Navigating the Institutional Trilemma of DeFi

Engaging in DeFi at scale presents unique challenges, summarized by the “DeFi institutional trilemma” model: risk, reward, and capacity.

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

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

However, engaging in DeFi at scale presents unique challenges, summarized by what we call the “The Institutional Trilemma of DeFi“Model — Risk, Reward and Ability.

Understanding the Institutional Trilemma of DeFi

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

• Risk: In DeFi, the risks are multiple and often more complex than in TradFi. Technical risks arise from vulnerabilities in smart contracts and protocol designs, while economic risks arise from market dynamics and protocol mechanics. Historical data reveals that more than $58 billion was lost due to various incidents, highlighting the need for a thorough risk assessment.
• Reward: Rewards in DeFi are generally simpler to quantify. They range from staking and liquidity rewards to lending rates and liquidity mining. For example, providing liquidity to lending protocols like Aave can generate returns that are influenced by market conditions and borrower demand.
• Ability: DeFi capacity is a unique factor that determines how much capital can be deployed without significantly decreasing returns or increasing risk. Unlike traditional assets like Treasuries, DeFi strategies have limited capacity due to liquidity and protocol limitations. This factor is crucial to running profitable DeFi strategies at scale.

Yield Generation in DeFi

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

• Staking: Involves locking tokens into a network to secure it and earn rewards.
• Liquidity provision: Provide liquidity to pools on decentralized exchanges (DEX) to earn trading fees.
• Liquidity extraction: Receiving protocol governance tokens as a reward for providing liquidity.
• Ready:Earn interest by lending assets on platforms like Compound.
• Air drops: Distribute tokens to early adopters or liquidity providers to decentralize governance.

Additionally, leverage can be used in many of these yield mechanisms, such as staking and lending, to maximize returns. While this increases returns, it also increases the complexity of a strategy, and therefore its risks.

Risk Assessment in DeFi

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

Technical risks include smart contract vulnerabilities, such as reentry attacks and key mismanagement. Economic risks involve factors such as liquidations, impermanent losses, and de-pegging events. The collapses of Terra and Iron Finance are prime examples of economic risks that resulted in significant losses.

To mitigate these risks, investors should:

• Ensure that protocols are regularly audited by reputable companies.
• Diversify your investments across multiple protocols to reduce exposure to a single point of failure.
• Stay informed about the latest developments and potential vulnerabilities within the DeFi ecosystem.
• Track unique economic risk factors for each protocol in which they are active.

Capacity Management in DeFi Protocols

Capacity management is essential to maintaining optimal returns and minimizing risk. It is something that institutional investors simply cannot ignore. For example, in liquidity pools, increasing the amount of capital can lead to lower returns because increasing capital linearly decreases incentives. Understanding capacity dynamics helps investors determine how much capital to deploy without significantly reducing returns.

Performance profile of an AMM strategy

Factors affecting capacity include:

• Returns decrease as more capital is added to a pool.
• Protocol-level mechanisms, such as exit fees and AMM slippage.
• Liquidity constraints in credit markets, which may impact the availability of assets for borrowing and lending.

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

Imagine a stablecoin pool with $500,000 in liquidity, offering a 10% annual return through incentives. If you were to deposit an additional $500,000 into the pool, the return would 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. Therefore, the effective capacity of this strategy would be less than $500,000, as additional deposits would result in diminishing returns.

The Future of Yield in DeFi

The DeFi space is evolving at an incredible speed and we have seen many new yield opportunities emerge in various areas of DeFi. One of the latest and most promising of these is the integration of DeFi and TradFi via tokenized real assets (RWA). For example, treasuries and real estate are entering the DeFi space, providing 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 financial giants are leveraging blockchain technology to deliver innovative financial products.

Strategic considerations

While the DeFi space offers many exciting opportunities for institutional investors, strategies can be multidimensional and complex, while concepts such as capacity require very specific knowledge. Nevertheless, by understanding and addressing the dimensions mentioned in this article, institutional investors can effectively engage in DeFi, harnessing its potential while managing the inherent risks.

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

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