The following is a guest article by Vincent Maliepaard, Director of Marketing at IntoTheBlock.
As Bitcoin surpassed all-time highs earlier this year due to interest from institutional investors, many expected a similar surge in the decentralized finance (DeFi) space. With DeFi total value locked (TVL) exceeding $100 billion, it's the perfect time for financial institutions to jump on board. However, the anticipated inflow of institutional capital into DeFi has been slower than expected. In this article, we explore the main challenges hindering organizational DeFi adoption.
Regulatory hurdles
Regulatory uncertainty is perhaps the biggest hurdle for institutions. In major markets such as the US and EU, compliance is complicated by unclear classification of crypto assets, particularly stablecoins. This ambiguity increases costs and discourages institutional involvement. Some jurisdictions, such as Switzerland, Singapore and the United Arab Emirates (UAE), have adopted clearer regulatory frameworks, which is attracting early entrants. However, a lack of global regulatory consistency complicates cross-border capital allocation and deters financial institutions from confidently entering the DeFi space.
Furthermore, regulatory frameworks like Basel III impose strict capital requirements on financial institutions that hold crypto assets, further discouraging the desire to participate directly. Many financial institutions choose indirect exposure through subsidiaries or specialized investment vehicles to circumvent these regulatory constraints.
However, President Trump is expected to prioritize innovation over restrictions, potentially leading to a reorganization of US DeFi regulations. Clearer guidelines could lower compliance barriers, attract institutional investors, and establish the United States as a leader in the field.
Structural barriers beyond compliance
While regulatory issues often dominate conversations, other structural barriers also impede institutional DeFi adoption.
One notable problem is the lack of proper wallet infrastructure. While retail users are well served by wallets like MetaMask, educational institutions require secure and compliant solutions like Fireblocks to ensure proper storage and governance. Additionally, the need for a seamless on/off transition between traditional finance and DeFi is critical to reducing friction in capital flows. Without a robust infrastructure, financial institutions will struggle to move efficiently between these two financial ecosystems.
DeFi infrastructure requires developers with highly specialized skill sets. The skill set required is often different from traditional financial software development and may vary from blockchain to blockchain. Institutions looking to deploy only on the most liquid strategies may need to deploy on multiple blockchains, increasing overhead and complexity.
liquidity fragmentation
Liquidity remains one of DeFi’s deepest problems. Fragmentation of liquidity across various decentralized exchanges (DEXs) and borrowing platforms creates risks such as slippage and bad debt. It is critical for financial institutions to execute large trades without significantly impacting market prices, but shallow liquidity makes this difficult.
This can create a situation where financial institutions have to perform transactions on multiple blockchains to execute a single transaction, increasing the complexity of the strategy and increasing the risk vector. To attract institutional investors, DeFi protocols need to create deep, concentrated liquidity pools that can support very large trades.
A good example of liquidity fragmentation can be seen in the evolution of layer 2 (L2) blockchain environments. As it becomes cheaper to build and trade on the L2 blockchain, liquidity has migrated away from the Ethereum mainnet. This has reduced the liquidity on the mainnet for certain assets and transactions, thereby reducing the scale at which financial institutions can deploy.
While technology and infrastructure improvements are being developed to address many liquidity fragmentation issues, this is a major impediment to deployment by institutional investors. This is especially true for L2 deployments, where liquidity and infrastructure issues are more pronounced than on mainnet.
risk management
Risk management is paramount for institutions, especially when involved in nascent sectors like DeFi. Beyond technical security to mitigate hacks and exploits, institutions must understand the financial risks inherent in DeFi protocols. Protocol vulnerabilities, whether in governance or tokenomics, can expose institutions to significant risks.
Compounding these complexities is the lack of organization-wide insurance options to cover large-scale loss events such as protocol exploits, which often result in high-R/R It means that only assets are allocated to DeFi. This means that low-risk funds with potential BTC exposure are not deploying to DeFi. Additionally, liquidity constraints, such as the inability to exit positions without significantly impacting the market, make it difficult for financial institutions to effectively manage their exposures.
Educational institutions also need advanced technology Tools to assess liquidity riskincluding stress testing and modeling. Without these, DeFi remains too risky for institutional portfolios that prioritize stability and the ability to deploy or unwind large capital positions while minimizing exposure to volatility. .
The way forward: Building institutional-level DeFi
To attract institutional capital, DeFi needs to evolve to meet institutional standards. This means developing an institutional-grade wallet, creating a seamless capital on- and off-ramp, offering a structured incentive program, and implementing a comprehensive risk management solution. Addressing these areas will pave the way for DeFi to mature into a parallel financial system, one that can support the scale and sophistication required by large financial players.
By building the right infrastructure and aligning it to the needs of institutions, DeFi has the potential to transform traditional finance. As these improvements continue, DeFi will not only attract more institutional investors, but also establish itself as a fundamental component of the global financial ecosystem, ushering in a new era of financial innovation. Probably.
This article is based on Latest research papers from IntoTheBlock About the future of DeFi for institutional investors.
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