Aave is the largest DeFi lending protocol with more than $16 billion in cryptocurrency assets locked. It’s planning to launch Aave Pro, which will operate segregated permissioned pools of ‘whitelisted’ users that have passed Know Your Customer (KYC) protocols. This removes one of the key roadblocks to regulated institutions participating in decentralized finance (DeFi).
Why would institutions be interested? Because they can earn 2.1% (3.2% including Aave token rewards) on U.S. dollars with relatively low risk, though it’s not riskless. The returns are possible because cryptocurrency investors don’t want to sell their Bitcoin. Using a smart contract based protocol, they borrow up to 85% of the value of their holdings and pay 3.1% for the secured loan. For depositors, competitor Compound offers a lower return of 1.6% for lower risk because a maximum of 70% is loaned against the secured cryptocurrency. If the cryptocurrency price drops too low, the asset used as security is automatically liquidated.
The recent steep decline in prices was a good test for the sector. While it has come through well, it is still not riskless. There is the possibility that if a cryptocurrency price decline is sufficiently steep that the asset used as security might not be capable of being sold fast enough. Or some smart contract bug could be uncovered. For the main protocol, by now the bugs should have been ironed out because there has been a lot of money locked for some time.
News that Aave was trialing private permissioned liquidity pools first surfaced in May when someone noticed an inaccessible pool. The news was confirmed by Aave during a Blockworks webinar last week.
Aave CEO Stani Kulechov says it provides “accessibility to institutions without knowing their counterparties and mitigating their risk of compliance.”
In the initial phase, custody and security firm Fireblocks implements the KYC based on rules that have been agreed with the General Counsels at several institutions who have been participating in the pilots. But other custody providers will also provide solutions in the future.
The regulated DeFi approach
Mike Novogratz, the founder of cryptocurrency asset manager Galaxy Digital said there are three approaches that institutions might take to participating in DeFi. The first is to assume that the U.S. the Department of Justice won’t be interested in DeFi. As a regulated institution, that wasn’t something he’s comfortable with. A regulated approach would either be a segregated pool, as in this case or rely on an organization like Chainalysis to analyze blockchains to give you comfort about where the transactions are coming from with a high degree of probability.
“I think both of those are going to work to protect, to give a prophylactic to the user,” said Novogratz. “You’re going to see an increase in users because somebody like us, we’re going to be more comfortable participating in DeFi more aggressively.”
However, Novogratz is concerned about regulator interest in the sector and whether this will make it awkward for Aave and force them to choose between permissionless and permissioned. “Will businesses like Aave have to say we’re not going to be open and permissionless like we were. We’re going to have some form of KYC no matter how it comes in, to let the regulators continue to allow them to exist,” asked Novogratz. “That’s an existential question. I don’t know the answer. I just know it’s going to get asked.”
Aave’s General Counsel Rebecca Rettig said, “It’s already being asked.” But she was keen to distinguish Aave, the company, from the decentralized protocol. She also said the company is very engaged with educating regulators.
A threat to banks
Novogratz was asked what might create FOMO (fear of missing out) for DeFi with institutions. His response was big institutional names participating will attract others, as happened with Bitcoin.
The irony with many players in the DeFi and cryptocurrency sectors is the simultaneous courting and disdain for institutions. Rettig was slightly more diplomatic when she said, “it (DeFi) is superior in many ways to the traditional financial system and the banks have to be a little nervous about it.”
An Aave colleague was more direct:
And someone not directly associated with Aave thought the idea of institutions participating in a DeFi permissioned liquidity pool was worthy of a Meme.