• DeFi is a monumental advancement in finance but is easy to misuse, leaving institutions hesitant to participate out of fear of compliance risk.

• Permissioned DeFi, an up-and-coming model of DeFi, could present a new approach to DeFi that caters to the need for compliance frameworks while retaining DeFi’s core principles.

• From permissioned LPs to permissioned payment systems, DeFi can be made more palatable to institutions with a risk-mitigated PDeFi model.

Decentralized Finance (DeFi) leverages permissionless blockchain technology to create a trustless ecosystem where financial products and services promise to be accessible to anyone with an internet connection, without the need for intermediaries like banks or financial institutions. This paradigm shift signifies a new era of financial inclusivity and democratization, presenting exciting opportunities for innovation and growth.

Between 2020 and 2021, centralized finance (CeFi) protocols gained prominence, providing widespread access to cryptocurrency as an investment class. In 2022, however, certain influential CeFi entities negatively impacted the industry through nefarious malpractices, triggering extensive market sell-offs and liquidations wiping out billions of dollars in value. This turbulence paved the way for 2023 to usher in significant DeFi advancements, including the development of shared-pool perpetual decentralized exchanges (DEXs) and innovative peer-to-peer financial solutions.

Looking ahead to 2024, DeFi faces a regulatory reckoning as governments hone in on their responsibility to prevent money laundering and terrorist financing through these new financial tools. DeFi’s decentralized architecture makes it extremely difficult for governments to regulate, at least in the way TradFi is regulated. This presents friction points for regulated, risk-averse institutions actively seeking out ways to leverage decentralized innovations in a compliant way.

DeFi is here to stay, so how do you balance the need to be compliant within a dynamic regulatory landscape with retaining core DeFi principles?

Permissioned DeFi

The answer is Permissioned DeFi (PDeFi) — essentially DeFi for the compliance-conscious that retains the core principles of DeFi. PDeFi operates by integrating regulatory compliance controls into the blockchain framework in key points to allow for compliance without removing the permissionless nature of the decentralized processes underneath. It utilizes robust Know Your Customer (KYC) checks and whitelisting to ensure secure and regulated financial transactions while leveraging the permissionless DeFi technology.

Unlike PDeFi’s fully decentralized counterparts, such as GMX, Lido, Morpho, etc., this controlled access model prioritizes concerns related to regulatory compliance, privacy, and security, providing an attractive new access point for institutions in 2024 and beyond. This new model adheres more closely to regulatory standards and a growing demand for compliance, making it suitable for institutional adoption and use in broader financial applications.

Permissioned LPs

One of the more notable DeFi projects that recently began implementing PDeFi is Aave. Aave is a well-known decentralized cryptocurrency lending platform that enables users to borrow, lend, and earn interest without the involvement of a third party. Aave Arc is a separate deployment of the Aave V2 liquidity pool for institutional players. Fireblocks, the first active whitelister for Aave Arc, has developed a framework for whitelisting institutions that references globally accepted KYC/CDD/EDD principles, per FATF guidelines. This approach guarantees that all participants are KYC and AML compliant.

There are a few key differences between Aave Arc and “normal” DeFi liquidity pools. First, Aave Arc is permissioned, while “normal” DeFi liquidity pools are permissionless. This means that institutions must be vetted and approved to participate in Aave Arc, while anyone can participate in “normal” DeFi liquidity pools. Second, Aave Arc is subject to regulatory requirements, while “normal” DeFi liquidity pools are not. This means that Aave Arc must comply with certain rules and regulations, while “normal” DeFi liquidity pools do not.

Permissioned Payment Systems

In addition to Aave’s specific use case, PDeFi can revolutionize payments to mitigate risk, for all parties involved, by creating a compliant layer with KYB, KYC, and whitelisting. This would allow an institution to leverage the innovations within DeFi but filtered through a regulated, permissioned payment system that allows for new Web3 possibilities while remaining safe and compliant. Future payment systems rooted in the PDeFi methodology can bring this balance between permissionless and permissioned DeFi to improve the user experience of how people and institutions acquire and use digital assets.

Permissionless DeFi, which can enhance cross-border payments, offers benefits such as instant value transfer, improved traceability, user control, and direct interactions. However, its shortcomings in compliance measures expose it to risks like fraud and erroneous payments, causing institutional hesitation in widespread adoption. Despite its advantages over traditional payment systems, these security concerns limit its scalability and acceptance in the broader financial ecosystem.

Permissioned DeFi addresses these concerns by combining the efficiencies of the permissionless model with the required risk and compliance controls to offer significant advantages over traditional payments. In the context of cross-border payments, these verification functions would help businesses face some of the endless challenges of managing financial risk with confidence.

The Implications of PDeFi

If PDeFi takes off, it could have a significant impact on the DeFi space. It could lead to increased institutional participation in DeFi, which could attract more capital and liquidity to the space. It could also lead to the development of new DeFi products and services that are designed for institutions. PDeFi’s relation to institutional adoption of DeFi is a snowball effect — a more permissioned means for institutions to participate in DeFi increases the likelihood that risk-averse institutions participate, which then benefits all of DeFi.

As the DeFi landscape evolves, Permissioned DeFi emerges as a crucial innovation, marrying the decentralized ethos with necessary regulatory frameworks. It’s an elegant solution, threading the needle between open access and secure compliance. PDeFi represents more than just a middle ground; it’s a new frontier in finance where inclusivity meets integrity. This evolution is poised to redefine our interaction with digital assets, making the financial world not only more accessible but also more trustworthy for everyone involved.