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 in the year, 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 themselves 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 greatly 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).
But DeFi will lose in a vacuum. Although certain layers of the DeFi tech stack (like settlement, asset and protocol layers) are decentralized, others must plug into the traditional financial system. Indeed, a growing number of 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 certain 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 that are driven partly by the institutions’ regulatory obligations. This is no simple task. 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:
Crypto companies building on top of DeFi that cannot meet these expectations are unlikely to survive. In contrast, those that invest now in experienced executives and strong 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 step onto the field with those institutions and their regulators, with the highest of stakes, the time to suit up is now (even if over T-shirts with rainbows and unicorns).