Why European Institutions Love DeFi
Genesis
Reading recent headlines that cover crypto clampdowns in Asia and digital asset drama in North America, you would be forgiven for thinking that the center of cryptocurrency activity was in either of those two hemispheres. According to a recent report by crypto forensics firm Chainalysis, you would be mistaken.
The report shows that Central, Northern and Western Europe (CNWE) now has the largest cryptocurrency economy in the world in terms of transaction volume, accounting for 25% of global activity. What’s more, the recent growth was driven by institutional inflows, and was largely concentrated in decentralized finance (DeFi) assets and platforms.
This was surprising to many – European investors have a reputation for being traditionally conservative, yet they have become a leading force in one of the most innovative markets in the world. Why?
Below we’ll examine how the traditional European financial landscape makes European institutional investors the ideal partners for DeFi services. We’ll also step back and look at how this fits in to the evolution of the ecosystem.
But first, let’s review the recent growth of the institution-sized portion of the crypto market.
Crypto market growth
For an asset to be investable by institutions, it needs to have significant liquidity. Let’s assume $100 million as the minimum average daily spot volume for an asset to be considered liquid enough for institutional investment purposes. At the beginning of 2020, fewer than five assets regularly exceeded this level. Today, over 45 assets do.
The range of accessible derivatives is also expanding. The CME added to its crypto derivatives offering this year with ether futures and bitcoin micro contracts; but European institutions, unlike many of their US counterparts, have access to exchanges that offer a much broader range of crypto asset futures, perpetual swaps and options.
Institutions also require reliable onramps. This has improved notably over the past few years, as a handful of European exchanges have raised significant funding rounds and global exchanges have expanded their European presence.
So, European investors today have a much broader range of accessible crypto assets to choose from, and a maturing array of platforms on which to transact. While bitcoin is a significant feature in most institutional crypto allocations, the Chainalysis report shows that the majority of institutional investment in Europe has been heading in a different direction.
According to the study, well over half of institution-sized cryptocurrency transfers (over $10 million) since the beginning of 2021 has gone to DeFi platforms, mainly Ethereum, Uniswap and Instadapp.
Without going into the merits and risks of these platforms’ assets, or their relative outperformance so far this year, let’s examine why this growth shouldn’t really be surprising at all.
The European financial culture
Why are typically conservative investors betting on high volatility tokens?
The answer can be summed up in two words that characterize the European banking landscape: “yield” and “technology”.
Europeans are used to getting yield on bank deposits, and regard an account that pays a higher rate than inflation as a liquid investment. This has not been possible over the past few years, and while banks have resisted passing negative interest rates on to retail customers, many corporate clients are now paying to keep money in the bank.
Rate hikes in Europe over the next few months are expected, which could bring interest-bearing deposits back, but these hikes are likely to be subdued and possibly temporary. So, European institutions need to find yield in other areas. Most DeFi platforms are currently offering yields well above the EU inflation rate. Staking on Ethereum, for instance, earns an APY of 5.23% at time of writing. Lending tether on Aave could earn over 8%. Some combinations offer returns of over 20%.
When yield is no longer available through traditional means, innovative alternatives become more attractive.
The potential of technology
What’s more, European financial institutions are not afraid of technological innovation. They have historically been more IT-oriented than US banks, largely out of necessity since they tend to be less profitable than their US counterparts (due in a large part to a more hostile interest rate and economic growth environment). Innovation has played a significant role in the recent growth of the banking sector, and many Europeans cannot remember the last time they saw a paper check. In some parts of Scandinavia, they don’t remember what cash looks like.
As a consequence, financial institutions see decentralized finance as less of a threat and more of an opportunity. Some leading stock exchanges are already setting up for the convergence of traditional and crypto asset trading. Many banks are looking into both centralized and decentralized blockchain-based applications and have declared intentions to offer crypto trading, a process that is likely to accelerate as their institutional clients become more active in the field.
This is significant as Europe is a more bank-focused economy. Unlike in the US, corporates raise money from banks more than from the market. The general attitude of banks, therefore, seeps through to institutional investment expectations.
Where is this likely to go?
The pressing need for yield in institutional investments is not going to fade any time soon – Europe is dealing with an aging population with growing pension needs against a backdrop of rising prices. It has an effective cap on its interest rates in that it does not want the euro to significantly appreciate against the US dollar, since it is a larger exporter relative to GDP than its trading partner across the ocean.
So, yield will increasingly need to come from technology opportunities – and that will increasingly mean decentralized finance platforms.
This could end up being helped by regulatory changes. The EU legislation known as MiCA (Markets in Crypto Assets) is expected to be implemented next year. It will establish a comprehensive framework for crypto asset service providers and issuers, providing regulatory clarity that institutional investors will find reassuring. Some DeFi platforms may find themselves unable to comply with the requirements, but many will make the necessary commitments in order to benefit from access to a large and interested marketplace.
All these trends push crypto assets even further towards convergence with traditional finance, opening up more opportunities for returns for investors, entrepreneurs and executives. The recent performance of crypto markets and the detailed study of institutional flows have shown that there is a high-quality level of demand. And the innovation that this demand supports will end up benefitting market participants of all types.
DISCLAIMER: This commentary is based on public information that we consider reliable, but do not represent as accurate or complete and should not be considered investment advice. Genesis conducts a global prime brokerage service, integrating digital asset lending, trading and custodial services. We and our affiliates, officers, directors and employees could have long or short positions in, act as principal in, and buy or sell the digital assets or derivatives referred to in this research. This research is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. The price and value of any assets referred to in this research and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur.
