to existing off-chain processes and control mechanisms, such as custody and reconciliation. For example, on the Onyx Digital Assets platform, securities accounts holding US Treasuries maintained by J.P. Morgan for the benefit of its clients are tokenized to enable intraday repo transactions. On the other hand, real world assets can be issued directly on a blockchain as native tokens, such as through security token offerings (STO). It is worth noting that asset tokenization is rapidly evolving, and there may be more ways to issue tokens in the future.
Settlement recognition – Settlement recognition depends on whether or not a token transfer on-chain is recognized by law, regulation, or contractual arrangement as a final transfer. This is a notable issue for consideration in respect of non-native tokens, where additional steps may be required to be taken with respect to the off-chain asset being represented. However, as noted above in respect of CSD registration requirements, this issue may arise due to regulation in respect of native tokens as well. Off-chain settlement is when a token transfer is not recognized as a transfer of the underlying asset. In this case, settlement finality is recognized off-chain, in which an off-chain ledger is updated to reflect ownership change. On-chain settlement is when settlement finality is recognized on-chain, whereby the on-chain ledger is recognized as the single source of truth for transfer and ownership.
Token standards – Token standards are the set of principles on which tokens are issued and smart contracts are developed. These standards influence the ability to interact with different DeFi protocols, and hence the interoperability and functionality, of the asset tokens. Different public standards might be appropriate depending on the type of token to be issued. For example, the ERC-721 standard is designed for non-fungible tokens (NFTs) while ERC1155 is suitable for both fungible and nonfungible tokens and can be explored for tokenized assets.

There is no one-size-fits-all Institutional DeFi solution

Design choices for Institutional DeFi solutions need to be tailored for specific, prioritized business objectives. However, a specific design choice may help achieve one business objective while imposing limitations on another. As such, the task for any firm considering an Institutional DeFi solution is to choose a complementary set of options within each design choice to address its business objectives, taking into account asset classes, jurisdictions, and the target value proposition.

Experimentation is crucial to understanding different approaches to Institutional DeFi. Finance industry participants around the world are increasingly conducting pilots and experiments to explore different design objectives and choices.

Project Guardian is designed to help MAS build a digital asset ecosystem framework, develop and enhance relevant policies, and provide direction on technology standards. Project Guardian will test the feasibility of applications in asset tokenization and DeFi, while managing risks to financial stability and integrity. The central bank aims to develop and pilot use cases in four main areas:

Open, interoperable networks

Explore the use of public blockchains to build open, interoperable networks that enable digital assets to be traded across platforms and liquidity pools. This includes interoperability with existing financial infrastructure. Open, interoperable networks can mitigate against the formation of walled gardens in digital exchanges and fragmented private markets.

Trust anchors

Establish a trusted environment for the execution of DeFi protocols through a common trust layer of independent trust anchors. Trust anchors are regulated financial institutions that screen, verify, and issue Verifiable Credentials to entities that wish to participate in DeFi protocols. This ensures that participants interact only with verified counterparties, issuers, and protocol developers.

Asset tokenization

Examine the representation of securities in the form of digital bearer assets and the use of tokenized deposits issued by deposittaking institutions on public blockchains. The project aims to build upon existing token standards, incorporate trust anchor credentials, and enable asset-backed tokens to be interoperable with other digital assets used in DeFi protocols on open networks.

Institutional-grade DeFi protocols

Study the introduction of regulatory safeguards and controls into DeFi protocols to mitigate against market manipulation and operational risk. The project will also examine the use of smart contract auditing capabilities to detect code vulnerabilities.

In the first pilot, our co-authors gained first-hand experience in implementing DeFi solutions in the financial markets, including foreign exchange and government bond markets. This section details the pilot’s business objectives, design choices, and the lessons learned to date.

Business Objectives: What did we set out to achieve?

Pilot One was led by co-authors DBS, Onyx by J.P. Morgan, and SBI Digital Asset Holdings. It sought to determine whether tokenized real-world assets and deposits could be transacted on a public blockchain leveraging DeFi protocols, in a compliant manner that preserves financial stability and integrity. The intent was to explore the delivery of traditional financial services in a more open manner, fostering broader participation in foreign exchange and government bond markets through an open and efficient ecosystem that attracts liquidity providers and liquidity takers.

We illustrate the design choices made under the four focus areas:

Exhibit 9: Guardian Pilot Setup

Source: Oliver Wyman Forum, DBS, Onyx by J.P. Morgan, SBI Digital Asset Holdings

A public blockchain, Polygon was selected for its potential to allow higher interoperability of tokenized real-world assets and DeFi protocols, which allowed participants to develop their own solutions based on a set of agreed upon technical standards.
Trust anchors were developed to ensure all trades were conducted within a controlled, trusted environment. W3C Verifiable Credentials issued by trusted financial institutions were used to enable compliant access to the DeFi protocols. Verifiable Credentials consisted of tamperresistant information (identifiers and metadata) that cryptographically attested to the identity of the entity/person using them. These credentials were developed using W3C standards to reinforce Project Guardian’s interoperability objective.
The pilot leveraged tokenized assets created by the co-authors across two workstreams. In workstream one, Onyx by J.P. Morgan focused on tokenized Singapore dollar (SGD) deposits and SBI Digital Asset Holdings focused on tokenized Japanese Yen (JPY) assets. In workstream two, DBS focused on tokenized SGD deposits and tokenized Singapore Government Securities (SGS), and SBI Digital Asset Holdings focused on tokenized JPY deposits and tokenized Japanese Government Bonds (JGB). Our co-authors played unique roles to complete bilateral trades within these workstreams.
Participants used modified public DeFi protocols to conduct the transactions – a lending and borrowing protocol (Aave) was applied to a foreign exchange use case in workstream one, and a decentralized exchange protocol (Uniswap) was applied to the trading of foreign exchange and government bonds.

Design Choices: What did we do to make DeFi work?

Among multiple design aspects, our coauthors believe at least two were critical:

A trusted compliant method – Trust anchors and Verifiable Credentials were used to authenticate identity and connect with existing legal frameworks. Trust anchors were regulated financial institutions that verified and issued Verifiable Credentials to participating traders, enabling them to transact on the public blockchain. The trust anchors can be viewed as the universal trust layer, providing participants with a compliant gateway to the Institutional DeFi solution.
The implementation of the trust anchor mechanism was flexible and couldvary across institutions. For example, authorized traders were issued credentials by their parent institutions, through various internal processes and credential issuing software. These credentials were attached to trade instructions to the DeFi pool, and on-chain verification of these credentials ensured that only instructions with legitimate credentials were forwarded to the DeFi pool.
Alignment on technical standards – Standards such as ERC-20 and W3C were used to allow potential interoperability among pilot participants.The participants aligned on technical standards to allow interoperability between specific DeFi protocols and existing legacy off-chain systems.Interoperability also drove the choice towards the use of ERC-20, the mostcommon token standard in the Ethereum ecosystem, to define token ownership, supply, type of issuance, and data to be stored on-chain, such as the token name and ticker.
Moving forward, there may be other standards such as ERC-1155 that could better represent traditional instruments on-chain and for trading. The Verifiable Credentials were developed based on W3C standards to enable participants to transact in a compliant manner on a modified version of the permissioned Aave protocol on the Polygon network.

Exhibit 10: Summary of Project Guardian Design Choices

Lessons Learned to date: What needs to be done to reach scale?

Scaling the solution to benefit global financial markets will require more work. From experience with Pilot One to date, our co-authors have jointly identified seven areas that would need broader industry efforts to build the scalable foundation for Institutional DeFi offerings.

#1 Legal clarity on frameworks
Participants need to actively identify areas that need clarity within the prevailing legal and regulatory framework and engage with regulators and legislatures to drive regulatory and legislative solutions that account for this new financial environment enabled by the new technology. These efforts should address issues such as recourse mechanism, on-chain settlement treatment, KYC and AML, usage and holding of crypto-assets, and legal and accounting treatment of business activities:

Recourse mechanism – Existing legal recourse and dispute management processes may be insufficient to address potential disputes in a blockchain environment in the absence of separate contractual arrangement, especially for issues currently handled by an intermediary or agent. For example, crypto bridge Nomad alerted law enforcement about a loss from a cyberattack, but there was limited recourse as authorities could not retrieve the funds, and Nomad had to bear a $200 million loss.38 Pilot One utilizes bilateral agreements to resolve potential legal disputes and address this issue. A multilateral framework and pre-defined participation rulebooks could reduce legal complexity among more participants.
On-chain settlement treatment – Token based trading and settlement require enhanced forms of record keeping and synchronization across on- and off-chain ledgers. For example, transactions were recorded (manually) in Pilot One on an off-chain legacy system for reporting and auditing purposes. Clear guidelines are needed to clarify roles of on-chain and off-chain operations, such as accounting and redemption processes, to comply with regulations and controls.
KYC and AML – Further regulatory guidance is needed with regards to dealings with KYC, AML, and sanction issues for on-chain financial transactions, given the pseudonymous nature of existing DeFi protocols. Pilot One’s Verifiable Credentials-based identity solution serves as an example of how to ensure each counterparty is a permissioned and trusted entity. The pilot established that trust mechanisms can be universally accepted despite being implemented in different ways as long as they adhere to a common fundamental standard.
Usage and holding of crypto-assets – Different regulators have imposed different restrictions on financial institutions with regards to holding crypto-assets, which are needed to pay for verification/processing of the transactions (gas fees) on public blockchain networks. Regulation will play a key role in reducing this friction.
Legal and accounting treatment of business activities – It is currently uncertain how to classify certain transactions that use DeFi protocols when there is an interaction with a common asset pool. For example, it is currently ambiguous, from accounting and legal perspectives, when and how to classify contributions into liquidity pools, as the transaction may be treated as a sale, an investment in a fund, or not recognized until a trader trades the asset against the pool. While Pilot One mitigated this ambiguity via bilateral agreements, clarity on accounting and legal recognition will be required at a broader level to achieve scale.

#2 Adoption incentives
In addition to the efficiency gains of Institutional DeFi solutions, appropriate incentive mechanisms could encourage scalable adoption. Novel tokenomics arrangements in the crypto-asset industry, which enable liquidity providers and developers to earn tokens as participation rewards, might not apply readily in mainstream finance. Targeted incentives will be needed to encourage adoption and such incentives are likely to differ across various stakeholders and participants. Further iteration is required as the Institutional DeFi space is at a very early stage of development.

#3 Guardrails or tools
To ensure transactions happen in a safe and trusted manner, preserve transaction privacy, and provide security assurance against potential hacks, more tools are needed to streamline DeFi protocol development and improve the integration experience to drive usage. Pilot One participants engaged with third-party auditing services to conduct complete smart contract audits prior to deployment.
Participants also used Verifiable Credentials to establish a strong framework for instituting trusted identities and the accompanying qualifications to ‘permission’ the participation in the DeFi liquidity pools. Nonetheless, more can be done to facilitate industry adoption, such as establishing an industry-recognized smart contract standard for interoperability.
Other feasible actions include formalizing how Verifiable Credentials and similar solutions can be leveraged, limiting a trader’s access to company funds/assets, protecting against concepts such as maximal extractable value (MEV), and lowering the threshold for developers to deploy and participants to use Institutional DeFi solutions.

#4 End-to-end co-ordination
Orchestration between legacy systems and blockchain-based assets and business logic is required to enable process and data interoperability. Participants need to explore Institutional DeFi in a comprehensive manner, involving all relevant business lines and evaluating and updating existing processes to capture/realize the potential benefits. For example, as transaction data is recorded on a mutualized public ledger, workflows can be adapted to refer to the ledger instead of legacy systems for faster reconciliation. At a broad level, programmable smart contracts could enable a high degree of automation, transparency, and efficiency in financial transactions.

#5 Continuous test-and-learn and improvements
Modifying DeFi protocols to force-fit them for institutional use is a test-and-learn process. DeFi protocols are designed to ensure that key market metrics, such as interest rates, collateral haircuts, and the like, follow supply and demand dynamics of the assets trading within them. For Pilot One, some of these codified rules had to be tailored to force-fit the business objective, such as altering interest rates of the lending protocol to zero, to avoid unintended behavior during transactions.

#6 Alignment on industry-wide technical standards
Standardized, well-adopted frameworks lay a strong interoperability foundation on which DeFi applications could be built and interact. Furthermore, seeking and collaborating with l ike-minded participants – and moving from proofs of concept to production – are critical in creating such a foundation. The value of this approach was demonstrated by Pilot One’s rapid solution development by leveraging an Ethereum-compatible public blockchain, ERC token standards with W3C Verifiable Credentials standards, and open-source DeFi protocols.

#7 Refined business models
The pilot demonstrated that DeFi protocols can unlock benefits associated with tokenized asset transactions. A key valueadd of using DeFi protocols is the ability to codify core and non-core functions within financial services. The use of blockchain as the book of records allows for potential minimization of post-trade reconciliations between participants, thereby reducing operational overhead. Other potential benefits include greater transaction transparency, lower settlement risk, as well as enhanced efficiency and trading velocity due to atomic settlement. Nonetheless, the use of DeFi could lead to alteration of exiting business operations, requiring participants to refine business and operational models to capture the incremental business value.

Institutional DeFi is feasible, but work is needed to drive adoption at scale

While Pilot One demonstrates the feasibility of Institutional DeFi solutions when paired with tokenized assets, more work is needed to drive adoption and scale. Drawing on the seven lessons learned, we believe the industry should focus its collaborative efforts in three areas: a) addressing legal and regulatory uncertainties, b) establishing shared standards, and c) envisioning a target market structure.

We are seeing emerging efforts to tap into the value of Institutional DeFi and transform the finance industry by creating new solutions or enhancing existing ones. This process is still in its early days and more work is needed by both individual firms and the broader industry to scale these efforts.

Drawing on lessons learned from industry pilots, we see three areas where industry could work together (see exhibit 11). Coordination is essential for widespread adoption of Institutional DeFi. Siloed efforts create the risk of inconsistencies across the industry, potentially stymieing progress and porting existing challenges to this new technology; joint efforts maximize network effects via interoperability and are likely to accelerate adoption.

Industry participants will play different roles toward these ends. We will share perspectives of a general industry framework for roles and responsibilities but be mindful that each business and jurisdiction may require refinement based on its localized specificities.

The rapid evolution of blockchain technology and the potential disruption it can bring requires institutions to get ahead of the curve to avoid being left behind. This is not meant to suggest every institution needs to be a leader, but it does require institutions to form a house view on the future of DeFi and the implications for the business, and then define the relevant participation and operating models to fulfill on their ambitions. This is not a one-off exercise. It should be iterative given the dynamic nature of blockchain and DeFi protocols.

Part A: Develop a house view on DeFi

Institutional DeFi efforts are already happening and starting to bring change to the finance industry. The road ahead remains unclear, and the degree of change is likely to vary by business and market segment.

We see a spectrum of potential paradigms for the future of financial services, ranging from a modest evolution of existing market structures to a complete revolution that leaves DeFi triumphant. We already observe how both ends of the spectrum are driving change, with financial institutions starting to evolve and develop Institutional DeFi solutions while native DeFi players are looking to disrupt financial services with their decentralized solutions.

Exhibit 14: Potential Future Paradigms of Financial Services

Source: Oliver Wyman Forum, DBS, Onyx by J.P. Morgan, SBI Digital Asset Holdings

Change will likely be significant regardless of the paradigm that dominates, but the specific outcome will likely vary by market, jurisdiction, and business line depending on customer and regulatory acceptance. With all this uncertainty, it is important that industry participants take a scenario-based approach that enables them to examine multiple different potential futures while maintaining analytical discipline by requiring each scenario to use coherent and integrated assumptions. Based on these scenarios, firms could form a house view of the future and assess its implications for their business portfolios, profitability, funding costs, and the like. To get to that view, firms could consider three broad questions:

What are the future scenarios shaping the industry and key watch points or triggers?
What are the implications for our clients and competitors?
What does this mean for our portfolio and financials?

Once they form their view of the future, firms could perform an impact analysis to assess the specific implications on their current business and financials while agreeing on the key watch points to monitor to potentially accelerate or pivot their responses.

Depending on the scenarios used, regulatory developments, and the firm’s current position, implications could take on varying degrees of scale and urgency. Scenario analyses should aid senior management to align on a view of the future and implications for the business. Based on this, firms can then determine if, where, and how to participate, which we discuss next.

Exhibit 15: The Implications for Key Industry Sectors

Part B: Decide on a participation strategy

Where should a firm play in the Institutional DeFi space? This is a question firms will need to work through in defining their strategy. In doing this, firms should look not only to transform existing end-to-end processes with new technology but also think about creating new businesses and new business models. According to a 2022 Celent survey of global institutional investors, 72% showed a preference for working with an integrated provider for all digital asset needs, indicating the need for significant upgrades to current investment management systems.

As strategy is all about trade-offs, being clear on the right trade-offs is critical to aligning an institution and putting in place guardrails to ensure that where and how it participates is in line with its risk appetite and other internal considerations. To think through this, firms may want to consider several questions that can help them agree on a bespoke participation strategy.

Exhibit 16: Our Ambition For Institutional DeFi

#1 What is our ambition for Institutional DeFi?
Our co-authors set and share clear ambitions to evolve their business with new technologies over long-term time horizons.

DBS makes significant technology spending each year which includes experimentation of blockchain technology, as it prepares for a disrupted future where “blockchain will power world’s back office in five to 10 years
J.P. Morgan started its efforts in the blockchain and digital asset space in 2015, launched its blockchain focused business Onyx by J.P. Morgan in 2020, and is committed to investing further in the space as it plans to “bring trillions of dollars of assets into DeFi
SBI established its digital asset arm in 2018, set up its Capital Markets Services subsidiary in 2020, and plans to launch an institutional-grade digital asset securities platform

#2 Where and how will we participate?
#3 What will we not do?
Our co-authors continuously assess endtoend business flow to identify where DeFi logic could potentially fit in, whether that is in their non-core functions or core functions. Formulating a firm’s participation strategy requires an understanding of their clients’ starting point, including their DeFi IQ and willingness to use new technologies. Sell-side firms could guide clients through the adoption journey from a solution-driven perspective, which includes thoroughly understanding clients’ pain points, replicating traditional offerings in a new digital format, and building tooling to assist smooth adoption while also testing innovative new products, like intra-day liquidity, and new business models, such as automated market making.
The quality of the new offerings is critical to win the confidence from end-clients. Firms can consider taking gradual approaches to focus on products that are not overly complex and/or markets requiring efficiency improvement on day one, such as illiquid asset classes.

Our co-authors set and share clear ambitions to evolve their business with new technologies over long-term time horizons.

DBS offers end-to-end capabilities in the digital assets space. DBS Digital Exchange allows for listing and trading of both digital payment tokens, including crypto and security tokens such as DBS Digital Bond originated by DBS Capital Markets; DBS Digital Asset Custody provides an institutional-grade solution to safekeep digital assets; Partior (a joint venture with Onyx by J.P. Morgan and Temasek) enables atomic settlement of payment transactions
J.P. Morgan provides different products and infrastructure in the space, including intraday repo and tokenized collateral services on its Onyx Digital Assets platform, and blockchain-based deposit account products on the JPM Coin System, and continues to explore expanding to other asset types and the other blockchain environments, including public blockchain
SBI is actively involved in the space, launching efforts across numerous digital asset classes, including NFTs, Web3 tokens, and tokenized traditional securities, and providing infrastructure and tools, such as AsiaNext, their regulated digital asset exchange joint venture with Swiss Digital Exchange (SDX)

Each finance industry institution needs to tailor their participation strategy for specific markets, business, and clients.

Part C: Get the organization ready

There are a number of “make it happen” areas firms could consider as they work to fulfill their ambitions. In this section we focus on three areas of capabilities. The degree of effort in each requires clear alignment with a firm’s ambition:

Design organizational structure to
deliver on the ambition

The level of organizational support and engagement determines the feasibility of achieving such transformative opportunities. Each of our co-authors has opted for different operational set ups, with varying extents of centralization, such as focusing on one business unit only, or stretching across the entire business. SBI Holdings created a separate centralized entity, SBI Digital Asset Holdings; JP Morgan established Onyx by J.P. Morgan within the firm to engage on blockchain matters across the entirety of the firm’s businesses; DBS leverages an ecosystem approach to engage in blockchain initiatives across the organization and externally with industry partners. DBS established DBS Finnovation, a holding company which houses DBS Digital Exchange and Partior (a joint venture among DBS, Onyx by J.P. Morgan, and Temasek).

Choose the right delivery model given
internal capabilities, risk appetite

There are a number of factors to consider when determining the delivery approach, such as ensuring that proofs of concept are done with scaling in mind; working with likeminded partners to build, test, and evolve the proposition based on lessons learned; and taking a co-creative approach with clients and regulators, being clear on what is needed from regulators to make pilots a scalable reality. External collaborations would require due diligence to ensure suitability of partners and alignment on new solution.
Regarding ways of working with partners, there is no one size that fits all. We observe a few notable delivery approaches depending on a firm’s level of belief and participation strategy - in-house builds, use of vendors, or leveraging industry consortiums. For instance, Vanguard partnered with vendor Symbiont and its blockchain platform Assembly; BNY Mellon, Morgan Stanley, and UBS joined a consortium led by iCapital to leverage blockchain-based solutions; J.P. Morgan delivered its blockchain solutions through internal efforts spearheaded by its Onyx by J.P. Morgan unit and predecessor teams; DBS leverages a mixture of options such as tapping internal capabilities for the solutioning in this pilot while also engaging external vendors for some of the other initiatives.

Develop the right talent strategy to
build propositions

Building out these bespoke solutions requires a mix of talent, not just technologists. Our co-authors have built teams with professionals from a variety of backgrounds while at the same time working to right-skill their existing teams. The coauthors note that to attract the right talent, firms need to complement talent strategies with branding efforts to ensure they have a compelling “digital brand” aligned with their ambitions. At the same time, existing talent needs to be refreshed with internal “mindset change” efforts, such as training and incentive programs.
To help drive change, we also observe peers building specialist task forces. These teams play a role in driving proofs of concept and also act as a catalyst for reshaping the culture and right-skilling teams. The task forces tend to play various roles depending on a firm’s ambition. They also can work with relevant middle- and back-office teams to understand requirements and assess new solutions, such as digital identity solutions. They also can work with front-office teams to assess demands from clients and jointly determine whether new solutions are sufficiently valuable for clients. These task forces can be complemented by other efforts depending on a firm’s starting point, including driving firmwide education initiatives, running or supporting hackathons and other internal accelerators, and driving co-creation workshops to apply DeFi and identify challenges that need to be worked through.

Four effective moves for seizing Institutional DeFi opportunities

Focus on business impact and getting production-ready, instead of just running proofs of concept for the technological feasibility of employing blockchain, tokenization, or DeFi
Collaborate with like-minded peers and clients to advance solutions and set tokenization and DeFi standards for interoperability as the foundation of scaling and mass adoption
Assess improvement areas with multiple teams throughout the existing end-to-end business process, and innovation areas to build new businesses, rather than siloed efforts
Proactively work with regulators, sharing feedback and concrete asks based on first-hand findings to co-create environments that protect clients and financial stability.

Closing Remarks

The opportunity is here.
The time to build the future is now.

From the carrier pigeon to the telegraph, the transistor to the mainframe, technology has shaped the finance industry for generations. We believe Institutional DeFi has the potential to be the next great transformative force. It may be too early to predict the end-game scenario, but there are no-regret moves executives can take now to prepare their organization for future options. There is no single right answer, but an answer is needed at both the institution and industry level to move from debates and pilots to scalable, industrialized solutions. Given the challenges discussed in this paper, we expect first movers will have an advantage because they will learn how best to deploy the technology and create a talent environment that fosters innovation.

November 2, 2022

By Larissa de Lima, Jason Ekberg, Michael Ho and Teddy Hung

DALI It’s Time to Explore Institutional DeFi

Combining the power of decentralized finance with appropriate safeguards can unlock value for issuers, investors, and financial firms