A seemingly never ending chain of institutional failures — Celsius, Three Arrows, SBF’s hundreds of corporate entities — has defined the crypto markets in 2022.
As crypto-natives, we understand that to move forward from these failures we need to leverage *more* DeFi technology rather than less. But we also understand that for Traditional Finance players, DeFi can be difficult to understand and navigate.
JPMorgan recently published a list of their concerns, which has provided a helpful starting point in our journey to educate.
In this blog, we’ll walk through some common objections they’ve raised related to DeFi adoption — and explain why we think these hurdles will be overcome.
Objection 1. Pooling of liquidity with unknown or unverified parties makes institutional investors uncomfortable.
Given the stringent KYC/AML requirements that institutions need to uphold, there are some concerns around unknown or unverified parties that could also be interacting with DeFi liquidity pools. However, in this instance, there are several solutions that can give institutional investors peace of mind.
Tools like Metamask Institutional provide pre-trade compliance features, which enables institutional investors to trade comfortably. Here’s a short demo video to show you how that works:
Alternatively, institutional investors could consider using ParaSwap Hub, which is an aggregator of DEX pooling liquidity. It enables a network of KYC/KYB’d market makers to provide liquidity to other KYC/KYB’d participants.
In each case, institutional investors can ensure that regulations and requirements around their counterparties are being met and upheld at all times.
Objection 2. DeFi has many unknown risks, such as smart contract hacks, protocol attacks, governance failures, high gas fees and bottlenecks during times of distress.
As a new and technical arena, DeFi is a complicated space for those that don’t have the niche technical knowledge in-house to assess risks and get comfortable with them. We can understand why Traditional Finance firms don’t have that expertise in-house and struggle to get comfortable with these risks.
At Avantgarde Technology, our engineering teams have spent the last six years working with DeFi protocols as we diligence them and assess how they get integrated into the asset management protocol, Enzyme. In order for a DeFi protocol to be usable from the Enzyme app, it needs to be integrated as something that we refer to as an “adapter”. This requires a lot of hard thinking and engineering work.
One of the unique things we do when integrating adapters, is consider all the ways that a fund manager might be able to manipulate or misappropriate funds from it. This requires us to go deep into the governance design, code base, and audits to understand the mechanics of the protocol. Once we understand the risks, we decide whether we want to move forward with an integration and if so, we develop policies to minimise, to the fullest extent, against any attack vectors that we have identified. After that, we test the adapter & policies and use a top tier smart-contract auditor to audit these independently.
Using vaults to interact with DeFi can also enable you to batch transactions and share them amongst a number of parties so that gas costs become less of a concern.
The work that Avantgarde Technology does is very synergistic to the work we do with Avantgarde Asset Management. The deep understanding our tech team accumulates when working on these integrations is shared with our asset management team and helps to get us comfortable with the quality and risks of various DeFi protocols such that we can use them in our every day business.
Objection 3. DEXs are less attractive than CEXs because of issues such as slow transaction speeds, a lack of privacy and limited functionality.
3.1 DEXs have slow transaction speeds compare to CEXs
CEXs do have faster transaction fees, however, this comes at a trade-off. They run an opaque, closed-loop, central processing system. What market participants gain in minor transaction speed benefits they sacrifice in transparency and trustlessness. In other words, when using a CEX the participant has no oversight over the back-end of the order book, and simply needs to trust that the third-party exchange will facilitate the transaction smoothly. As the FTX scandal has shown, even the most “trusted” CEXs can act in nefarious ways against the best interests of market participants.
3.2 DEXs don’t allow hedge funds and trading firms to maintain privacy around trades
This is a common misunderstanding amongst Traditional Finance players. Interestingly, most DEX order books are actually off-chain and the privacy of market participants can be preserved in such a way that the trade only gets published on-chain, after being executed.
3.3 DEXs open up the possibility for participants to front-run transactions ahead of large orders.
Again, most DEX order books are off-chain and privacy can be preserved. However while we’re on this topic, let’s not pretend that front-running of transactions doesn’t happen on CEX’s or in Traditional Finance.
Leaked documents from the FTX and Alameda fiasco show that it’s entirely possible for CEXs to front-run their own customers, too. In this instance, FTX shared upcoming private token listings with Alameda, who front-ran the market by purchasing these tokens at a discounted price before the announcement went public.
3.4 DEXs don’t provide access to limit order and stop loss functionalities.
This is simply not true. AMM’s do not provide limit orders and stop loss functionalities because they are well, as the name suggests Autonomous Automated Market Makers. However, there is also a growing number of automation tooling protocols like Gelato that allow for complex order types to be designed and executed on top of AMMs. Also, other DEXs like 0x and Paraswap which operate order books do natively provide limit orders and thus stop loss functionalities.
Objection 4. DeFi governance is a big challenge for the proper functioning and security of a protocol
Like in TradFi, not all decentralised governance models work well. However, there are plenty of DeFi protocols with decentralised governance that are run professionally and focus on optimising functionality and security.
Compound is a great example of this. The protocol’s governance has voted to allocate a substantial $4 million per year budget to support a full time auditing firm (Open Zeppelin). Open Zeppelin is responsible for analysing and risk monitoring the protocol and any upgrades or changes to its code pushed through its token holder governance.
Enzyme is another example of DeFi governance design where security is prerequisite. In fact, to earn a seat on the DAO, members must meet a high standard of technical requirements. The Enzyme Technical Council includes smart-contract auditors, who serve to help regulate decision-making and ensure that security comes first.
Objection 5. Systemic risks are heightened due to unstoppable code-enforced liquidation cascades in cases of extreme collateral volatility.
Even in traditional finance, automated liquidation of collateral is exactly what futures exchanges do. It’s good practice. The idea that code-enforced liquidation increases systemic risk is a weak argument, given the alternative would be to not liquidate busted positions.
On the contrary, we believe that one of the benefits of DeFi is that it executes programmatically without the need for trusted intermediaries or third parties.
Ultimately, not liquidating in time is what can cause problems to compound and become even more systemic. The alternative here is to allow leveraged traders to have too much lee-way in order to artificially prevent a market move downwards. This model actually encourages actors to be more complacent around risk-management, which ultimately leads to much bigger and more systemic problems.
Looking at this from the lender’s perspective (the more vulnerable party in this), code-enforced liquidation provides lender protection thanks to programmatic execution. When Celsius Network (a CeFi player) went under in July 2022, DeFi protocols were the first to have their loans repaid. Celsius paid back $41.2 million in DAI to Maker and $50 million in DAI to Compound to recoup more than $650 million worth of BTC they had posted as collateral.
Meanwhile, the CeFi lenders have been left in limbo and might only get something back after a long and lengthy legal process.
Objection 6. Assessing risks & returns is difficult given the fragmented nature of DeFi (different apps for different interactions, no standardised view).
This is true for many players across the DeFi ecosystem, and it’s why we’ve built Enzyme with this specific use case in mind.
Enzyme is an asset management protocol that aggregates DeFi into one simple, easy to use interface. It uses an integrated end-point to provide standardised reporting on risks and returns, regardless of whether the assets are held, borrowed, lent, interest paid or other. Enzyme does this through a value interpreter which cleans and standardises the data to give end users an easy look-through.
You can watch this quick demo video to learn more about how Enzyme operates:
As DeFi grows in maturity and sophistication, it’s becoming increasingly well-equipped to meet the standards and expectations of traditional finance. As you can see, many of these objections are weak or due to a lack of in-depth technical knowledge, rather than a fundamental flaw in the mechanisms of DeFi itself.
At Avantgarde, we believe that as the world becomes ever more digital, leveraging the DeFi stack will be crucial for a healthier financial system, especially when seeking to protect investors and enable a more open, honest and competitive market.
This is why we are working with institutional investors to:
- Provide better education about the opportunities in DeFi
- Professionalise the way institutions access DeFi
- Leverage the security and transparency of DeFi to ensure SBF-proof outcomes
The DeFi framework stands in stark contrast to the centralised stacks that companies like FTX were built on, which provided zero transparency or insight and ultimately failed to show how badly risk-managed they were.
Instead, the DeFi tech stack enables asset positions to be scrutinised in real time whilst being fully accounted for. Risk management can be enforced programmatically. Investors can retain an option of self-custody if they so desire. Additionally, it hedges against central points of failure as it is built on decentralised infrastructure.
If you have any questions on this topic, you can book a complimentary 30-minute consultation with us here.