Beyond safeguarding Private Keys: the new role of a digital asset custodian in the DeFi ecosystem
For nearly a decade, the traditional financial world has been characterized by zero-yield or even negative interest rates. This is a result of the past financial crisis and the enduring expansionary monetary policy of central banks around the world. As a result, prices of shares, bonds, and real estate have been globally rising, which eventually lead to diminishing growth and marginalized yields for investors. With decreasing earnings yield, there is a growing discrepancy between promised returns and what institutional investors are able to generate — especially endangering the business model of pension funds or insurance companies.
Meanwhile, enabled by the rise of blockchain technology, we see a completely new ecosystem developing strongly and offering a variety of attractive new investment opportunities.
At Finoa, we have been closely following the development of this Decentralized Finance (DeFi) ecosystem and see many promising investment opportunities evolving, which could add to the overall investment scope of the traditional system.
We have seen the explosive popularity of cryptocurrencies or utility tokens such as Bitcoin, Ethereum, and others. Here we are not talking about the price increases in Bitcoin, Altcoins, or any speculative investments into Initial Coin Offerings, Initial Exchange Offerings, Security Token Offerings, etc.
Instead, the DeFi ecosystem offers several high investment returns at a relatively low risk, which can be very attractive to institutional investors. We analyzed the opportunities and shortlisted our favorites:
Lending and Borrowing
Within the DeFi ecosystem, the process of lending and borrowing (digital) assets becomes swift and easy.
Every digital asset holder, regardless of his or her location and credit history, is able to borrow digital assets against collateral. In essence, decentralization abolishes the necessity for intermediaries in the lending process, whereas, under the traditional financial system, the only way to draw a loan would be through a bank or another intermediary.
Since there is no central authority in DeFi, there is no risk to be turned down for a loan: if you possess enough digital assets to put as collateral, you will be likely to receive the loan — from daily accessibility to long-term lending.
It is not only easy and comfortable to lend capital in the DeFi system it also offers very attractive returns. Platforms such as Celsius or Nexo offer rates of nearly 6% on Bitcoin or even of up to 10% on dollar-backed stablecoins, while the assets remain accessible and liquid. Where else are you currently getting these returns as an investor?
In recent years, we see a growing number of protocols within the blockchain ecosystem that are shifting their consensus algorithm from Proof-of-Work (PoW) to the Proof-of-Stake (PoS) algorithm. There are many reasons for this: PoS delivers guaranteed returns of staking, it enables voting power on the network, and it is significantly more cost and energy-efficient, as transactions are not confirmed through such an energy-heavy mining process as in PoW.
Staking is somewhat similar to a lottery in which the number of crypto assets is equivalent to holding a given number of lottery tickets.
By winning you validate a transaction and take a commission.
With PoS rising in popularity, we can see a significant growth of companies providing a semi-passive digital asset earning solution through staking-as-a-service. Such services allow individuals and institutions to delegate their digital assets and voting rights to a trusted party and receive the respective staking rewards (=dividends) as the asset owner.
The average Annual Staking Yield is 12.83%, showing a maximum of up to 160% for protocols like Livepeer (not accounting for inflation).
Staking providers have been rising over the last years and are increasingly expanding their product offerings. Staked.us for example offers institutional investors that hold digital assets to stake and compound the returns on behalf of them, promising up to 100% return depending on the asset staked. In addition to that, they just recently launched their RAY (Robo Advisor for Yield), an AI-powered algorithm running a set of smart contracts that automatically allocate crypto assets to the highest yielding opportunities.
Investments into alternative assets
When talking about Blockchain, the deepest use case one can see is the process of tokenization. Simply speaking, tokenization is the process of transforming illiquid, “paper-based”, physically represented assets into fully digital, fungible, and liquid ones (=tokens). It currently targets rather illiquid assets such as real estate or startup shares but will eventually move to standardized issuing products such as listed equities and bonds (our thorough analysis on tokenization can be found here).
With this, currently, high-yielding (alternative) assets such as Real Estate, Venture Capital, Hedge Funds, or Private Equity could eventually become available to the public taking away the wealthy elite’s proprietary access. We at Finoa call this the democratization of investment opportunities.
Despite the increase in PoS protocols though, with Bitcoin running on PoW, there is still a lot of noise around crypto-mining. Mining, as adding transactions to the ledger, is typically done leveraging dedicated computer hardware, since it requires heavy CPU and electricity usage. Thus, we see such companies as Slush or Poolin, offering mining pool solutions for miners to share their processing power over their network and accordingly benefit from the mining rewards distributed for solving consensus algorithms for block mining.
Another interesting example is participation in tokenized factoring. This is an intriguing investment opportunity where illiquid (but high-yield) factoring contracts are tokenized and distributed to the public market. For the seller, the factoring process on a token basis could not be any easier; for the investor, there is a new return opportunity arising — by cutting out the intermediary with a very attractive and much higher return than in traditional finance.
A great example here is Centrifuge, which is able to speed up the supply chain processes. By tokenizing illiquid real-world assets such as invoices, royalty payments, or artworks, Centrifuge turns them into non-fungible tokens (NFT). Then these NFTs in collateral give access to lending protocols on the platform, which finally is bought on the market and liquidized. Along with factoring, Centrifuge also has an option to borrow assets.
Risk Management and Hedging
DeFi not only provides you with an extended portfolio of investment opportunities but also lets investors manage and hedge their risks in a new way.
Through decentralized applications, investors can structure their own derivatives or contracts peer-to-peer with several different counter-parties and without the need of an intermediary and their limited set of opportunities.
The team of Vega, for example, has developed a protocol that enables users to create their own markets and define their own parameters, while providing enough second-layer scaffolding to simplify the DeFi experience and automate as much as possible. This serves as a decentralized model for how financial products can be equitably and efficiently created and traded online.
Vega’s protocol is built in a way that incentivizes and rewards price makers and market makers for providing liquidity to power various financial markets. Thus, we can see how Vega provides high degrees of control over financial products and how these derivatives greatly diversify the applications of technologies like blockchain and consensus in the financial sector to open up new investment or hedging opportunities.
Similar to that, we have seen the early evolution of decentralized prediction markets such as Augur. In such markets, you are able to speculate on world events and market narratives by ‘investing into’ or betting on one of the narratives that you believe is going to happen.
In contrast to a centralized prediction market, the decentralized one gives open access for everyone to invest in predictions without the limits of location, money caps, and censorship of markets.
You can invest in a prediction, as if buying shares of the predicted outcome, on various topics: from weather forecasts to political elections and market crashes. The price of these shares is set by the perceived probability, which is based on the publicly available information on the event.
How can investors benefit from this?
DeFi’s promising nature (and we have only shown a sample of use cases) is gaining traction in value and customers. But despite its rapid development it still remains a niche, leaving out the vast majority of digital asset investors.
Attracting those investors, however, requires more than communication. Financial applications have to enable investors, especially non-crypto-native ones, to participate in this high-yield ecosystem and reap its benefits.
We at Finoa see ourselves with the duty to facilitate and deliver access to the DeFi ecosystem and services — to our current and future customers. We are proud to announce that soon we will expand our institutional-grade digital asset custody platform into a complementary ecosystem serving institutional investors handling digital assets. With exciting times ahead in the DeFi ecosystem, stay tuned for Finoa’s roadmap.