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Why Institutional Investors Cannot Afford to Ignore DeFi

Authored by Will Hamilton

Professional investors are concerned with one thing: returns. Ideally, the goal is to produce consistently increasing returns that outperform the market, however, this is becoming more and more difficult. Now, more than ever, institutions are beginning to notice that digital assets are outperforming most of their traditional counterparts, despite their inherent volatility. 

While this has brought a new wave of reputable financial institutions and corporations to the space, there’s actually an even bigger opportunity emerging, and that’s DeFi or Decentralised Finance. DeFi stands to add a new layer of financial opportunity through niche product offerings not available in traditional finance. This subsector of the digital asset market has been largely untapped by institutional investors, however this is changing.

Bitcoin isn’t taboo anymore

It took some time, but the price performance of both Bitcoin (BTC) and other digital assets has turned many institutional heads in recent years. In fact, a recent survey found that a full 62% of investors not already exposed to digital assets plan to invest within the next year. 

This comes as Bitcoin and its brethren are being increasingly better understood, and more professional avenues for gaining access are beginning to become available. Reputable companies are currently offering investors access to Bitcoin-based products with a large amount of success given how hot the market has been over the last year or so.

Large investment managers typically are averse to the drawdowns faced in the digital asset market. However, the potential for upside has seen many of these asset managers balance their higher risk digital asset exposure with more stable growth products. This has ultimately seen their overall portfolios add value more so than they traditionally would have. Small allocations to digital assets are the first step for professional money managers and given the attractive risk-adjusted returns of digital assets, it can be safe to assume larger allocations to the space will be made in the future.

DeFi is the true next level

Beyond just Bitcoin, there is the realm of Decentralized Finance, as we briefly mentioned above. Known as DeFi for short, it is an entire ecosystem of financial assets and services run on decentralized networks such as Ethereum. This is made possible thanks to “smart contracts,” or basically programmable money. Now, there’s a whole emerging plethora of decentralized exchanges, lending platforms, yield compounding opportunities and more.

For example, investors who hold various digital assets can put them to work by pledging them into a liquidity pool used to power a decentralized exchange. Without getting too technical, decentralized exchanges, or DEXs, basically use these pools to facilitate trades in a way that is entirely governed by code, with no human oversight. The trades have small fees attached to them, which are then distributed to all liquidity providers based on their share of the pool. Because these systems are very straightforward and have no middlemen, lenders receive notably higher returns than they would on virtually any legacy financial platform. APYs of 5-10% are quite common, and even products offering over 20 or 30% are fairly easy to find. 

As such, institutional investors need to realize that returns from digital assets are not only generated from gains in the underlying product but also via the interest gained from yield bearing financial products in the DeFi sector. The emerging DeFi system is more profitable, more efficient and overall faster than the traditional financial products and services. In fact, some companies are already beginning to notice, and take a step into this next frontier. 

The shift has already begun

Things move fast in DeFi, and institutional investment in the space has been no different. According to an upcoming report from Chainalysis, the share of total DeFi transaction volume coming from large institutions rose from around 10% in Q3 2020 to over 60% in Q2 2021. This means that big money is picking up on DeFi and its opportunities very quickly.

There are specific, practical examples too. Trovio Capital Management (TCM), an asset management company that is focused exclusively on digital native assets, is announcing the launch of a Digital Asset Income Fund, a market-neutral, non-directional fund that plans to extract yield through strategically investing in stablecoin-based DeFi protocols and capitalizing on more traditional arbitrage opportunities. Essentially, the fund is designed to maximize ROI by balancing its portfolio in 90% stablecoin based DeFi opportunities, which have very low volatility, and 10% into more volatile, but still highly vetted products. This type of approach mitigates volatility and mirrors how many investors already balance digital asset exposure in their personal portfolios. TCM believes the Fund is capable of returning 15%-20% net of fees per annum.

Clearly, the wheels are already turning. TCM is a major example, but it isn’t the only one, and the numbers speak for themselves as to how powerful this movement is becoming. There is undoubtedly more work to do. Decentralized Finance is still largely unregulated and as such there are many who will stay away until the ink is dry on all the laws, and this is understandable. These platforms, too, are still all works in progress, and despite the financial opportunities, there will likely be some calamities along the way. Still, this new asset class and all the opportunities it presents cannot be ignored by the professional investment community. Those who wait may be safer, but may also be left behind in just a few years time. 

About The Author

Will Hamilton is Head of Trading & Research at TCM Capital. Will has been heavily involved in the cryptocurrency industry since 2016, and prior to this, he worked at Pitt Capital Partners, the internal investment bank of investment house Washington H. Sol Pattinson (‘ASX:SOL’).

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.