Asset Management in DeFi

Decentralized finance (DeFi) is transforming how financial services and products are created, managed, and used. By replacing traditional intermediaries like banks and brokers with smart contracts on public blockchains like Ethereum, DeFi enables a wider range of financial services to be developed and accessed permissionlessly.

One area of financial services seeing rapid innovation in DeFi is asset management. Asset management refers to the management of various asset classes like equities, fixed income, commodities, real estate, etc. on behalf of investors. DeFi is creating new decentralized models for asset management that do not rely on traditional intermediaries.

Introduction to Decentralized Finance

Decentralized finance refers to financial applications being built on top of distributed blockchain networks. The main value proposition of DeFi is removing intermediaries in financial services by implementing them as blockchain-based smart contracts.

Key attributes of DeFi include:

• Open Access - Anyone can access DeFi applications without permission or identity requirements.
• Transparency - DeFi apps operate on public blockchains, providing transparency into protocols and transactions.
• Interoperability - DeFi apps can interconnect and build on top of each other in a modular way.
• Reduced Costs - Disintermediation cuts out excessive fees and rent seeking.
• Censorship Resistance - DeFi protocols are censorship resistant and remain available at all times.

These attributes make DeFi well suited as an infrastructure for redesigning financial services like asset management to be more efficient and accessible. The immutability, transparency, and auditability of blockchains enables the creation of asset management applications with reduced need for trust in centralized intermediaries.

DeFi emerged in 2017 with the issuance of ERC-20 tokens on Ethereum, which created a composable ecosystem for managing and trading tokenized assets. DeFi grew slowly initially but saw explosive growth in 2020, with the total value locked in DeFi rising from $600 million in January 2020 to over $100 billion by October 2022. DeFi has moved beyond just cryptocurrency assets, with protocols emerging for more sophisticated on-chain asset management.

Benefits of DeFi for Asset Management

DeFi offers several key advantages for reinventing asset management services in a decentralized way:

Reduced Costs
DeFi eliminates rent seeking and excessive fees charged by legacy intermediaries. Trading, settling, and holding assets on blockchains cuts out these high costs. For example, trading stocks on DeFi costs just 0.3% vs. 5-12% at traditional brokerages.
24/7 Trading and Settlement
DeFi protocols never sleep, enabling 24/7 access to trading, lending, leverage, and other activities. Assets settle instantly without humans or institutions needing to approve transactions.
Accessibility
Anyone globally can access DeFi platforms without paperwork, identity verification, or meeting minimum wealth requirements. Geographic and regulatory arbitrage is minimized.
Transparency
Unlike closed legacy systems, DeFi transactions are viewable on public blockchains. Investors can analyze risks, returns, inventories, and other data.
Censorship Resistance
Government authorities cannot stop or restrict transactions on decentralized protocols. Asset managers and investors need not worry about political risks or capital controls.
Composability
DeFi applications are interoperable money legos. Asset managers can easily combine multiple DeFi protocols like lending, DEXs, derivatives, and more to generate returns.
Programmability
The logic of DeFi apps is governed by public smart contract code that is customizable. Asset managers can create automated, customized investment strategies.
Enhanced Liquidity
By pooling assets globally, DeFi offers deeper liquidity for assets including long-tail assets not well served by legacy systems.

The combination of these benefits makes DeFi highly advantageous for providing asset management services like trading, portfolio diversification, yield generation, risk management, reporting, and more in a more efficient and customizable manner.

Overview of Asset Management Activities

Asset management refers to the administration and management of various asset classes to meet investment objectives. Key asset management activities include:

Portfolio Management
Constructing portfolios of assets like equities, bonds, commodities, currencies, real estate, etc. and managing them to achieve client investment goals.
Trading & Execution
Executing trades to adjust portfolios. Requires access to liquid markets and often leverage to amplify positions.
Risk Management
Measuring and managing portfolio risks like volatility, drawdowns, liquidity, etc. Often utilizes hedging strategies.
Research & Analysis
Researching markets, assets, and investment strategies. Involves valuation models, data analysis, and qualitative judgment.
Reporting & Compliance
Monitoring portfolio positions and performance. Also handle regulatory compliance requirements.
Settlement & Custody
Settling asset transactions and holding custody of client assets. Requires integration with banks and custodians.

In traditional finance, these activities are carried out by various intermediaries like investment banks, brokers, custodians, and funds. DeFi is creating decentralized alternatives for executing these functions directly on-chain without rent-seeking intermediaries.

Different DeFi protocols focus on specific pieces of this asset management value chain. However, the composable nature of DeFi allows these discrete building blocks to be synergistically combined to provide end-to-end decentralized asset management services ranging from front ends to back ends.

We will now explore major DeFi protocols playing a role across these various facets of asset management.

DeFi Protocols for Asset Management

Many DeFi protocols have emerged to help digitize, tokenize, manage, trade, leverage, earn yield on, and securitize both traditional and digital asset classes. We will provide an overview of the growing palette of DeFi primitives for asset management, which can be mixed and matched in creative ways.

Aggregators

Aggregators are platforms that integrate with multiple DeFi protocols and dashboards to provide unified interfaces for asset management. Leading aggregators include:

• Yearn Finance - Vaults for asset deposits that automatically move funds between lending protocols, liquidity pools, and other yield generators for optimal returns.
• Convex Finance - Enhances yields for suppliers on Curve crypto pools by optimizing rewards and leverage.
• Badger DAO - Automated yield farming tools including vaults, lending, and hedging strategies tailored for Bitcoin.
• Beefy Finance - Yield optimizer vaults across different chains like BNB, Polygon, Avalanche, and Fantom.
• Harvest Finance - Aggregates lending, supply pools, and other instruments while hedge risks using vaults.

Aggregator platforms improve capital efficiency and takes the complexity out of asset management on DeFi. Asset managers can tap aggregators for one-stop yield generation, optimization, and risk management across a spectrum of underlying protocols.

Tokenized Asset Management

Various protocols focus on tokenizing real world assets like equities, commodities, real estate, art, and more to create new digital asset classes tradable on blockchains. Major tokenized asset platforms include:

• tZERO - Tokenizes public and private equities like stocks, funds, REITs on blockchain.
• RealT - Fractions of US real estate properties represented as ERC-20 tokens.
• Centrifuge - Platform for tokenizing business assets like invoices, mortgages, and supply chains.
• Harbor - Compliant platform for tokenizing private securities like real estate funds, private equity, and more.
• Masterworks - fractionalized ownership in blue chip artwork as ERC-20 tokens.

These platforms create blockchain-based representations of real world assets. This makes previously illiquid assets easier to fractionalize and trade on DEXs and DeFi protocols. For asset managers, it expands the universe of investable assets on-chain.

Decentralized Exchange (DEX) Trading

Decentralized exchanges allow trading of tokens directly between users without intermediaries. Leading DEXs include Uniswap, SushiSwap, Curve Finance, Balancer, Bancor, Kyber Network, Loopring, dYdX, and more.

DEXs use automated market maker algorithms rather than order books to facilitate trading. Asset managers can use DEXs for low cost, efficient trading to adjust their portfolios. DEXs also offer deep liquidity for DeFi-native assets.

Lending and Borrowing

DeFi lending protocols allow users to supply assets and earn yield or borrow assets. Top platforms include Aave, Compound, MakerDAO, AAVE, and more. Typical interest rates range from 2-15% APY.

For asset managers, DeFi lending provides easy yield on idle assets. Cash not deployed can earn low risk returns. Borrowing allows leveraging up positions. No intermediary or credit checks are required.

Derivatives

Financial derivatives like options, futures, and swaps allow expressing directional and hedging strategies. DeFi derivatives include:

• Options - Platforms like Hegic, Opyn, Ribbon Finance
• Futures - dYdX, FutureSwap, Perpetual Protocol
• Swaps - Uniswap, Curve Finance

Derivatives are important to asset managers for managing risks and generating alpha. DeFi expands derivative markets to cryptocurrencies and tokens.

Index Funds

DeFi index funds provide broad market exposure for passive investors. Top index projects include:

• Set Protocol - Tokenized index of various DeFi tokens that rebalance automatically.
• PieDAO - Range of index tokens tracking baskets of DeFi assets.
• PowerPool - Enable creation of custom indices of tokens.
• TokenSets - Managed portfolios of assets that rebalance based on algorithms.

Index funds give asset managers quick diversified exposure. Custom indices can also be created to capture unique segments of the market.

Asset Management Wallets

Wallets customized for asset management activities are emerging. Examples include:

• Gnosis Safe - Multi-signature and configurable smart contract wallet for teams.
• Argent - Features DeFi integrations and asset management tools.
• Zerion - Dashboard for managing DeFi positions across multiple protocols.
• InstaDApp - Wallet with embedded lending, swaps, and portfolio management.
• Zapper - Dashboard for analyzing asset positions and liquidity pools across DeFi apps.

These wallets make asset management on DeFi simpler and more transparent. Features like multi-accounts, transaction batching, reporting, and interoperability reduce friction.

This sample shows the diversity of DeFi protocols innovating across the asset management stack. While still early stage, the building blocks already exist to replicate many core activities of asset management in a non-custodial, trustless way on blockchains.

Use Cases of DeFi Asset Management

DeFi-based asset management can provide benefits for various investor types from retail to institutions. Major use cases include:

Retail Investors

DeFi gives retail investors access to professional quality asset management tools like trading, derivatives, indexing, and more that may not be available at incumbent consumer platforms. DeFi eliminates gatekeepers like accredited investor requirements and minimum balances. Geographic restrictions are also lifted since DeFi has no concept of residence or citizenship.

For hands-on retail investors, DeFi asset management also enables greater customization based on personal strategies and preferences. Investors can mix and match DeFi protocols like money legos to build their own unique asset management environments optimized for their needs. Rather than being constrained to rigid products, retail investors can be their own asset managers.

Institutional Investors

DeFi provides institutions an opportunity to expand their opportunity set into decentralized digital assets and decentralized financial services. DeFi protocols offer deep, programmatic liquidity for crypto assets that may be inaccessible or inefficient to trade at centralized crypto exchanges.

The transparency and auditability of on-chain data also enables better analysis of market dynamics. Derivatives like options, futures, and swaps that may be restricted for institutions in centralized finance are readily available in uncensored DeFi environments.

Institutions accustomed to passive index tracking strategies also benefit from DeFi index funds giving exposure to specific niches like decentralized exchanges, layer 1 blockchains, NFTs, and more.

Advisors and Fund Managers

For investment advisors and fund managers, DeFi can be used as infrastructure to create customized portfolios and investment products. The modular nature of DeFi apps allows money managers to mix and match components like leverage, derivatives, indices, aggregators, and more based on their investment thesis.

Investment strategies can be coded into smart contracts to create "rules-based portfolios" that automatically rebalance and readjust. These customized portfolio management strategies can be tokenized into ERC20 tokens and sold to clients for a management fee like traditional funds. But replacing opaque fund administrators with transparent on-chain rules verified by the Ethereum network.

Risks and Challenges With DeFi Asset Management

While promising, utilizing DeFi for professional asset management also comes with distinct risks and challenges:

Technical Risks
DeFi apps can have bugs and hacks that lead to loss of funds. Smart contract code needs rigorous auditing and testing. As newer technology, DeFi may be less battle-tested compared to legacy systems.
Market Risk
Cryptocurrency markets still exhibit high volatility. DeFi tokens remain highly correlated, lacking diversification. Sudden price swings call for advanced risk management that not all assets manager possess.
Liquidity Risk
Unlike mature markets, DeFi liquidity can dry up instantly during periods of volatility or protocol failures. This can leave asset managers unable to exit positions. Managing liquidity risk is vital.
Regulatory Uncertainty
Many jurisdictions have unclear or adverse policies towards decentralized digital assets. Navigating disparate global regulations poses challenges for DeFi asset management.
Custody and Private Keys
Asset managers must securely store private keys to DeFi assets. Losing keys means losing assets. Custody solutions for institutions are still maturing.
Onboarding/Offboarding
Moving fiat currencies and real world assets into and out of DeFi requires integration with traditional, slower financial rails. Adding latency and costs for investors.

These risks imply DeFi may be best suited initially for more risk tolerant investors with deeper expertise in blockchain and cryptocurrencies. However, the DeFi space is evolving rapidly. As technology and regulatory clarity improves over time, mainstream asset managers can progressively participate in this emerging financial paradigm.

Regulatory Landscape for DeFi Asset Management

A key consideration for pursuing asset management activities using DeFi protocols is understanding the evolving global regulatory landscape:

Securities Regulations
If tokens traded in DeFi are deemed securities by authorities like the SEC, then exchanges, indices, and asset managers may have to comply with pertinent securities laws. Most jurisdictions remain undecided on how to classify cryptoassets.
Custody and Fund Regulations
Acting as custodian and administrators of assets like traditional asset managers may require licensing such as a qualified custodian requirement in the US. Operating pooled investment funds also invites regulations.
Regulatory Arbitrage
As regulations emerge, more onerous regimes may incentivize users and developers to migrate to friendlier jurisdictions. Already the case as DeFi ecosystem concentrates on Ethereum.
Compliance Difficulties
Anonymity and pseudonymity of users on public blockchains makes enforcing compliance like KYC/AML practically difficult. Regulators concerned DeFi can facilitate criminal activity.
Central Bank Digital Currencies
If major central banks launch their own digital currencies, they may be integrated into DeFi - but with more surveillance and censorship compared to permissionless cryptocurrencies.
Self-Regulatory Organizations
Groups like the DeFi Association consisting of major DeFi builders aim to promote voluntary best practices and standards to head off restrictive government policies.

The decentralized nature of public blockchains makes imposing controls difficult for regulators. For now, DeFi protocols are generally non-compliant but regulator tolerance remains unclear. Clarity may have to emerge on a case-by-case basis depending on how DeFi services get used. For prudent risk management, asset managers should monitor regulatory developments applicable to their particular activities.

Future Outlook for DeFi Asset Management

Despite still being early stage, DeFi has made significant progress expanding access, capabilities, and sophistication of on-chain asset management in a short few years.

If growth continues, DeFi is poised to become a major new paradigm for asset management given its structural advantages over legacy approaches. Mainstream asset managers would be prudent to start evaluating potential integration of DeFi into their businesses.

Several key trends will shape the future evolution of DeFi asset management:

Asset Tokenization
More real world assets like private securities and funds will be tokenized to make them tradable 24/7 in DeFi environments. This expands the design space for on-chain portfolios.
Polkadot and Layer 2
Cross-chain asset management on Polkadot and scaling solutions like zkRollups will mitigate some limitations of isolated DeFi siloes.
Integration of TradFi
Decentralized and centralized finance will increasingly intersect rather than compete - combining the best of both worlds.
Mobile-First
Retail-friendly mobile DeFi apps will broaden access globally, especially in emerging economies lacking robust legacy banking.

Compliance and Regulation

As the DeFi space matures, expect more integration of compliance like KYC and investor accreditation to appease regulators. This may bolster institutional adoption. Central bank digital currencies issued by governments and integrated into DeFi could also accelerate mass adoption.

Professional Asset Managers

More traditional asset managers and institutions will start allocating to DeFi as infrastructure solidifies. Their large inflows of capital and expertise can significantly enhance the space.

Algorithmic Management

Asset management strategies will become increasingly automated using smart contracts. This reduces costs and error stemming from manual processes.

Exotic Assets

DeFi will move beyond just simple tokens towards more exotic asset classes like carbon credits, intellectual property, human capital, and even fractional ownership of businesses.

Decentralized Autonomous Funds

The combination of tokenized assets, algorithmic smart contracts, and blockchain oracles enables the creation of sophisticated DAO-based hedge funds needing minimal human intervention.

The open, programmable nature of DeFi protocols ensures asset management innovation will continue as developers reimagine every element of legacy finance in a natively digital format. While the risk-return profile remains volatile in these pioneering early stages, DeFi promises to fundamentally evolve how money and markets operate at large.

Conclusion

In summary, DeFi represents a paradigm leap in how technology can reduce costs, friction, and rent-seeking in financial services like asset management. It offers a more customizable, open, and transparent way to trade, invest, earn yield, and optimize portfolios. Much innovation is still needed and regulation remains uncertain. But the pace of change has been astonishing. For forward thinking asset managers, it is prudent to start exploring this new decentralized frontier of finance even if incrementally. The potential benefits over the long term are too significant to ignore.

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