The Evolving Legal Risks in DeFi: Why Institutional Investors Must Reassess Exposure

The decentralized finance (DeFi) ecosystem has evolved from a niche experiment into a multibillion-dollar sector, driven by innovations like tokenized real-world assets (RWA) and permissioned lending pools. Yet, as of 2025, institutional investors remain cautious, with legal uncertainty and regulatory ambiguity acting as persistent barriers to meaningful capital allocation. This disconnect between technological progress and legal clarity underscores a critical risk for investors seeking exposure to DeFi-a space where smart contracts and blockchain infrastructure promise efficiency but lack the enforceable frameworks of traditional finance.

Legal Uncertainty: The Core Deterrent

At the heart of institutional hesitancy lies unresolved legal questions surrounding smart contracts and token ownership. According to a Sygnum report, large institutional investors, including pensions and sovereign wealth funds, are constrained by mandates that prohibit exposure to unresolved legal risks. For instance, the enforceability of self-executing smart contracts in courts remains untested in many jurisdictions, creating ambiguity about recourse in disputes. Similarly, token ownership-often governed by decentralized protocols rather than legal titles-leaves gaps in asset protection and liability frameworks. These uncertainties render DeFi protocols unsuitable for core institutional allocations, even as they offer attractive yields.

Tokenized private credit platforms, another DeFi innovation, face similar challenges. While these platforms have grown in complexity, inconsistent due diligence processes and the absence of a robust secondary market deter institutional participation, the Sygnum report also notes. The lack of standardized legal frameworks to govern tokenized assets further exacerbates risks, particularly for investors accustomed to the transparency and accountability of traditional markets.

Regulatory Catch-Up and Institutional Liquidity

Regulatory bodies have struggled to keep pace with DeFi's rapid innovation. In the recent quarter of 2025, the Flare Network's relaunch of SparkDEX Eternal introduced on-chain perpetual contracts for XRP DeFi users, expanding trading pairs and incentivizing liquidity through tiered fee discounts, as reported in Coinotag coverage. While such advancements signal maturing infrastructure, they also highlight the absence of clear regulatory guardrails. For example, the legal status of perpetual contracts on decentralized exchanges remains undefined in many markets, leaving investors exposed to potential enforcement actions.

Polygon Labs' partnership with Manifold Trading offers a glimpse of how industry players are addressing liquidity challenges. By integrating institutional-grade execution features and data-driven liquidity management, Polygon aims to create a professional environment for institutional traders, according to a FinanceFeeds article. Manifold's strategies-such as tightening trading spreads and stabilizing prices-mirror traditional market practices but lack the legal protections that institutional investors rely on. As a Crypto.News piece notes, these efforts tackle liquidity fragmentation but do not resolve the underlying issue of regulatory uncertainty.

The Infrastructure-Adoption Disconnect

Despite infrastructure upgrades like Polygon's Rio hardfork and AggLayer framework-designed to enhance speed, reduce costs, and unify cross-chain liquidity-total value locked (TVL) in permissioned lending pools remains minimal, as highlighted in a Coinotag piece. This suggests that legal and regulatory risks, not technical limitations, are the primary barriers to adoption. For institutional investors, the absence of a clear legal framework for tokenized assets and smart contracts creates a paradox: DeFi's infrastructure is advancing rapidly, but its legal foundation remains fragile.

Reassessing Exposure: A Call for Caution

Institutional investors must approach DeFi with a dual lens: evaluating both the promise of innovation and the risks of regulatory catch-up. While partnerships like Polygon-Manifold demonstrate progress in bridging the gap between DeFi and traditional finance, they also underscore the sector's reliance on self-regulation. Until legal frameworks evolve to address smart contract enforceability, token ownership rights, and secondary market liquidity, institutional capital will remain on the sidelines.

For now, DeFi's potential is undeniable-but so are its risks. Investors must weigh these factors carefully, recognizing that the absence of legal clarity is not a temporary hurdle but a structural challenge requiring systemic solutions.