The following is a guest post from Vincent Maliepaard, Marketing Director at IntoTheBlock.
As Bitcoin surpassed its all-time high earlier this year, driven by institutional interest, many expected a similar surge in the decentralized finance (DeFi) space. As DeFi surpassed $100 billion in total value locked (TVL), it was the perfect time for institutions to come on board. However, the expected influx of institutional capital into DeFi has been slower than expected. In this article, we will explore the main challenges hindering the institutional adoption of DeFi.
Regulatory hurdles
Regulatory uncertainty is perhaps the most significant obstacle for institutions. In major markets like the United States and the European Union, the unclear classification of crypto assets, especially stablecoins, complicates compliance. This ambiguity increases costs and deters institutional involvement. Some jurisdictions, such as Switzerland, Singapore and the United Arab Emirates, have adopted clearer regulatory frameworks, which has attracted early movers. However, the lack of global regulatory consistency complicates cross-border capital allocation, making institutions hesitant to confidently enter the DeFi space.
Additionally, regulatory frameworks such as Basel III impose strict capital requirements on financial institutions that hold crypto assets, further discouraging direct participation. Many institutions opt for indirect exposure via subsidiaries or specialized investment vehicles to circumvent these regulatory constraints.
However, Trump’s office is expected to prioritize innovation over restrictions, which could reshape US DeFi regulation. Clearer guidance could reduce compliance barriers, attract institutional capital, and position the United States as a leader in this area.
Structural barriers beyond compliance
Although regulatory issues often dominate discussions, other structural barriers also prevent institutional adoption of DeFi.
A major problem is the lack of suitable wallet infrastructure. Individual users are well served by wallets like MetaMask, but institutions need secure and compliant solutions, such as Fireblocks, to ensure proper custody and governance. Additionally, the need for seamless transitions between traditional finance and DeFi is key to reducing friction in capital flows. Without robust infrastructure, institutions struggle to effectively navigate between these two financial ecosystems.
DeFi infrastructure requires developers with very specific skills. The skills required often differ from traditional financial software development and can also vary on a blockchain-by-blockchain basis. Institutions looking to deploy only in the most liquid strategies will likely need to deploy across multiple blockchains, which can increase overhead and complexity.
Liquidity fragmentation
Liquidity remains one of DeFi’s most persistent problems. Fragmented liquidity across various decentralized exchanges (DEXs) and borrowing platforms presents risks such as slippage and bad debt. For institutions, it is vital to execute large transactions without significantly affecting market prices, and low liquidity makes this difficult.
This can create situations where institutions must execute transactions on multiple blockchains to complete a single transaction, adding complexity and increasing risk vectors on the strategy. To attract institutional capital, DeFi protocols must create deep and concentrated liquidity pools capable of supporting very large transactions.
A good example of liquidity fragmentation can be seen with the evolving layer 2 (L2) blockchain landscape. As it becomes cheaper to build and transact on L2 blockchains, liquidity has moved away from the Ethereum mainnet. This has reduced liquidity on mainnet for certain assets and transactions, thereby reducing the size of the deployment that institutions can make.
Although technologies and infrastructure improvements are being developed to address many liquidity fragmentation issues, this poses a major barrier to institutional deployment. This is especially true for deployments on L2s where liquidity and infrastructure issues are more pronounced than on the mainnet.
Risk management
Risk management is paramount for institutions, especially when engaging in a nascent sector like DeFi. Beyond technical security, which mitigates hacks and exploits, institutions must understand the economic risks inherent in DeFi protocols. Vulnerabilities in protocols, whether governance or tokenomics, can expose institutions to significant risks.
Compounding these complexities, the lack of institutional-level insurance options to cover large loss events like a protocol exploit, often means that only assets intended for high R/R are allocated to DeFi. This means that low-risk funds that could be open to BTC exposure are not deployed in DeFi. Additionally, liquidity constraints, such as the inability to liquidate positions without triggering major market impacts, make it difficult for institutions to effectively manage their exposure.
Institutions also need sophisticated solutions tools for assessing liquidity risksincluding stress testing and modeling. Without it, DeFi will remain too risky for institutional portfolios, which prioritize stability and the ability to deploy or unwind large capital positions with minimal exposure to volatility.
The Way Forward: Building Institutional-Grade DeFi
To attract institutional capital, DeFi must evolve to meet institutional standards. This means developing institutional-quality portfolios, creating transparent capital entry and exit ramps, offering structured incentive programs, and implementing comprehensive risk management solutions. Addressing these areas will pave the way for transforming DeFi into a parallel financial system, capable of supporting the scale and sophistication required by large financial players.
By building the right infrastructure and aligning with institutional needs, DeFi has the potential to transform traditional finance. As these improvements are made, DeFi will not only attract more institutional capital, but also establish itself as a fundamental part of the global financial ecosystem, ushering in a new era of financial innovation.
This article is based on The latest research paper from IntoTheBlock on the future of institutional DeFi.
