How to Incorporate DeFi into Your Asset Management Strategy

As more institutional investors look to the digital asset class, decentralized finance (DeFi) is poised to become a common part of many investment portfolios. For those ahead of the curve, owning ETH and other ERC-20 tokens is like owning the HTTP protocol of finance before the internet. In other words, as the most popular development blockchain, Ethereum has become the de-facto infrastructure for building DeFi applications. By investing in DeFi protocols and the digital assets they utilize, investors are effectively rewarded for contributing to and securing the Ethereum network.

This vast ecosystem of staking, lending, liquidity provisioning, and trading protocols underpins the DeFi industry. This article will explore the main products and services that make up the DeFi investment universe available to investors, the risks associated with using these protocols, and how DeFi can be incorporated into an institutional asset management strategy.

The DeFi Investment Universe

The DeFi ecosystem offers various financial services and products, from staking and yield farming to lending and borrowing, derivatives trading, and more. What’s unique to DeFi versus traditional Finance (TradFi) is that individual participants can directly engage in these activities as opposed to going through a centralized financial institution. This arrangement provides a wider range of investment possibilities and more flexibility when constructing investments customized to individual risk and return objectives. Let’s start by taking a closer look at how each segment compares to TradFi.

Staking: Get Rewarded for Validating Transactions

One of the most popular DeFi activities is staking, which rewards investors for locking up capital to secure a network. To understand staking conceptually, a quick review of consensus mechanisms is required:

In general, there are two main consensus mechanisms that underpin most blockchains:

Proof of Work (PoW)

PoW is a consensus mechanism that uses computational power to mediate block production and ensure security. Miners compete to create new blocks full of processed transactions. The winner shares the new block with the rest of the network and earns a reward. The race is won by the miner that can solve a complex math problem the fastest – this produces the cryptographic link between the current block and the block that went before. Solving this puzzle is the work in PoW.

Proof of Stake (PoS)

With PoS, the consensus mechanism is mediated by validators that “stake” assets to participate in the system. A validator is chosen at random to create new blocks, share them with the network, and earn rewards. Instead of performing intense computational work, validators simply stake their assets in the network, incentivizing healthy network behavior.

A PoS system is kept secure because a single entity would need control over 51% of the total staked assets to defraud the chain. To prevent validators from acting maliciously, the network punishes fraudulent behavior economically. In summary, staking simply means participating in the validation of transactions, and getting compensated for it—but where does yield come from?

We can answer this question using the Ethereum blockchain as an example given its market dominance and because most other staking programs work similarly:

In this example, the yield generated by stakers depends on three variables:

• The amount of ETH staked
• Net transaction fees (the cost of using the chain)
• Maximal Extractable Value (MEV)

A mental model popularized by a16z’s Chris Dixon helps to further conceptualize this process. In this model, Chris suggests thinking of blockchains like Ethereum as sellers of blockspace. Blockspace is exactly what it sounds like—space on a blockchain where one can run code and store data. Transaction fees and MEV are fundamentally what participants pay for using blockspace.

What makes staking attractive is that it’s a relatively stable way to earn rewards, especially compared to other DeFi activities where institutions often have to be hands-on when identifying the best investment pools for attractive risk-adjusted yields. In line with the TradFi principle of “high risk, high reward,” DeFi opportunities that offer higher rewards often have a much higher variance of payoffs—which is arguably not the case for staking. Specifically, staking is one of the few instances where investors can participate in the revenue generation of an active network.

Lending: Be a Lender, Without a Bank

DeFi lending is another popular service that offers users a source of income. Specifically, these platforms allow users to lend their crypto assets in exchange for interest payments, similar to traditional lenders. DeFi lending provides an attractive alternative to traditional banking products because it often comes with higher yields and lower fees—both a result of having fewer intermediaries in the system providing services.

In addition, DeFi lending is generally much faster than conventional lending practices because it eliminates the need for extensive paperwork and manual processing. The loan terms are programmed into the smart contract, defining and executing the predetermined agreement once conditions are met. Unlike staking and liquidity provisioning, lending yields are more consistent because the former act as reward mechanisms. As such, lending might better suit income-seeking investors aiming for stable yields and pre-determined investment horizons.

Liquidity Provisioning: Get Paid as a Market Maker

DeFi liquidity provisioning is another way to incorporate DeFi into your asset management strategy. This service involves providing liquidity on decentralized exchanges and earning rewards through additional tokens. Like staking, this practice is an attractive way to generate passive income because users receive rewards for providing liquidity—without the need to trade actively. In addition, DeFi liquidity providers often benefit from lower fees, making it an excellent option for those looking for a cost-effective way to diversify their portfolio.

Trading and Exchanges: Trade Efficiently and Without Counterparty Risk

DeFi trading is similar to traditional trading, except it occurs on decentralized exchanges (DEXs) instead of centralized ones. These DEXs provide a trustless environment for digital asset swaps, eliminating the need for intermediaries and allowing users to trade directly. As a result, DeFi trading often comes with lower fees, making it appealing for those looking for low-cost transactions.

Without intermediaries, the settlement and counterparty risks associated with centralized exchanges are eliminated. In addition, DeFi gives users access to a broader range of digital assets than centralized exchanges, allowing investors a greater range of possibilities in their investment strategy. Finally, DEXs allow investors to trade almost any trading pair for which there is a market (i.e., supply/demand). This functionality ensures trades are settled directly between assets, instead of requiring “Asset A” to be converted to cash before buying “Asset B.”

The Five Key Operational Risks in DeFi Asset Management

Like all investment products, potential rewards come with risks. While digital assets exhibit specific investment risks (besides high volatility), the approach to managing them aligns closely with other liquid asset classes. However, one aspect that differs greatly from TradFi is the operational risks unique to DeFi—which is why we’re exploring them here (a more detailed article on these risks can be found in our Insights section). Specifically, investors should assess custody, liquidity, smart contract, governance, and execution risks when incorporating DeFi into an asset management strategy.

• Custody Risk: This risk occurs when an investor or custodian fails to control the funds or assets they manage. In the DeFi ecosystem, custodial services are usually provided by third-party smart contracts and protocols that hold your private kets. As such, asset managers need to trust the protocols they’re working with and verify the credentials of any custodian.

• Liquidity Risk: This risk occurs when an asset becomes illiquid or difficult to trade, which might occur if there aren’t enough buyers or sellers. Alternatively, the asset might be complex and hard to value. For this reason, asset managers should always take steps to maintain liquidity, diversifying across different asset classes.

• Smart Contract Risk:  As self-executing, blockchain-based code, smart contracts can generate risk if the underlying code fails to function correctly. As a result, asset managers must ensure the protocol has undergone extensive auditing to ensure the code is safe and secure.

• Governance Risk: These risks arise in the DeFi ecosystem because many protocols incorporate unique governance models. These mechanisms can include specific voting processes, token models, or decentralized autonomous organizations (DAO) that can propose and implement protocol changes. As such, asset managers must be aware of such changes or updates to ensure that strategies are adapted accordingly.

• Execution Risk: This risk occurs because of latency issues, network congestion, or coding errors. Alternatively, execution risk can occur due to a poor user interface (UI) or user experience (UX), triggering unexpected events. Asset managers should maintain the necessary infrastructure, resources, and safeguards to reduce execution risk.

Digital Assets in a Traditional Portfolio

Despite the operational risks that arise from utilizing DeFi protocols, there are several benefits to incorporating digital assets into traditional portfolios. For instance, including digital assets allows for greater diversification which, if correctly applied, has been shown to increase the risk-return ratios of traditional portfolios. In addition, digital assets can also provide access to markets that aren't typically accessible through traditional investment vehicles, increasing potential returns. Digital assets also provide investors with a direct way to participate in the financial system, bypassing the transactional friction generated by intermediaries found in TradFi. Finally, investing in digital assets allows investors to take advantage of the vast opportunities in DeFi as a financial system while increasing traditional portfolio diversification.

While the benefits of incorporating DeFi into your asset management strategy are promising, it’s critical that managers address how specific digital assets appear in a multi-asset portfolio, maintaining a holistic view of exposures and risks. For example, stablecoins might be defined as cash equivalent depending on how they're collateralized, while staking ETH could be modeled as a delta-neutral fixed-income instrument or as a source of return on top of the pure asset return.

The Alloy Advantage

Alloy provides the infrastructure you need to participate seamlessly in the DeFi ecosystem. Specifically, Alloy delivers regulated asset custody services and an investment management system that streamlines the integration of digital assets. By allowing asset managers to access multiple DeFi protocols on one platform, Alloy supports a fully integrated interface that optimizes investment strategies, from staking to complex multi-protocol yield farming—with only a few clicks. In addition to dramatically simplifying the entire front-to-back investment process, Alloy supports robust portfolio analytics that allows investors to mitigate their risk exposure. Finally, Alloy adheres to institutional procedures and reporting systems that enable investors to integrate DeFi into every aspect of their investment strategy and execution.

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