If DeFi Wants to Grow, It Has to Embrace Real-World Assets

With greater than $44 billion in total value locked, there’s no denying decentralized finance (DeFi) has been a big hit among cryptocurrency investors, providing an innovative new way for them to grow their wealth.

The reason for DeFi’s success in crypto is it advantages everyone involved. Crypto holders get a way to earn passive income on their assets through mechanisms such as yield farming, while borrowers can obtain loans in seconds, with advantageous terms no traditional financial institution can match.

DeFi is big in the crypto world. But, if we look at the overall financial industry, it remains a tiny, almost minuscule niche market, albeit one with potential. DeFi is still taking its first baby steps, but, if it’s to stand tall on its own two feet, it desperately needs a way to connect with the traditional financial ecosystem, where it can tap into real businesses and institutional investors.

Enrico Rubboli is the CEO of Mintlayer, a layer 2 solution that allows users to build a decentralized finance ecosystem on the Bitcoin blockchain, opening Bitcoin to DeFi, smart contracts, atomic swaps, NFTs, apps and more.

The issue is that DeFi is plagued by crippling problems that cannot be solved by internal means. One of the biggest restrictions with DeFi is the requirement that borrowers must over-collateralize their loans to account for price volatility. Most DeFi protocols require collateralization above the value of the loan (stablecoin issuer MakerDAO, for example). If someone wants to borrow $1,000, they must put down $1,500. Should the value of that collateral fall below $1,500, they will be hit with a liquidation penalty.

This over-collateralization requirement presents a big risk to borrowers and seriously hinders accessibility. If DeFi is to live up to its promise of making financial services more accessible, it needs to find a way to cater to the millions of businesses globally that struggle to obtain funding elsewhere. At present, most businesses can’t use DeFi as a source of funding, because they’re not allowed to use anything but crypto as collateral.

Also holding back DeFi is the issue of incentivization, which is directly linked to the available liquidity in protocols. When DeFi hit an all-time total value locked (TVL) of $236 billion in November 2021, everyone was happy. Then, along came crypto winter, and by mid-2022 the TVL in DeFi had collapsed to just $40 billion, with the value of most DeFi tokens dropping by 80%-90%. This caused catastrophic damage to DeFi’s incentive system, as lenders are rewarded with yield based on the amount they deposit, paid out in DeFi tokens that were suddenly worth much less.

Fixing DeFi with TradFi

DeFi protocols can become much more relevant by integrating with real-world assets, or tokenized versions of financial instruments such as bonds, equities and debt, and physical assets such as gold, real estate and art. Doing this would introduce more stable assets into DeFi, making users’ investments safer and protocols more accessible.

Tokenization refers to the process of creating digital representations of real-world assets that can be hosted on a public blockchain. This enables assets to be traded transparently and without intermediaries, making transactions faster and more efficient, with lower costs.

DeFi protocols have already proven their worth in the digital asset markets and their efficiency is so compelling that traditional financial institutions are studying their potential. While there is still some opposition to the idea of automated and decentralized asset trading, due to its association with a crypto market that’s often perceived to be lawless and volatile, there’s a growing consensus that traditional finance can no longer ignore the potential benefits blockchain can provide.

Read more: Jeff Wilser - Tokenize Everything: Institutions Bet That Crypto’s Future Lies in the Real World

That explains why we’ve seen several reputable institutions dipping their toes into DeFi. Earlier this year, BlackRock applied to the U.S. Securities Exchange Commission (SEC) for permission to set up a spot bitcoin exchange-traded fund (ETF). Some analysts believe that its application has a good chance of being approved, and it has been followed by a wave of similar applications from the likes of Fidelity, Invesco, Wisdom Tree and Valkyrie, which all applied for their own bitcoin ETFs in June.

Other signs of the growing institutional appetite for DeFi include Banco Santander educating its users about digital assets, and the launch of the EDX Exchange, which is backed by financial powerhouses such as Charles Schwab, Fidelity and Citadel Securities.

Real-world assets in DeFi

DeFi is an alluring concept for traditional financial institutions because it can be a superior alternative to traditional financial systems. The tokenization of traditional stocks, commodities, government bonds and even things like art and real estate will enable more seamless transactions with far greater transparency than existing mechanisms.

At present, such markets rely on intermediaries such as stock brokers, who invariably take a small cut from any transaction. DeFi eliminates these intermediaries through its use of smart contracts, which are automated, coded agreements that can execute automatically when certain conditions are met. They process transactions faster, with reduced administrative and operational costs, and they’re more transparent as everything is recorded on a publicly viewable blockchain for everybody to see. So they increase trust and accountability in the process too.

Moreover, the DeFi protocols themselves benefit from offering assets with a level of stability that they could previously only dream of. Real-world assets are far stabler than most DeFi tokens, and the reduced volatility will drastically reduce the number of liquidations. Moreover, these real-world assets can be used as an alternative form of collateral, enabling many kinds of businesses to access DeFi for the first time. For instance, businesses could tokenize its outstanding invoices to obtain short-term credit.

By tokenizing real-world assets, investors can also take advantage of services unique to DeFi, such as “staking” and yield farming.

Fractional ownership is another unique benefit that will transform accessibility in existing markets. It will enable assets such as real estate and art to be split among multiple owners. A property or picture represented by tokens becomes divisible, transferable and instantly tradeable across decentralized platforms. In this way, DeFi protocols can be incredibly disruptive, offering greater inclusion.

Though there may be some pushback from hardcore crypto enthusiasts who are ideologically opposed to integration with fiat and traditional financial markets, many can likely be brought onside. As TradFi becomes more closely entwined with DeFi, real-world assets will act as a gateway to the wider digital asset ecosystem. As institutional investors become more comfortable with decentralized assets, they’ll start looking at tokens like Bitcoin and Ethereum more closely.

DeFi and TradFi are better together

The DeFi market has been stuck in a rut for close to two years following the onset of crypto winter, while traditional financial markets have continued to grow even amid the wider global economic uncertainty.

Left alone, DeFi is unlikely to ever shake off the volatility that plagues the wider cryptocurrency ecosystem, and investors will just have to endure the never-ending bull and bear market cycles for years to come. However, if DeFi opens up to real-world assets, it too can benefit from the consistent, long-term growth that’s associated with traditional financial markets.