Institutional Digital Asset Management: What You Need To Get Started

As decentralized finance (DeFi) becomes more popular, many institutional investors are looking to incorporate digital assets into their portfolios. However, this process can be quite complex without the expertise of a crypto-native team. Despite the similarities between traditional finance (TradFi) and DeFi, there are significant differences that institutional investors need to be aware of before getting started.

By understanding the key elements needed to access DeFi, investors can make informed decisions about allocating their resources and benefit from opportunities in digital assets. In this article, we’ll break down each component of institutional asset management and how it translates to DeFi and how Alloy overcomes common challenges to make digital assets more accessible for institutional-scale DeFi.

Wallet Infrastructure and Fund Custody

At a minimum, you’ll need a way to safely hold crypto assets. Specifically, as an institutional asset manager in DeFi, you’ll need to consider where to keep your customers’ and investors’ assets while ensuring the appropriate infrastructure is in place to compliantly secure funds. In DeFi, wallets are similar to traditional bank accounts, allowing investors to secure and manage their digital assets. However, on a more technical level, while conventional banks utilize account numbers, DeFi wallets use public keys to identify unique “addresses,” while private keys function similarly to traditional access codes (PIN).  Every wallet has private and public keys, with private key holders exercising complete authority over funds held.

The key element to consider regarding wallets is that you can choose to hold your wallet on internal infrastructure (self-custody), or use a third party custody provider. In the former case, you’re responsible for ensuring wallet safety and security by holding and securing your own private keys. In contrast, you can choose the more traditional approach by appointing a custodian to secure the wallet for you. This scenario aligns more closely with the traditional segregation of duties between an asset manager who oversees the funds, and an external custodian who is responsible for holding the assets—which belong to the beneficial owners or investors. To summarize, the difference is dictated by who safeguards the private keys. With self-custody, you’re responsible for holding the private keys. Alternatively,  a custodian can safeguard the private keys.

For institutional investors in DeFi, it’s prudent to have a clear segregation of duties, meaning a third-party custodian is often necessary to manage funds. And while a small family office could technically forego using a custodial service to lower costs, more prominent institutional investors in the U.S. must engage an approved custodian when assets under management (AUM) exceed $150 million.

For DeFi newcomers, establishing this segregation can be a challenge—that’s where Alloy can help. The Alloy platform is based on BaFin-regulated custody with segregated wallets, with private keys secured by multi-party computation (MPC) technology. Specifically, clients own a dedicated wallet so assets and transactions can be constantly identified, accessed, and even reconciled on-chain. And for those clients that prefer to use Alloy with a non-custodial wallet, the necessary integration is also available.

Trading Infrastructure and Market Access

After establishing custodial infrastructure or engaging a third party, asset managers must also provide trading infrastructure and manage market access. In other words, DeFi asset managers need connectivity to markets, whether it’s through a broker, exchange, or both - let’s take a closer look at exchanges first.

Digital Asset Exchanges

In the DeFi ecosystem, centralized exchanges (CEXs) and decentralized exchanges (DEXs) facilitate digital asset trading. Notably, CEXs take custody (and thereby constitute counterparty risk) of investor funds, while DEXs do not. As such, CEXs require that investors go through an onboarding process while DEXs can be more readily accessed by simply connecting your wallet. For institutional investors, DEXs have changed the landscape of DeFi asset management by providing a more secure and trustless environment for digital asset exchanges. In addition, DEXs usually offer access to a wider range of trading pairs. However, CEXs typically offer deeper liquidity, making themmore suitable when executing large trades.

CEXs can also be easier to use, which makes them suitable for newcomers unfamiliar with the complexities of DEXs. Overall, DEXs and CEXs have advantages and disadvantages regarding DeFi asset management, meaning institutional investors must evaluate their risk-reward profiles before deciding which is best for their clients. Some investors choose to use a combination of both to remain flexible and manage counterparty risk. For those asset managers aiming to benefit from a range of trading venues, prime brokerage services may offer an alternative to accessing exchanges directly.

At Alloy, we’re strong believers in the power of DeFi, but also recognize the complementary aspects of CEXs. For this reason, we provide safe access to DEXs and CEXs, delivering choice and flexibility to investors. Specifically, both types of liquidity venues can be easily accessed through a single platform, eliminating the need to connect and interact with each liquidity venue individually.

Prime Brokers

Like exchanges, prime brokers are critical to facilitating institutional investor access to DeFi—however, the mechanism is different. Specifically, brokers provide traders with access to a range of venues with which they’re connected, allowing them to execute transactions on behalf of their clients. These brokers also offer liquidity services and leverage, enabling institutional investors to enter and exit positions quickly and efficiently. Finally, brokers may offer additional services such as portfolio advice, market research, and customer support. By leveraging these services, institutional investors can access a wider range of venues without connecting to each one of them. Notably, the DeFi assets available depends on the broker’s offering, meaning certain assets may not be available for trading.At Alloy, we provide access to a network of prime brokers, allowing investors to choose their trading counterparties.

DeFi Protocol Access

In addition to ensuring adequate market access, asset managers must understand the inner workings of DeFi protocols, interact with user interfaces, and consolidate data to gain valuable insights. For traditional asset managers, this process can be challenging for several reasons. Namely, there's no standard for interacting with each of these protocols and their diverse user interfaces. As such, DeFi asset managers need to extensively familiarize themselves with each protocol interface before use. In addition,, consolidating data from multiple protocols is critical to achieving a comprehensive picture of exposures, performance, and risks.

For this reason, asset managers must have expertise with each DeFi protocol and establish systems that can effectively monitor and analyze data from all of them. This process can be time-consuming, but it is essential to successfully manage a portfolio of DeFi assets. Finally, the operational complexity of using various DeFi protocols can be both an inhibitor and source of alpha for DeFi asset managers. As a result, it’s critical to utilize a robust system when managing DeFi investments to generate sustainable returns.

At Alloy, accessing and navigating DeFi protocols is at the core of what we do and continues to guide the evolution of our product. With our robust platform, users gain access to multiple DeFi protocols through one UI while gaining the ability tobuild, automate, and rebalance highly complex multi-protocol strategies.

Middle Office, Back Office & Administration

Establishing back, middle, and front office processes is critical to any asset management strategy, especially for institutional investors looking to incorporate DeFi into their portfolios and existing  processes. Specifically, you’ll need an asset manager running the portfolio, someone executing trades, and another individual from the middle office monitoring and reconciling transactions—each of these functions is crucial. Simply put, these individuals ensure all processes are completed efficiently and correctly, with a clear division of responsibility and an appropriate level of auditability.

In addition, from risk and compliance to portfolio management and trading systems, user access should be limited to authorized personnel, and activity should be logged and monitored to ensure compliance with institutional standards. To service these functions, users need access to on-chain insights such as trade, execution, and position information in addition to pricing and market data. Connecting to on-chain data sources and providers that deliver pricing data is a criticall part of this process and should be extensively integrated with systems and respective operational processes.

At Alloy, we’ve built our product with institutional investment processes in mind. For this reason,  we’ve integrated functionality  that caters to the complete front-to-back investment process using APIs. Specifically, these APIs provide full access to all Alloy data points for further downstream processing.

Investment Tools

With the basic infrastructure in place, there’s still a need for appropriate tooling that enables specialized functionality throughout the investment process. For starters, research and market monitoring is essential to understanding the DeFi space and making informed decisions. This process includes researching different products and strategies while monitoring liquidity, pricing, and overall trends in the DeFi market. Research informs investment decisions along with appropriate portfolio analytics. These insights are typically available through separate platforms where investors can connect their different wallets.

However, these platforms are usually only focused on portfolio analytics whereby portfolio construction or rebalancing is done across separate in-house tools or spreadsheets. Once investment decisions are taken, execution happens through wallet providers, brokers, or directly on exchanges. The execution of transactions is often monitored within the same platforms, or separately through on-chain tools. All the data and analytics on exposures, transactions, performance, and risks must also be captured in reports for various stakeholders. Certain reports can also be generated within these tools or through traditional Business Intelligence (BI) platforms. In either case, the availability of data and integrations with reporting systems are crucial.

Finally, tax reporting is a critical component of any investment activity, especially because DeFi is a relatively new asset class that introduces several complexities from a tax reporting perspective. As a result, there’s still a lot of ambiguity around accurately reporting DeFi gains for tax purposes along with several  other taxation considerations. As a result, asset managers must work with tax experts to ensure accurate and complete annual filings.

The sheer number of tools, technologies, and interfaces needed to consistently manage DeFi is overwhelming and challenging to maintain, especially at scale. That’s why Alloy has integrated these key functionalities into a single platform, eliminating the need to combine or create individual solutions.

Data System Integration

Eventually, all the above components should be combined and integrated with your organization’s existing data and systems. Specifically, it’s essential to have a plan in place to ensure all of the different protocols, applications, and services are communicating correctly. This integration process often requires using multiple APIs, which can be time-consuming and complex. For this reason, it’s essential to have an experienced team that understands the complexities of DeFi and the challenges associated with the underlying data, and its integration into existing systems.

By combining the infrastructure, technology, tools, and data needed to manage DeFi investment portfolios, Alloy serves as a gateway tof DeFi. Instead of interacting with multiple APIs, organizations can utilize one, gaining access to valuable functionality and data in a single, efficient interface.