Through the Looking Glass - Navigating Safely Through the World of DeFi

Some may be familiar with the book Through the Looking Glass, Lewis Carroll’s sequel to Alice’s Adventures in Wonderland. Stepping through her bedroom mirror, Alice enters the looking-glass world, where everything is the opposite of what she knows: needing to move further from an object to get closer, future events happening before the past, and characters who act in unpredictable and nonsensical ways.

For those who have spent their careers in traditional finance (“TradFi”), entering the world of decentralized finance or “DeFi” can feel much the same, with DeFi providing many of the same, familiar functions as TradFi but with rules inverted from what TradFi investors know and a need to rely on systems and algorithms they don’t understand.

This post aims to:

Provide some background and context for the rise of the DeFi space and why it is necessary to evolve the current investment paradigm, especially in the world of private markets.

Explain how, in certain select instances, both the centralization of TradFi and the “de-centralization” concept of DeFi can be taken too far, with sometimes disastrous consequences; and

How a solution to combine the freedom of DeFi with the oversight and control processes of TradFi can advance private markets investing more safely and stably.

Some History Behind the Rise of DeFi

DeFi first arose in the wake of the 2008 financial crisis as a reaction to the failures of a centralized banking and financial system – i.e., where a relatively small number of large banking institutions controlled the financial system, including banking, investments, and lending transactions. The issues inherent in the centralized banking system are well known and include conflicts of interest, a compensation system that encourages short-term as opposed to strategic thinking, and a propensity to put the banking institutions’ interests ahead of those of their clients.

The goal of DeFi is to create an open and “permissionless” financial system, driven by technology and algorithms, with full transparency via maintaining transactions indefinitely on blockchain. Bitcoin, a digital currency based on technology and mathematics rather than central bank-issued money, was introduced in 2009. The introduction of Bitcoin started a democratization of the banking system, where small business owners globally could transact more efficiently and cheaply. In some parts of the world, Bitcoin became both a liberator and a safety net. For example, in unstable regions, bitcoin provided certainty and security over the risks of cash's inherent portability and transferability. Further, it enabled entrepreneurs to protect their wealth in environments where trust in traditional cash-based transactions was low.

The second significant milestone was the creation of Ethereum’s blockchain in 2015. This development paved the way for smart contracts, sowing the seeds for the current boom in DeFi. Smart contracts automated and, in effect, replicated many of the services previously provided exclusively by banking institutions, including lending and investments in digital or tokenized assets.

As DeFi continues to evolve, it’s apparent that many other areas of finance could benefit from this move towards decentralization.

Benefits of DeFi to Private Markets

As private markets asset managers increasingly tap into additional distribution channels, such as the high net worth and retail client base, the tokenization of private markets interests will become a significant accelerator for the democratization of private markets. Tokens, when combined with the right fund structure, are significantly more fungible than limited partnership interests. As such, they can enhance liquidity in various ways, including through more efficient transfers of interests and through hypothecation. They can be easily fractionalized, meaning that the cost of entry to private markets is greatly reduced. They can enhance customization in a more cost-effective way than separately managed accounts or the provision of co-investment rights. All of these characteristics are features that are important to high net worth and retail clients and will help to evolve the private markets materially. A deeper dive into the advantages of tokenization and blockchain technology for private markets investing can be found on Pontoro’s website here: https://www.pontoro.com/

Drawbacks of Complete Decentralization

Despite the benefits that the DeFi space can provide to the financial system, there can be risks as well. Just as there are problems with concentrated centralization within TradFi, when the pendulum swings too far in the opposite direction, there is a point at which decentralization can be taken too far, increasing risks to investors. For example, investments in cryptocurrencies and digital assets can sometimes be made without independent custodians or administrators; rather, there can be self-custody of digital “wallets”. Instead of a central General Partner (“GP”) or sponsor, some investments are structured as Decentralized Autonomous Organizations (“DAOs”), in which the investment program operates with no central authority, using blockchain technology and smart contracts to manage operations and governance. While this offers freedom and control, it also introduces significant personal risk.

A notable example was the loss of over $600 million in assets in the Ronin Network hack (2022), the Ethereum sidechain that powered the Axie Infinity game. The attack succeeded in part due to the overreliance on a small group of validator nodes without centralized oversight or robust fail-safes, revealing a flaw in the DAO-managed governance structure.

Even more recently, the Olympus DAO experiment, which aimed to create a decentralized reserve currency, suffered from volatility, governance confusion, and a lack of accountability as its price collapsedby over 90%. Many participants were left with losses and no clear recourse, as there was no central entity to engage with.

Synthetic stablecoins, backed by cryptocurrency algorithms, require total faith in the technology and algorithm. If investors lose faith in the algorithm, there is no real asset backing the stablecoin, which could lead to a complete collapse.

These examples illustrate how, without a central General Partner (“GP”), manager, or fiduciary, DeFi investments structured as DAOs can blur the lines of accountability. If something goes awry, whether due to technical failure, governance breakdown, or malicious attack, it becomes difficult to assess where the liability lies and how investors might recover. Over-decentralization, in these cases, created systemic fragility rather than resilience.

The Solution

The potential risks of over-decentralization in DeFi, as described above are no worse than the risks of too much centralization in TradFi. It can be argued that the depth and breadth of the 2008 global financial crisis impacted far more people than any of the DeFi failures described above.

We at Pontoro believe that the intersection of TradFi and DeFi will significantly evolve the way ordinary people invest and will be especially instrumental in advancing the democratization of private markets by facilitating access, liquidity, and customization. However, to achieve this evolution, there has to be a middle ground where decentralization, digital assets, and blockchain technology are utilized in a more responsible way. We believe that fintech companies, with their understanding of both TradFi and DeFi, are best placed to harness the power of DeFi firms to benefit TradFi.

At Pontoro, we form the nexus of technology and financial expertise. Our forward-thinking technology team has deep expertise in the space and prior experience at NASA, Vonage, and Engie. Our financial team has worked on many complex transactions and has its roots in Wall Street with team members' experience that includes Blackrock, Franklin Templeton, JP Morgan, Citi, Starwood, GE and Morgan Stanley. In contrast to many fintechs whose experience has mainly been centered in Silicon Valley, Pontoro also understands complex financial products, both their strengths and weaknesses. Pontoro was created with a vision to improve upon the traditional Wall Street model.

Our flagship solution, the Automated Liquidity Pool (ALP), exemplifies this integration by leveraging DeFi Automated Market Maker (“AMM”) principles to provide dynamic liquidity risk pricing for illiquid private fund interests while also maintaining portfolio manager oversight for credit risk pricing to leverage qualitative expertise and ability to respond to changing market conditions for which there no data sources that would allow an algorithm to respond in time.

Pontoro tokenizes private market LP interests, unlocking DeFi’s fractional ownership and programmability, while explicitly backing each token with verifiable real-world assets, aligning digital innovation with tangible economic value. Recognizing TradFi’s strength in regulatory compliance, we incorporate independent regulated custodians, comprehensive KYC/AML frameworks, and transparent audit trails directly into our blockchain architecture, achieving operational efficiency without compromising investor protection.

Conclusion

Alice's journey becomes a game of chess, where she is literally a pawn, moving forward one square at a time. Her fate is determined by the rules of the game and the whims of the characters she meets. At Pontoro, we believe private markets investors should not be subject to the whims of a concentrated group of behemoth financial institutions. Nor should they be at the mercy of the potential chaos of a completely decentralized and uncontrolled financial system. Pontoro seeks to harness the power and freedom of DeFi in a responsible way to help evolve the traditional private markets in a meaningful way.

About Pontoro

Pontoro’s financial backers include a combination of VC firms that focus on technology companies as well as financial industry giants. Our VC investors include well-known firms such as Illuminate Financial, which has made investments into companies including Talos, FileAI, and Copper, and is itself backed by investors such as JP Morgan, BNY, Jeffries, Citi, Euroclear, and Ulu Ventures, who wrote the first checks into SoFi and Palantir. Pontoro is also backed by esteemed financial giants such as Franklin Templeton and Intesa SanPaolo. Our advisers who helped us shape Pontoro have included Armen Meyer, Co-founder of the American Fintech Council and former NY Department of Financial Services chief of staff, and Juan Pujadas. Former Board Member of Wells Fargo Bank, and former Vice Chairman of PwC, and notably, Paul Atkins, who has been tapped to head the U.S. SEC.

Pontoro’s combination of deep expertise crossing both the technology and financial worlds makes us uniquely qualified to bridge the gap between DeFi and TradFi. We understand DeFi’s innovation and the power of a decentralized ledger, programmable digital assets and currencies, but we also understand TradFi’s lessons in regulatory compliance, stable governance and that these digital assets need to be backed by real-world assets.

We also understand the potential flaws in the traditional financial system. All our employees are owners of Pontoro. As such, we are forced to think creatively as well as strategically. There is no upside to short-term thinking and results. Our solutions are designed to actively mitigate conflicts of interest and solve the most pressing issues of GPs and LPs in the private markets space. For more details on Pontoro’s solutions addressing private markets, please visit our website at https://www.pontoro.com/.