Navigating the Institutional DeFi Trilemma

The DeFi industry promises to address many of TradFi’s inefficiencies, offering a broad range of opportunities for both retail and institutional investors.

With the recent spotlight on crypto ETFs, institutional interest in crypto has surged, positioning DeFi as a prime opportunity for many organizations.

However, engaging in DeFi at scale presents unique challenges, encapsulated by what we term the “Institutional DeFi Trilemma” model—Risk, Reward, and Capacity.

Understanding the Institutional DeFi Trilemma

Successfully navigating DeFi at scale requires a nuanced understanding of three critical dimensions: risk, reward, and capacity. These factors are interdependent and must be carefully balanced to optimize investment strategies and ensure sustainable growth.

• Risk: In DeFi, risks are multifaceted and often more complex than in TradFi. Technical risks arise from vulnerabilities in smart contracts and protocol designs, while economic risks stem from market dynamics and protocol mechanisms. Historical data reveals that over $58 billion has been lost due to various incidents, underscoring the necessity of thorough risk assessment.
• Reward: Rewards in DeFi are typically more straightforward to quantify. They range from staking and liquidity provision rewards to lending rates and liquidity mining. For instance, supplying liquidity to lending protocols like Aave can yield returns influenced by market conditions and borrower demand.
• Capacity: Capacity in DeFi is a unique factor that determines the amount of capital that can be deployed without significantly diminishing returns or increasing risks. Unlike traditional assets like treasuries, DeFi strategies have constrained capacities due to liquidity and protocol limitations. This factor is crucial for executing profitable DeFi strategies at scale.

Yield Generation in DeFi

DeFi offers numerous ways of earning yield on assets, making it an attractive avenue for investors looking to maximize their returns. On a basic level, we can identify the following key strategies for yield generation in DeFi:

• Staking: Involves locking tokens in a network to secure it and earn rewards.
• Liquidity Provision: Providing liquidity to pools on decentralized exchanges (DEXs) to earn trading fees.
• Liquidity Mining: Receiving protocol governance tokens as rewards for providing liquidity.
• Lending: Earning interest by lending assets on platforms like Compound.
• Airdrops: Distributing tokens to early users or liquidity providers to decentralize governance.

Furthermore, leverage can be used in several of these yield mechanisms, like staking and lending, to optimize returns. While this increases returns, it also increases the complexity of a strategy, and thus its risks.

Evaluating Risks in DeFi

DeFi’s complexity introduces a variety of risks, which can be classified into two main categories; economic risk and technical risk.

Technical risks include vulnerabilities in smart contracts, such as re-entrancy attacks and improper key management. Economic risks involve factors like liquidations, impermanent loss, and depegging events. The Terra and Iron Finance collapses are prime examples of economic risks that led to significant losses.

To mitigate these risks, investors should:

• Ensure protocols undergo regular audits by reputable firms.
• Diversify investments across multiple protocols to reduce exposure to any single point of failure.
• Stay informed about the latest developments and potential vulnerabilities within the DeFi ecosystem.
• Track the unique economic risk factors for each protocol they are active in.

Managing Capacity in DeFi Protocols

Capacity management is crucial for maintaining optimal yields and minimizing risks and is something institutional investors simply cannot overlook. For example, in liquidity pools, increasing the amount of capital can lead to yield decay, as the increase in capital linearly decreases the incentives. Understanding the dynamics of capacity helps investors determine how much capital to deploy without significantly reducing returns.

Factors affecting capacity include:

• Yield decay as more capital is added to a pool.
• Protocol-level mechanisms, such as exit fees and slippage in AMMs.
• Liquidity constraints in lending markets, which can impact the availability of assets for borrowing and lending.

To put this into perspective, let’s consider a practical example of yield decay.

Imagine a stablecoin pool with $500k in liquidity, offering a 10% APY through incentives. If you were to deposit an additional $500k into the pool, the yield would be projected to decrease to 5%, assuming all other factors remain constant.

At this point, earning a 5% return on stablecoins becomes less attractive, especially when compared to the risk-free rate offered by treasuries. Consequently, the effective capacity for this strategy would be less than $500k, as further deposits would lead to diminishing returns.

The Future of Yield in DeFi

The DeFi space moves incredibly fast, and we’ve seen numerous new opportunities for yield arise in various areas of DeFi. One of the latest and most promising of these is the integration of DeFi and TradFi through tokenized real-world assets (RWAs). For example, treasury bonds and real estate are entering the DeFi space, offering new opportunities for yield generation and risk diversification.

Institutional players like BlackRock and PayPal are also exploring DeFi. BlackRock’s BUIDL fund and PayPal’s PYUSD stablecoin demonstrate how traditional finance giants are leveraging blockchain technology to provide innovative financial products.

Strategic Considerations

While the DeFi space offers many interesting opportunities for institutional investors, the strategies can be multi-faceted and complex, while concepts like capacity require highly specific knowledge. Nonetheless, by understanding and addressing the dimensions mentioned in this article, institutional investors can effectively engage with DeFi, leveraging its potential while managing the inherent risks.

This article is based on IntoTheBlock’s most recent research paper on institutional DeFi. You can read the full report here.