Opinion: Robert Schmitt, founder and co-founder of Cork

DeFi has entered the institutional phase. As gigantic investors dip their toes into cryptocurrency ETFs and digital asset vaults (DATs), the ecosystem is gradually evolving into a stand-alone, institutional-grade financial system, with the introduction of up-to-date financial instruments and digital equivalents of established instruments.

The current development of DeFi reveals growing risks that can lead to trust lock-ups. For institutions to safely adopt up-to-date solutions, the ecosystem must implement stronger risk protections and resilient infrastructure.

It’s worth examining the main areas where risk is concentrated, how TradFi deals with similar challenges, and the guardrails that DeFi needs to safely scale institutional participation.

Breaking down the biggest risks of DeFi

Let’s start with the risks of the protocol. DeFi’s composability is both its strength and its Achilles heel. The interconnectedness of LSTs, credit markets and perpetual instruments increases systemic dependency. A single exploit can cascade between protocols.

Then consider the risk of reflexivity and consider how derivatives betting and looping strategies create positive feedback loops that amplify market fluctuations. As prices rise, collateral increases and leverage increases.

But when prices fall, liquidations accelerate in the same way, without coordinated circuit breakers.

Finally, duration risks as credit and betting markets mature may become increasingly critical given the need for predictable access to liquidity. Institutions need to understand the types of duration risks present in the markets in which they participate. Few people realize that advertised payout times for many protocols actually depend on solver incentives, strategy downtime, and validator queues.

Institutional supercycle

The next challenge for DeFi is not higher efficiency or higher TVL. Another DeFi challenge is building trust. To bring the next trillion of institutional capital onto the chain, the ecosystem needs standard risk safeguards and a up-to-date risk management discipline.

The last two years of DeFi have been defined by institutional adoption. Regulated institutional products have gained a huge number of TVLs. The two most successful ETF launches over the past two years (out of 1,600 ETFs) have been BlackRock’s iShares BTC and ETH ETFs. The net inflow into ETH ETFs is vertical.

Similarly, digital asset vault companies attract capital from institutions. Recently, ETH DATs have taken up approximately 2.5 percent of the ETH supply. The largest DAT, Bitmine Immersion, whose CEO is Wall Street legend Tom Lee, raised over $9 billion in ETH in less than two months, fueled by institutional demand for ETH exposure.

Stablecoins have become a suitable marketplace for cryptocurrency products thanks to up-to-date regulatory transparency. Now they move almost the same money every month in the form of a visa, and their total value locked (TVL) within the protocols is approaching $300 billion.

Similarly, the topic of tokenization has gained momentum, as evidenced by the rapid growth of tokenized real-world assets (RWAs). Major institutions are tokenizing products, including Robinhood Europe, which is tokenizing its entire exchange, and BlackRock, which is tokenizing its T-bill BUIDL product.

Both stablecoins and the rise of RWA tokenization are driving the narrative that the future of the financial system will be based on Ethereum. This, in turn, is driving the institutional adoption of ETFs and DATs.

The case for standard risk management

According to A the latest Paradigm reportRisk management ranks second among the cost categories in institutional finance. This is because it is properly understood as an operational pillar that goes beyond checking the compliance checkbox. Although time-honored finance has not completely eliminated risk, it has certainly systematized it to the greatest extent.

Related: Nnot all RWA growth is real and the industry knows it

In contrast, DeFi treats risk as a variable that varies from protocol to protocol. Each astute contract, treasury and strategy defines and discloses risk differently – if at all. The result is idiosyncratic risk management and lack of comparability between protocols.

TradFi has created common frameworks such as clearinghouses and rating agencies, as well as uniform disclosure standards, to address these types of risks and their real-world analogues. DeFi needs its own versions of these institutions: open, auditable, and interoperable standards for quantifying and reporting risk.

DeFi doesn’t have to give up experimentation to become a more mature ecosystem, but it could certainly benefit from formalizing it. The current risk framework established in DeFi protocols is not enough.

However, if we are determined to ride out the next wave of institutional adoption, we can be guided by the risk management principles established for financial instruments in time-honored finance.

Opinion: Robert Schmitt, founder and co-founder of Cork.

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