What is Permissioned DeFi? Benefits and Examples

What if you can use a financial system with the security and benefits of traditional banking and the speed of decentralized systems? This is the modern world of Permissioned DeFi, where security meets technology, transparency meets regulations, and the major financial players are no longer able to hold themselves back anymore.

Permissioned DeFi is taking over the world of finance by storm. Despite their initial cost-heavy setups, major financial institutions like J.P. Morgan are taking a plunge, enabling their whitelisted customers to make transactions worth millions of dollars in mere seconds.

However, permissioned DeFi systems are not without drawbacks and criticisms. Let’s take a deep look at what makes the Permissioned DeFi systems unique and why financial institutes are flocking to it despite its drawbacks.

What Is Permissioned DeFi?

A permissioned DeFi is a specialized branch of DeFi with access controls and compliance mechanisms in place to protect it from unwanted entities. Unlike a permissionless DeFi system, where anyone can join and participate, permissioned DeFi first vets the newcomers and only whitelists those who fulfill the criteria mentioned in smart contracts.

A permissioned DeFi system joins the transparency and automation of a DeFi system with the compliance and governance of TradFi, providing the users with the best of both worlds. This system is mostly used by banks, hedge funds, and government-regulated institutes and is often considered at odds with the spirit of DeFi systems by the purists.

In a permissioned DeFi system, a user must first verify their identify via either KYC or AML. Once done, they are allowed to interact with the DeFi protocols only if the smart contracts whitelist them.

Governance is divided among whitelisted users and board members (or people with power), unlike a DeFi system, where users hold all the power. Only specific people can access the liquidity pools with special permissions. Every permissioned DeFi integrates legal protocols in its smart contracts to comply with government policies.

Permissioned vs Permissionless DeFi: Key Differences Explained

While permissioned DeFi is derived from the permissionless DeFi, it has major differences that make it an entirely different entity with rules and regulations.

Feature	Permissioned DeFi	Permissionless DeFi
Access	Verified and Whitelisted users only	Public
Compliance	Full KYC or AML	None
Risk	Low due to security measures	High due to open nature
Institutional Adoption	High	Low
Governance	Semi-Decentralized	Fully Decentralized
Liquidity Pools	Available to special users only	Accessible by anyone with a wallet

The basic purpose of a permissioned DeFi system is to protect investments in major financial systems that have been working under strict laws and regulations for decades. They can’t adopt a fully open system where users are in control.

For this purpose, they have created a middle ground where individuals with special status hold power, and only verified users are allowed to access liquidity pools, while reaping the benefits of the autonomous system.

Key Benefits of Permissioned DeFi

While a point of contention for the DeFi purists, the permissioned DeFi systems offer numerous benefits for both users and governance holders. With its tightened security and checks in place, it becomes impossible for malicious individuals to hack the system and drain all the funds.

Every person in a permissioned DeFi system is known and a part of the official record, which can be traced. This adds another layer of security to the whole system.

Streamlined Governance

In a permissioned DeFi system, governance is often controlled by a small number of trusted and vetted groups. These groups are usually composed of trusted institutions, verified stakeholders, or designated experts, as opposed to the chaotic user-run governance in large permissionless DeFi systems.

This allows the governance to make fast decisions with credibility. As designated members of governance are highly qualified people, they can maintain the standards according to government rules and regulations. It also reduces the noise and allows qualified people to do their job.

Regulatory Compliance

All permissioned DeFi systems follow regulatory compliance by integrating KYC/AML checks. Anyone who wants to join a permissioned DeFi must verify themselves through these checks before accessing the blockchain.

Only whitelisted individuals, wallets, or institutions can access the smart contracts, adding a layer of security. With this system in place, everyone inside a permissioned DeFi system is known and registered with the government.

This method attracts banks, hedge funds, and other regulatory authorities, as it reduces legal risk and opens cross-border operations.

Better Security

With permissioned access via KYC/AML and whitelisting, only authorized and known wallets and individuals can interact with the smart contracts of a permissioned DeFi system. This method reduces the risk of hacks or unauthorized access to liquidity pools.

If a malicious person from the whitelist group is involved in the attack, they can be traced and caught, unlike a permissionless DeFi system. Imagine a wallet tries to borrow a huge amount of Stablecoins from a liquidity pool.

Upon checking by the smart contracts, they find suspicious activity associated with that wallet. The user will be flagged for fraudulent activity, and legal action will be taken against them immediately.

Institutional Liquidity and Investment

With semi-centralized governance, regulatory compliance, and security protocols in place, large financial institutions and banks are finally being attracted to the permissioned DeFi systems. These institutes would never have joined DeFi systems otherwise, especially those without security or government regulations in place.

This has opened a new wave of institutional liquidity investments in DeFi systems. Institutions that were once hesitant about the open nature of DeFi systems are now investing heavily, thanks to the permissioned DeFi systems.

Aave Arc and JP Morgan Onyx are two major examples of permissioned DeFi systems, first from a permissionless DeFi system and the other from a traditional bank.

Relatively Stable Market Environments

A permissioned DeFi system has a relatively stable environment as it filters out the malicious actors and potential threats. In a permissionless DeFi, anyone can access the system, including bots, whales, and hackers. This can lead to.

Pump-and-dump
Flash loans exploit
Liquidity drains due to hacks
Violent price swings

As these factors are no longer present in a permissioned DeFi system, it offers more predictable liquidity and lower market volatility. This increases the confidence of financial institutes and banks, and they don’t hesitate to invest in the system.

Customization Flexibility

In permissionless DeFi systems, smart contracts are proposed and developed by users before deployment and can’t be modified at will. However, in a permissioned DeFi system, smart contracts can be tailored to match the requirements of a special use case, satisfy risk appetites, or meet the jurisdictional requirements.

This gives a lot of flexibility to the system and allows it to protect itself from the backlash of regulatory authorities by complying with their rules at a moment’s notice.

Core Use Cases

With transparency and automation combined with regulations and security, permissioned DeFi is gaining significant traction among financial institutions. The use cases are rapidly increasing, making permissioned DeFi a major player in the world of finance.

Institutional Lending & Borrowing

A permissioned DeFi system only allows access to whitelisted entities, including banks, individuals, and financial managers, through strict KYC/AML. Only these entities can access liquidity pools and participate in lending and borrowing.

For a whitelisted participant to borrow, they deposit collateral in the form of tokens or crypto assets. A smart contract is executed, which sets the terms and conditions and distributes the loans immediately to the borrower.

The borrower pays the principal amount + interest, while the lender receives the fees for lending their assets. As this is all done by screening and with strict security measures in place, institutes are leaning towards this model due to its efficiency and transparency.

Tokenization of Real-World Assets (RWAs)

Tokenization of RWAs means converting your real-world assets into tokens that can be used in a blockchain to trade or use as collateral. These tokens represent the value of your assets that you hold in the real world.

Use of RWA tokens is only possible in a permissioned DeFi system, as only verified and whitelisted users can bring in these tokens to trade.

This allows them to follow regulatory compliance and secure issuance through banks. RWA tokens are only used within gated environments and are only available to approved investors depending on their geolocation.

Cross-Border Payments

With security and checks in place, funds in a permissioned DeFi system can be transferred from one whitelisted participant to the other in an instant.

This is faster than the traditional banking system and more secure than permissionless DeFi systems. Through this method, any payment from one country can be sent to the other without the interference of intermediaries in a second.

Compliant Staking & Yield

In permissioned DeFi systems, staking and yield are designed to meet institutional compliant. Only whitelisted and verified participants can stake their assets to yearn yields.

As all the participants in this system are known, this reduces the risk of hacks and asset loss. The yields may be lower than a permissionless DeFi system; however, they are secure and consistent.

Some Real-World Examples of Permissioned DeFi

As permissioned DeFi systems are becoming increasingly popular and lucrative, many traditional institutions and even some permissionless DeFi systems are getting into this system.

Aave Arc

Aave is a permissionless DeFi system that has entered the permissioned DeFi system with Aave Arc. This system is specifically designed for institutional users who don’t want to operate in financial environments without regulatory compliance.

Aave Arc has its own separate liquidity pool that can only be accessed by verified and whitelisted participants. Participants in this pool enjoy the same trading and yield-generating features while staying compliant with government regulations.

J.P. Morgan Onyx & JPM Coin

J.P. Morgan Onyx, or currently known as Kinexys, has brought permissioned DeFi systems to traditional banking. J.P. Morgan’s Kinexys offers RWA tokens, cross-border payments, on-chain FX settlement, and JPMD.

Since its inception, Kinexys has processed over $1.5 trillion in transactions among its whitelisted users Siemens, BlackRock, and Ant International. JPM coin is used as an asset for transactions between various whitelisted institutes, and it works on J.P. Morgan’s private blockchain.

Fireblocks & Alkemi Network

Fireblock offers MPC wallets for secure asset custody. It also offers support for stakingtrading, and token transfers. Fireblocks has recently collaborated with the Sui blockchain, allowing whitelisted institutes to custody SUI and Sui-based tokens.

Whitelisted users can also access Sui DeFi protocols and prepare for staking and yield generation securely.

Alchemy Network offers liquidity pools that are only accessible to whitelisted institutes. These institutes can use these pools to trade or stake to earn yields securely. It is integrated with Fireblocks for custody and access.

Challenges & Considerations of Permissioned DeFi

While permissioned DeFi offers the flexibility of a DeFi system combined with the security protocols of traditional banking, it is not without its drawbacks and challenges. Let’s explore those challenges in detail and see how institutes can overcome them.

Regulatory Evolution

Different countries have different regulations regarding DeFi systems. The USA has a “regulation by enforcement” stance when it comes to DeFi systems. While a permissioned DeFi system follows government regulations, it still falls under the DeFi umbrella, making it difficult to determine legislation guiding its development.

The legality of smart contracts and the usage of tokens is still a gray area, even for the permissioned DeFi systems, and the institutes must evolve according to government rules and regulations.

Smart Contract & Counterparty Risk

While smart contracts in a permissioned DeFi system are crafted under supervision with extreme care, they are still code that hackers can manipulate if a vulnerability is found.

As a smart contract is the soul of a DeFi system, controlling all protocols, transactions, and liquidity pools, a hack can result in the instant draining of funds. As smart contracts in permissioned DeFi systems are upgradable, this introduces further vulnerability to them.

Despite having strong protections in place, there is always a counterparty risk involved. If a borrower defaults, lenders will also face a penalty unless the collateral is properly managed.

Capital Efficiency & Liquidity Needs

Due to security compliance, many permissioned DeFi systems have low yields as they avoid taking any unnecessary risks. The liquid pool is limited in terms of participants, leaving little space for the participants to borrow or lend.

Institutions lending assets require high collateral, resulting in capital lock-up. Due to certain regulations, capital can’t be freed or withdrawn early once it is invested.

Capital in a permissioned DeFi system is often locked in a chain, reducing interoperability. There is also a risk associated with using the assets in cross-chains, as it can lead to delayed transactions or security issues.

Centralization Concerns

With the introduction of centralized governance and the implementation of government policies, permissioned DeFi systems are blurring the lines between DeFi and TradFi. This goes against the core rules of decentralized systems, where a group of people or companies can’t hold absolute power.

This can potentially alienate people who still believe in DeFi systems with no central governance and the users’ ability to control and manage smart contracts.

Onboarding & KYC Friction

In any permissioned DeFi systems, onboarding and KYC are compulsory. However, they can create friction with smaller institutes as they are resource-intensive and can put off users who were attracted to DeFi systems due to their open nature.

KYB can take days and weeks as it requires document collection, verification, and legal processing. This could slow down access to liquidity pools and trading.

Interoperability Limitations

As permissioned DeFi systems are designed to onboard users after whitelisting, this makes it difficult to work with other chains, especially the ones working in permissionless DeFi systems.

This reduces interoperability, and the users of a permissioned system are mostly limited to its blockchain, making it difficult to access other liquidity pools in case of capital lock-up in their own.

Trust & Transparency Trade-offs

While permissioned DeFi systems offer security and government compliance, they lack trust and transparency.

Smart contracts are opaque and offer limited public accountability. Governance is controlled by a select few, which doesn’t generate confidence amongst other users. As there is no open access, users must rely on the reputation of the entity after onboarding.

Wrapping It Up

Permissioned DeFi systems are taking over the traditional financial institutes by storm. They offer speed and trading opportunities of a DeFi system while maintaining the authority of institutions through strict government policies and centralized governance.

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