Ddecentralized finance (DeFi) skyrocketed in 2021. The total value locked in DeFi protocols, measured as the total amount of digital assets locked across all DeFi smart contracts, increased approximately 13x over the course of the year. year, hitting a record high of $260 billion.
But virtually all of this activity has supported speculation on the prices of digital assets rather than actual use cases. If DeFi is to fulfill the promise of better financial services, crypto companies that rely on DeFi must first connect to the traditional financial system.
In other words, crypto companies will determine the future of DeFi themselves, and most are not yet ready to play.
There are plenty of reasons to want DeFi to win. DeFi could increase global access to financial services, allowing users to quickly lend, borrow, and trade assets through automated protocols without much of the cumbersome intermediation of the current financial system. And DeFi can offer better returns than traditional finance. To date, returns from DeFi protocols have significantly exceeded returns from depository institutions and regulated treasuries (although returns can be expected to converge over time as the risks inherent in these protocols decrease).
But DeFi will lose in a vacuum. While some layers of the DeFi technology stack (like the settlement, asset, and protocol layers) are decentralized, others need to connect to the traditional financial system. Indeed, a growing number of crypto firms are creating products that seek to connect DeFi and traditional finance, using the aptly coined “DeFi mule” strategy – fintech on the front, DeFi on the back – to grow adoption by regular consumers.
These products require integration with activities reserved for traditional financial institutions, such as fiduciary entry and exit routes, trust accounts, secured loans, retirement vehicles and access to certain payment systems, among others. To integrate, crypto companies must either engage with these institutions (e.g. banks, institutional investors, investment advisors, rating agencies, etc.) or submit to direct regulation.
Crypto companies that choose to engage with traditional financial institutions will need to meet the institutions’ risk management and compliance expectations, which are in part driven by the institutions’ regulatory obligations. It is not a simple task. Regulated financial institutions will expect, to varying degrees depending on the engagement context, that their crypto partners have:
- Clear and comprehensive business plans explaining their products, customers and markets.
- Financial statements that demonstrate a sustainable ability to meet current and anticipated financial obligations.
- Strong leadership teams with solid reputations, relevant experience and clear visions for strategic success.
- Strong risk management and compliance programs and supporting policies and procedures, likely including comprehensive elements:
- Risk assessments, identifying the main risks and controls, which clearly explain the risks of the products offered and the new technologies involved.
- Risk management and regulatory compliance policies and procedures reflecting the company’s unique risk exposures.
- Internal controls, including testing and monitoring, training, reporting, third-party risk management, and certain product-specific controls, such as know-your-customer (KYC), fraud controls, and privacy protection. consumers for payments, loans and other products.
- Reliable technology systems and information security protocols aligned with best practices and industry standards, which may include third-party audits and plans to manage business interruptions and recover from disasters.
Crypto companies that rely on DeFi and cannot meet these expectations are unlikely to survive. In contrast, those who invest now in experienced executives and strong risk management, compliance and security practices will reap big dividends, both operationally and competitively.
Simply put, traditional financial institutions and their regulators think and talk in terms of risk, compliance, and security, and they want to see crypto companies that can do the same. As crypto companies that rely on DeFi prepare to enter the field with these institutions and their regulators, with the highest stakes, now is the time to dress up (even if on T-shirts with rainbows and unicorns).
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.