The following is a guest post from Daniel Bulaevsky, partner and General Counsel at Klaros Group.
Decentralized finance (DeFi) soared in 2021. The total value locked in DeFi protocols, measured as the aggregate amount of digital assets locked across all DeFi smart contracts, grew roughly 13 times, reaching an all-time high of $260 billion.
But virtually all that activity supported digital asset price speculation rather than real-world use cases. If DeFi is to realize the promise of better financial services, crypto companies building on top of DeFi must first connect to the traditional financial system.
In other words, crypto companies will determine DeFi’s future, and most are not yet ready to play.
There are many reasons to want DeFi to win. DeFi could increase global access to financial services, enabling users to lend, borrow and exchange assets quickly through automated protocols without much of the burdensome intermediation of the current financial system. And DeFi may offer better investment returns than traditional finance.
To date, yields across DeFi protocols have significantly outperformed yields from regulated depository institutions and treasuries (although one might expect yields to converge over time as the risks inherent in those protocols lessen).
DeFi will lose in a vacuum
But DeFi will lose in a vacuum. Although specific layers of the DeFi tech stack (like settlement, asset, and protocol layers) are decentralized, others must plug into the traditional financial system.
Indeed, many crypto companies are building products that seek to connect DeFi and traditional finance, using the aptly coined “DeFi mullet” strategy — fintech in the front, DeFi in the back —to increase adoption with regular consumers.
These products require integration with activities reserved for traditional financial institutions, such as fiat on- and off-ramps, trust accounts, secured loans, retirement vehicles, and access to specific payment systems, among others.
To integrate, crypto companies must either engage with those institutions (e.g., banks, institutional investors, investment advisors, rating agencies, etc.) or subject themselves to direct regulation.
Crypto companies that choose to engage with traditional financial institutions will need to meet the institutions’ risk management and compliance expectations driven partly by the institutions’ regulatory obligations.
This is no simple task.
Regulators’ expectations
Regulated financial institutions will, to different degrees depending on the context of the engagement, expect their crypto partners to have:
- Clear and comprehensive business plans explaining their products, customers and markets.
- Financial statements that demonstrate sustainable capacity to meet current and projected financial obligations.
- Strong management teams with solid reputations, relevant experience and clear visions for strategic success.
- Robust risk and compliance programs, along with supporting policies and procedures, likely including comprehensive:
- Risk assessments, identifying key risks and controls, which clearly explain the risks of the products offered and 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 consumer protections for payments, lending and other products.
- Reliable technology systems and information security protocols aligned to best practices and industry standards, which may include third-party audits and plans for navigating business disruptions and recovering from disasters.
Crypto companies building on top of DeFi that cannot meet these expectations are unlikely to survive.
In contrast, those that invest now inexperienced executives and robust risk management, compliance, and security practices will score big dividends, both operationally and competitively.
Put simply, traditional financial institutions and their regulators think and speak in terms of risk, compliance, and security, and they want to see crypto companies that can do the same.
As crypto companies building on top of DeFi prepare to join with those institutions and their regulators, the time to suit up is now (even if over T-shirts with rainbows and unicorns).
