Decentralized finance (DeFi) unlocks a wealth of opportunities to upgrade existing asset management strategies.
Decentralized finance (DeFi) has triggered a paradigm shift in the world of finance. Standing as a decentralized, transparent, and efficient alternative to traditional finance practices, DeFi eliminates intermediaries from the finance equation. In turn, investors are empowered to be autonomous, personally managing their assets to maximize their gains.
That is why DeFi has attracted significant institutional interest, with many investors seeking to weave digital assets into their portfolios. Comprising a range of protocols, the DeFi ecosystem is rich with opportunities for institutions to upgrade their investment strategies.
Specific to asset management, finance-oriented DeFi protocols such as lending, liquidity mining, and staking are instrumental in enabling asset managers to boost their clients’ portfolios. These protocols are centered around interest and yield generation, giving investors a greater breadth of tools to earn a passive income on their assets.
These wealth-creating protocols have greatly contributed to the overall popularity of DeFi, leading to the industry being valued at $13.61 billion U.S. dollars in 2022. Looking ahead, the DeFi industry is projected to continue expanding at a compound annual growth rate (CAGR) of 46.0% from 2023 to 2030.
This article therefore serves as a guide for asset managers, offering actionable steps they should take to effectively incorporate DeFi into their strategies.
Step 1: Grasp the fundamentals of DeFi
Skip this step if your organization already has a firm understanding of DeFi.
Before considering how to leverage DeFi for asset management, asset managers must first conduct thorough research to understand the basics of DeFi and how it differs from traditional finance.
In essence, DeFi refers to peer-to-peer financial services performed on public blockchains, predominantly Ethereum. Unlike traditional finance, DeFi operates entirely without the involvement of third-party intermediaries like banks and financial institutions, directly connecting users to transact with each other.
In place of such intermediaries, programs encoded with predetermined rules known as smart contracts execute transactions on the blockchain. Immutable and tamper-resistant, smart contracts are a robust alternative to fallible third-party intermediaries that are prone to human error.
Step 2: Research the DeFi ecosystem and identify protocols that best fit your asset management strategy
The DeFi ecosystem comprises a broad spectrum of protocols, each one offering different value to asset management firms. The onus lies with the firm to explore the different protocols and assess which ones best align with their asset management goals.
Powered by smart contracts, DeFi protocols are simply programs that determine how digital assets are utilized on a given blockchain network. DeFi protocols are instrumental for the operation of many DeFi applications (Dapps), such as decentralized exchanges (DEXs), liquidity mining, and staking.
Learn more about DeFi protocols designed for asset management.
As a general guideline, asset management firms must ensure that the protocols they use enable them to maintain full autonomy and ownership over their digital assets - in line with the core tenets of DeFi.
Key factors asset management firms must evaluate include:
- Security: This determines if the protocol enables asset management firms to generate returns in a safe and secure manner.
- Reputation: This factors into the overall trustworthiness of the protocol, with audits and security assessments determining if it is safe to deploy.
- Liquidity: Stored in liquidity pools, liquidity is a crucial factor that measures the financial health of the protocol and determines whether transactions between buyers and sellers can be efficiently completed.
- Fees: Every transaction comes at a cost, and this will inevitably impact the overall returns on investment. Asset management firms should therefore evaluate if the fees justify the returns.
- User experience: An easy, seamless user experience guarantees autonomy for the asset management firm, enabling them to personally oversee and determine how their digital assets are deployed.
Step 3: Define your firm’s investment strategy and risk parameters
Once your asset management firm has determined which DeFi protocols best suit its interests, the next step is to craft an investment strategy and establish clear risk parameters.
Similar to traditional finance practices, the use of DeFi is subject to your asset management firm’s investment goals and risk appetite. When these points are taken into consideration, your firm can then establish standard operating procedures (SOPs) to guide the allocation of digital assets for investments.
To complement or even enhance your firm’s asset management strategy with DeFi, key credit factors that are inherent to traditional finance apply, including:
- Capital structure
- Investment time horizon
Step 4: Protect your clients’ digital assets with a robust, self-custody, multi-signature wallet
With a clear investment strategy and risk boundaries established, your firm is ready to incorporate DeFi into its asset management practices. This begins with deploying a sturdy wallet to custody your firm’s digital assets.
At present, the market offers the following options:
- Self-Custody: Autonomous custody performed with technology derived from a custody technology provider.
- Third-Party Custody: Managed custody that a third-party custodian performs.
- Hybrid Custody: Mixed custody that combines self- and third-party custody.
Of the above options, self-custody is highly recommended for asset managers. Apart from empowering them with full autonomy over the management of their clients’ digital assets, self-custody is also the most secure way to protect said assets from security compromises.
Self-custody can be further broken down by security design model, with existing models encompassing the following:
- Single-signature: The wallet is paired with just one private key, assigned to a single user to sign and authenticate blockchain transactions.
- Multi-signature: The wallet is paired with two or more private keys, each one assigned to a different user. A majority consensus must be reached among users to sign and authenticate transactions.
- Multi-party computation (MPC): The wallet is paired with one private key, which is divided into three or more parts in a process known as sharding. Each shard is assigned to a different user, and similar to multi-signature, a majority consensus needs to be reached to sign and authenticate transactions.
Learn about the security design models of self-custody cryptocurrency wallets.
Between these three design models, multi-signature is highly recommended for institutional use. With ownership of the keys distributed to multiple users, multi-signature wallets are secured as every key holder is obligated to be accountable to each other. Digital assets cannot be accessed without the requisite approvals from most or all of the key holders.
When selecting a multi-signature self-custody wallet, asset management firms must also pay attention to its features. As a general guideline, the wallet must:
- Utilize an n-of-m quorum to enable at least one key to be kept as a backup
- Reinforce the backup key(s) with a hardware security module (HSM)
- Have a stringent backup process to facilitate the recoverability of funds
- Have a user-first interface
- Be built with a customizable policy engine for flexible organizational management
- Deploy a transparent and provable security model
Read the full breakdown of the features multi-signature wallets must have.
Levain is designed for institutional asset management. Apart from being a secure self-custody platform that utilizes a multi-signature security design model, Levain’s platform is also augmented with features that further reinforce autonomy and security.
Learn more about Levain and how our platform empowers your asset management firm with a secure gateway to DeFi.
Step 5: Begin with small investments and diversify
Once your asset management firm’s custody method is in order, it is now ready to move on to the next step and start applying digital assets to the DeFi protocols it chose in Step 2.
As with traditional asset classes, it is highly recommended that your firm diversify its investments across various DeFi protocols. Depending on your firm’s risk tolerance, it may also opt to be more conservative in the initial stages, especially when deploying digital assets belonging to clients who are completely new to DeFi.
If your firm is looking to access liquidity and trade tokenized assets, then you should explore decentralized exchanges (DEXs). From here, your firm can consider applying automation investment strategies to generate yield and optimize returns through activities such as yield farming and liquidity mining.
Step 6: Stay abreast of prevailing trends by participating in governance
To further gain an authoritative edge in DeFi, your asset management firm should consider engaging in the governance of DeFi protocols and platforms.
In a typical DeFi protocol, governance, or the control of the protocol, is separated from its developers and investors and distributed among its active users. In turn, this governance model makes the overall decision–making process democratic, where users vote on update proposals to move the protocol forward.
By participating in the governance of a DeFi protocol, your asset management firm can both propose changes and cast votes to shape its future direction. Active participation in the community will also offer insights from experts and other investors on how best to optimize existing investment strategies.
Step 7: Comply with regulatory requirements
Depending on the jurisdiction your asset management firm is based in, the regulatory requirements to operate in the DeFi space may differ. It is essential for your firm to stay updated on local laws surrounding DeFi and ensure that operations are in full compliance.
When engaging with DeFi protocols and platforms, firms must also ensure that they meet all Know Your Customer (KYC) and Anti-Money Laundering (AML) requirements. Where possible, your firm should consult relevant legal and regulatory bodies to ensure it adheres to prevailing guidelines.
Step 8: Be flexible in managing your firm’s DeFi investment strategy
Similar to traditional asset classes, DeFi is volatile and subject to change based on market conditions and the emergence of new opportunities. It therefore behooves your firm to regularly review and evaluate the performance of its DeFi strategy and be prepared to adjust its parameters accordingly.
Rise up to the power of DeFi with Levain
This article has outlined a step-by-step process for asset management firms to get started with incorporating DeFi into their investment strategy.
Before entering the DeFi ecosystem, it is crucial for asset managers to first establish a secure method of custodying their clients’ digital assets under management.
Levain’s self-custody solution is designed to meet the needs of asset management. Besides providing asset management firms with multi-signature wallet technology, Levain’s solution is also equipped with a customizable policy engine and a comprehensive portfolio monitoring system. This enables asset managers to maintain autonomy over their clients’ assets while also managing them in a secure manner.
Find out more about how Levain helps asset managers get started in DeFi. Get in touch at levain.tech.