Since the DeFi summer led to the 2020 bull market, everyone expected DeFi to move toward institutional development. Integration between TradiFi and DeFi has mainly occurred on the trading front, where centralized exchanges have become the intermediary for introducing cryptocurrency into TradiFi. Market makers and property funds began to carry out transfers and price arbitrage on centralized and decentralized platforms. To accommodate the flow of billions of dollars, these institutions began to finance key trading infrastructure projects. An example of such infrastructure is Pyth, where more than 70 institutional trading firms, such as Jump Crypto and DRW Cumberland, publish price information and improve market efficiency across different platforms. The addition of decentralized infrastructure in financial trading has allowed large flows of traders to enter the crypto markets.
Going beyond financial trading, we note that a second type of institutional capital is emerging in DeFi. These are private credit funds, which gained traction after the collapse of centralized lenders in May 2022. Prior to the liquidity crisis in May of this year, centralized credit bureaus issued a phenomenal amount of crypto loans. For example, Celsius, Genesis, and BlockFi together issued $45.6 billion in loans in the first quarter of 2022. Their main customers were institutional traders who were willing to pay 10%+ per annum for daily liquidity.
With the rapid decline in the use of these centralized structures, a liquidity shortage emerged in the market, and profitable cryptocurrency institutions turned to DeFi to solve this problem. The market saw the rise of Orthogonal Credit, M11 Credit, and Blocktower Credit, which are credit funds providing direct lending on platforms such as Maple Finance to market makers such as Wintermute, Auros, and Flow Traders, allowing them to borrow USDC at 8.5-10% and wETH at 5-6%.
Asset management products have also spread across the network, democratizing investment strategies that were historically only available to large institutional clients. Smart contracts and unique cryptocurrency non-linear strategies, such as DeFi Option Vaults (DOV), showed breakthrough volumes in 2021, with TVL peaking at $1 billion. Vaults such as Ribbon Finance, Friktion, Antimatter, and others provide a simple user interface that allows retail investors to earn premiums on vanilla options. Due to the underwriting of secured out-of-the-money calls and vanilla options, retail investors saw premiums for these options range from 20% to 40% returns at the time. These figures looked more attractive and reliable compared to yield farming with rewards. Based on this retail underwriting, institutional option market makers would buy all the option storage and sell it on exchanges such as Deribit, which at one point accounted for 90% of all crypto option flow. Currently, option storage has lower volumes for several reasons:
- Underlying crypto assets have experienced large drawdowns and may continue to experience large swings
- Yields have declined during periods of lower volatility in a bear market.
While DeFi volumes today depend on players whose well-being determines how active DeFi is, a more balanced ecosystem favors traders who can leverage the efficiency and transparency of this new idea. As the US Federal Reserve’s target rate rose from 3.75% to 4.00%, the DeFi spread (the difference between the DeFi borrowing rate and the US Treasury) changed to -1.2%. This raises questions about whether it makes sense to invest DeFi funds in USDC Compound pools, where yields are less than 2%. Where will DeFi funds go?
Given the above background and questions, this report will examine the current development of DeFi usage in the real world, the challenges that hinder such development, and the opportunities for integrating DeFi with TradiFi.
DeFi meets TradFi
The first phase of DeFi may have revolved around the flow of TradFi capital into DeFi, as well as how new capital is used to implement TradiFi functions in DeFi, including exchanges, trading, lending, derivatives, payments, etc. Until now, DeFi applications have been used primarily by crypto users. Unfortunately, due to the extended bear market, DeFi usage has declined amid subdued speculative activity. As a result, DeFi protocols have shifted their focus from retail investors to institutional investors and from crypto trading to tokenized real-world assets.
