Here’s how Compound and Aave are now targeting institutional investors

“A parallel financial system with no rules, no oversight, and no limits.” That’s how U.S. Senator Sherrod Brown described what the DeFi movement aims to create, during a hearing this week before the Senate Banking Committee.

It’s no wonder that many institutional firms have been hesitant about dipping their toes in water that is still so murky from a regulatory perspective. These firms abide by stringent requirements, particularly that they can only interact with identified individuals — while most entities in DeFi are pseudonymous.

But while some, like libertarian ShapeShift CEO Erik Voorhees, argue that DeFi should be a “protest” against the current financial system, one that outmaneuvers regulation wherever possible, others want to enable institutions to take part. The idea is to create DeFi products that comply with existing regulations in order to attract the large amount of institutional money.

“I think the potential in the institutional market is a magnitude bigger than we are now within DeFi,” says Stani Kulechov, founder of decentralized lending platform Aave. Aave plans to soon release Aave Arc, a permissioned version of its protocol aimed directly at this market.

Aave isn’t the only major DeFi protocol that recently announced plans to go after institutional capital. Earlier this month, lending platform Compound launched an institutional offering called Compound Treasury. 

“We’re entering the era of what I would call the bridges between the legacy financial markets and DeFi and the blending of them together,” says Compound Labs founder Robert Leshner recently on The Scoop. 

But how exactly is that going to work? Compound and Aave are each taking their own unique approach.

Compound Treasury

The main idea behind Compound Treasury is to hide all the complex crypto shenanigans that go on under the hood and offer a clean product that institutional investors can use with ease.

“We’ve heard again and again and again over the last couple of years that accessing the protocol for institutions is too difficult. They don’t want to manage cryptographic private keys. They’re not used to interacting with smart contracts,” says Leshner. “All they know is they want the yield from this market but the crypto part is complex and cumbersome.”

As a result, Compound Treasury is offering an interest account with a fixed rate of 4%. Institutions can wire US dollars to their Compound Treasury Account and earn this interest, with an experience similar to a bank account.

Behind the scenes, Compound will convert the dollars into USD Coin (USDC) and lend the money out using the Compound protocol. The yield earned through Compound is then returned to the institutions that invested. If the yield is above 4%, Compound takes the rest. If it’s below, it makes up the difference. 

Leshner says that early adopters of Compound Treasury are fintech companies using capital on their balance sheets. He hopes that these companies will provide their customers with products that provide access to this yield, particularly since interest rates are so low. 

“Compound treasury is designed to be so simple it can be the backbone of other financial offerings,” he says.

Aave Arc (formerly Aave Pro)

While Compound Treasury wants institutions to get the benefits of DeFi without actually using it, Aave wants to let all institutions get actively involved — no matter how stringent their regulatory requirements are.

Within the next few weeks, Aave is launching Aave Arc, a permissioned lending and borrowing pool, as a pilot. Only entities that have passed KYC procedures will be able to participate in the pool. Those that do will be able to lend and borrow tokens, likely at similar rates to public pools.

“The idea behind Aave Arc is to create a sanctioned pool, an environment in which the participants are pre-KYC’d and then you can be compliant with the fact you’re not interacting with illicit parties,” says Michael Shaulov, founder of institutional custody firm Fireblocks, which is providing KYC services for Aave Arc.

Shaulov explains that Fireblocks has around 400 clients and that 20% of them are interacting with DeFi protocols. But he also says that a considerable number of its clients are fully licensed institutional players who are unable to interact with the protocols because of such KYC requirements — and that the Aave pilot has finally given some of them a chance.

Currently, Fireblocks is the only KYC partner for the pool, so it’s acting as a gatekeeper but Aave’s plan is to open it up to other entities who can perform the same service. 

“I think the larger vision of the Aave Arc market is to create a more comfortable risk appetite for institutions to participate in decentralized finance before, for example, having the risk appetite to participate towards the permissionless decentralized finance, which is the bigger vision offering,” says Kulechov.

Aave will let its governance platform take control of the Aave Arc product in time, allowing holders of its governance token aave (AAVE) to vote on how the protocol should be developed. Kulechov says that if the token holders make poor decisions (for instance, if they decide to undermine the institutions) then the institutions can always simply withdraw their funds and not participate in the pool.