When will Asset Managers launch DeFi Funds?
The blockchain industry had a fantastic year in 2021. One of its fastest growing areas was Decentralized Finance (DeFi), for which the Total Value Locked (TVL) rose from $18bn in January to $240bn at year’s end — an increase of more than 13 times! Despite this surge in TVL and the profitable investment opportunities that came along with it, so far mostly retail investors have participated in DeFi. When will asset managers launch the first DeFi investment solutions so that institutional money can enter the space?
It seems obvious that conservative institutional investors are turned away observing the price volatility of some of the DeFi protocols’ native tokens or of cryptocurrencies. However, the participation in DeFi does not necessarily require an investor’s exposure to high price volatility. Stablecoins such as USDC or DAI were created as a “safe haven” for crypto investors, pegging their values to one USD each. Stablecoins offer the benefits of crypto (fast, global, cheap settlement) without the downsides (price volatility), and are increasingly being used as settlement for goods and services.
One of the most interesting DeFi applications for institutional investors could potentially be stablecoin lending and borrowing via bluechip protocols, such as Aave and Compound. As of February 2, the supply rates on these protocols for USDC and DAI are approximately 2.6% per year. At the same time, the interest rates for deposits in bank accounts and money market instruments are zero or negative in most economies. Under these circumstances, the allocation of a small portion of an investor’s cash holding to stablecoin lending seems attractive. However, the use of DeFi protocols like Aave or Compound still is not very user friendly and requires technical knowledge for setting up wallets and handling of private keys. A remedy for all non-crypto-natives (and institutions) who still want to access DeFi protocols could be traditional investment vehicles (like mutual funds) that invest in stablecoin lending. If asset managers took care of the technical setup, such as establishing the interface to the DeFi protocol, they could offer their investors “stablecoin lending funds”, which can be purchased by investors just as any other security. Such a fund would deploy its investors’ capital in the lending protocols and generate a variable stream of return (interest income). Although the investment of such a DeFi fund would be made via a blockchain protocol, the characteristics of the returns are most closely related to the one of the asset class cash and cash equivalents. The remaining part of this article is dedicated to the potential demand for DeFi funds as well as regulatory concerns.
Would anyone actually buy a DeFi investment fund that does stablecoin lending with an expected annual return of around 3%? While the majority of current participants in DeFi are tech-savvy retail investors, non-crypto-native individuals and institutions face high barriers to embrace this technology. It is not reasonable that every party with a desire to join DeFi can assume the setup of a non-custodial wallet and the handling of private keys. Although non-tech-savvy individuals could also be potential investors in DeFi funds, the remainder of this article focuses on institutional investors as they own the lion share of the world’s assets under management (AuM).
Some institutional investors such as pension funds and insurance companies have to comply with many regulatory requirements regarding their eligible investments and can therefore not (yet) invest in DeFi/crypto. On the other hand, less regulated investors, e.g. private corporations, family offices, university endowments and sovereign wealth funds, could be more prone to tip their feet into crypto waters. In a zero or negative interest rate environment for money market instruments, these investors may want to substitute a small portion of their cash holdings in favor of stablecoin lending funds. These funds would neither require lock-up periods nor be exposed to interest rate risk due to their very short-term duration. By not having launched DeFi funds yet, asset managers are at risk of losing clients to innovative startups. For example, Meow, founded in 2021, connects corporate treasuries to crypto markets and promises variable annual rates up to 4% for business savings accounts. The company says it can offer an “alternative approach to those worried about the risks of inflation, as well as provide crypto-sourced yield in fiat (USD), which is the way corporate treasurers are used to operating.”
To clarify, numerous crypto funds have already been launched by asset managers. However, those funds pursue either buy-and-hold strategies to track the prices of cryptocurrencies (mostly BTC & ETH) or more complex quantitative trading strategies. The latter are primarily used by crypto hedge funds, which are most often domiciled in the Cayman Islands. These existing crypto funds are highly volatile and do not provide the stable income stream made possible by stablecoin lending.
Investment Fund Regulation
How are investment funds regulated and what vehicle would be appropriate for stablecoin lending? The investment business is highly regulated in Germany and there are laws outlining eligible assets for different types of investment funds:
- Mutual funds (UCITS): Throughout the EU, open-end mutual funds, which are accessible for retail investors, may fall within the regulatory European UCITS framework (Undertakings for the Collective Investment in Transferable Securities). The eligible assets for UCITS funds in Germany are highlighted by the German Investment Code (§193–198 KAGB). Currently, it is not allowed for UCITS funds to directly invest in cryptocurrencies or DeFi. However, UCITS funds may invest in securities tracking the performance of cryptocurrencies, such as exchange traded commodities & currencies (ETC), exchange traded notes (ETN) and certificates.
- Mutual funds (AIF): Mutual funds in the EU, which do not fall within the UCITS framework, are classified as alternative investment funds (AIF). Their universe of eligible investments is broader than the one for UCITS funds. However, neither open-end AIF (§219, 221 KAGB) nor closed-end AIF (§261 KAGB) are currently eligible to directly invest in cryptocurrencies or DeFi.
- Special-AIF: These funds are the least regulated investment fund type in Germany because they are not accessible for retail investors but only for (semi) professional investors. Since the Fund Jurisdiction Act (Fondsstandortgesetz) was published in Germany in 2021, open-end special-AIF are eligible to invest up to 20% of their portfolio value in crypto (§284 KAGB).
- Discretionary portfolio management (mandate): This is not an investment fund but a contractual agreement in which a portfolio manager invests assets on behalf of a (wealthy) client or legal entity. In this context, investing in crypto is permissible.
In short, due to regulatory reasons, it is currently not possible to launch stablecoin lending investment funds for retail investors in the EU. Special-AIF, which are exclusively for (semi) professional investors, may allocate only up to 20% of their portfolio value to stablecoins (crypto). Investment mandates currently represent the only framework in which asset managers may offer pure stablecoin lending strategies to institutional clients.
Banking, KYC & AML Regulation
Another interesting yet unanswered question is: how will authorities regulate stablecoin lending? Will it fall under the definition of “lending” of the German Banking Act (§1 KWG) and therefore only be permissible to be conducted by regulated banks? What licenses (if any) would asset managers need if they offered stablecoin lending products to their customers? Interestingly though, Coinbase, which holds a crypto custody license in Germany (but no banking license!) offers a stablecoin lending product to its German customers (DAI via Compound protocol).
Further crucial issues, which could hinder institutional investors from deploying capital in stablecoin lending protocols, are Know-Your-Customer & Anti-Money-Laundering requirements.The vast majority of current DeFi users are anonymous. One of the first DeFi protocols which introduced a separated capital pool for institutional investors is the lending/borrowing protocol Aave. With Arc, Aaave launched a permissioned “institutional version” of their protocol in early 2022, requiring all participants to first go through KYC & AML checks.The Aave community voted the company Fireblocks to be their first official whitelister for Arc. It is expected that other third parties will be approved to act as whitelisters as well.
As the DeFi infrastructure grows at a rapid pace and the regulatory landscape in the European Union provides increasingly more guidance, the adoption of digital assets at financial institutions accelerates. While the current focus of many investors is on buying and holding volatile cryptocurrencies like BTC and ETH, stablecoin lending provides a stream of income based on a non-volatile principal (e.g. USDC). Although the expected annual yield of around 3% makes the substitution of a small portion of an investor’s cash holding with stablecoin funds seem attractive, asset managers have yet to launch respective investment solutions. Given a 100% portfolio allocation to stablecoin lending is currently not permissible for any investment fund type in Germany, the only viable solution (so far) is discretionary portfolio management (a.k.a mandates). Asset managers are mostly not yet ready to launch such DeFi investments due to a variety of technical hurdles ranging from the required interface to the lending protocols (API), to on- and off-ramps to crypto as well as secure custody of assets. To mitigate the risk of losing corporate clients and to offer DeFi investment solutions in a timely manner, asset managers might be well advised to cooperate with an enabling fin-tech startup that acts as a one-stop shop for crypto.
Sources (all links accessed in January / February 2022):