The following is a guest article by Vincent Maliepaard, Director of Marketing at IntoTheBlock.
Since Bitcoin surpassed its all-time high earlier this year, driven by institutional interest, many expected a similar surge in the decentralized finance (DeFi) space. With DeFi’s total value locked (TVL) surpassing $100 billion, it was the perfect time for institutions to get on board. However, the expected influx of institutional capital into DeFi has been slower than predicted. In this article, we will look at the key issues hindering institutional adoption of DeFi.
Regulatory obstacles
Regulatory uncertainty is perhaps the biggest hurdle for institutions. In large markets such as the US and EU, unclear classification of crypto assets, especially stablecoins, makes compliance difficult. This ambiguity increases costs and deters institutional participation. Some jurisdictions, such as Switzerland, Singapore and the UAE, have adopted clearer regulatory frameworks, attracting early entrants. However, a lack of global regulatory coherence makes cross-border capital allocation difficult, leaving institutions hesitant to enter the DeFi space with confidence.
Moreover, regulatory frameworks such as Basel III impose strict capital requirements on financial institutions holding crypto assets, further reducing the incentive to participate directly. Many institutions opt for indirect exposure through subsidiaries or specialized investment vehicles to circumvent these regulatory restrictions.
However, Trump’s office is expected to prioritize innovation over restrictions, potentially changing DeFi rules in the US. Clearer guidelines could lower barriers to compliance, attract institutional capital, and position the United States as a leader in this area.
Structural barriers beyond compliance
While regulatory issues often dominate conversations, other structural barriers also hinder institutional adoption of DeFi.
One of the important problems is the lack of a suitable wallet infrastructure. Retail users are well served by wallets like MetaMask, but institutions require secure and compliant solutions like Fireblocks to ensure proper storage and management. Additionally, the need for a smooth transition between traditional finance and DeFi is critical to reducing friction in the flow of capital. Without a robust infrastructure, it is difficult for institutions to effectively move between these two financial ecosystems.
DeFi infrastructure requires developers with a very specific skill set. The required skill set is often different from traditional financial software development and can also vary from blockchain to blockchain. Institutions that seek to use only the most liquid strategies will likely need to deploy multiple blockchains, which can increase overhead and complexity.
Liquidity fragmentation
Liquidity remains one of DeFi’s most persistent challenges. Fragmented liquidity across various decentralized exchanges (DEXs) and borrowing platforms creates risks such as slippage and bad debt. It is vital for institutions to conduct large transactions without significantly affecting market prices, and shallow liquidity makes this difficult.
This could create situations where institutions would have to transact across multiple blockchains to complete a single trade, adding complexity to the strategy and increasing risk vectors. To attract institutional capital, DeFi protocols must create deep and concentrated liquidity pools capable of supporting very large trades.
A good example of liquidity fragmentation is the evolution of the Layer 2 (L2) blockchain landscape. As it becomes cheaper to create and conduct transactions on L2 blockchains, liquidity has migrated from the Ethereum mainnet. This has reduced on-chain liquidity for certain assets and trades, thereby reducing the size of the deployment that institutions can make.
While technology and infrastructure improvements are in development to address many of the challenges of liquidity fragmentation, this is a key barrier to institutional deployment. This is especially true for L2 deployments, where liquidity and infrastructure issues are more pronounced than on the mainnet.
Risk management
Risk management is of utmost importance for institutions, especially when interacting with a nascent sector like DeFi. In addition to technical security that prevents hacks and exploits, institutions need to understand the economic risks inherent in DeFi protocols. Protocol vulnerabilities, whether in governance or tokenomics, can expose institutions to significant risks.
Compounding these challenges, the lack of institutional-scale insurance options to cover large losses such as a protocol exploit often means that DeFi is allocated only to assets designed for high R/R. This means that low-risk funds that may be exposed to BTC are not deploying to DeFi. In addition, liquidity constraints, such as the inability to exit positions without causing severe market consequences, make it difficult for institutions to effectively manage risk.
Institutions also need sophisticated liquidity risk assessment toolsincluding stress testing and simulation. Without this, DeFi will remain too risky for institutional portfolios that prioritize stability and the ability to deploy or unwind large positions of capital with minimal exposure to volatility.
The Path Forward: Building Institutional Grade DeFi
To attract institutional capital, DeFi must evolve to meet institutional standards. This means developing institutional-grade wallets, creating seamless capital transitions, offering structured incentive programs, and implementing comprehensive risk management solutions. Addressing these issues will pave the way for DeFi to become a parallel financial system capable of supporting the scale and complexity required by large financial players.
By creating the right infrastructure and aligning it with institutional needs, DeFi has the potential to transform traditional finance. As these improvements are realized, DeFi will not only attract more institutional capital, but will also establish itself as a foundational component of the global financial ecosystem, ushering in a new era of financial innovation.
This article is based on IntoTheBlock’s Latest Research Paper on the future of institutional DeFi.
