Decentralized finance, or DeFi, has become perhaps the biggest phenomenon in cryptocurrency over recent years. According to one aggregator service, the total value locked in DeFi applications rose from under $1 billion to over $150 billion in the year leading up to May 2021. Wired magazine has declared DeFi the future of crypto, while former US acting comptroller of the currency Brian Brooks warned in an article for the Financial Times that the world should prepare for DeFi-enabled “self-driving banks.”
To date, DeFi has operated much as crypto did in its earlier days – experimental, explosive, and frequently drawing comparisons with the Wild West. So is it a leap to make predictions about their future potential to disrupt the financial markets? Based on current developments, the potential is already beginning to come to fruition.
DeFi’s Three Pillars
There are now literally hundreds of DeFi applications, but they all fall under one or more of three broad segments: decentralized exchanges, lending protocols, and synthetic assets and derivatives.
Decentralized exchanges or DEXs have evolved over the years, but the Uniswap model, which relies on automated market makers (AMM), is the current most popular. Whereas a traditional exchange model relies on an order book, Uniswap operates liquidity pools of token pairs.
Liquidity providers deposit their funds into these pools in return for a share of the transaction fees paid by users who swap their tokens using that pool. Some sophisticated economic calculations take place under the hood. But effectively, the AMM is a pricing algorithm that continually adjusts the quote according to the balance of supply and demand in the pool.
Token issuers often incentivize liquidity providers to deposit into their pools with token rewards, a practice known as yield farming.
Lending pools are even more straightforward. On the lending side, a user simply deposits their funds into a lending pool to earn interest paid by borrowers using the pool. Borrowers access decentralized credit by depositing cryptocurrency as collateral into a smart contract. The smart contract algorithm adjusts interest according to supply and demand from both sides. Loans are usually overcollateralized to account for the volatility inherent in crypto and to offset counterparty risk.
Compound operates this type of straightforward lending model. However, Maker, which allows users to mint the crypto-backed stablecoin DAI, is also a kind of lending protocol.
Synthetics and Derivatives
Synthetic assets and derivatives are perhaps the most nascent area of the three, but one that offers tremendous potential. It’s possible to mint synthetic tokenized versions of almost any kind of asset. By feeding price oracle data into a blockchain smart contract, trade them in the same way as the assets themselves.
In this way, users in DeFi apps can gain exposure to assets in the real world, like tokenized stocks or forex pairs. Synthetix was among the first of its kind in this space, allowing users to trade Tokens mirroring the price of all kinds of crypto assets, as well as fiat currencies, commodities, and indices.
Finally, governance tokens are another common feature of DeFi protocols. Token holders have the right to vote on matters such as adding new features or major upgrades. Even though they convey no ownership rights, governance tokens such as UNI and AAVE have become popular among traders.
Current and Future Developments
The three pillars above form the basis of what could be described as the “first wave” of DeFi. However, several notable trends are unfolding right now that indicate what we can expect from DeFi in the mid-term future.
It’s worth noting that until late 2020, the vast majority of DeFi existed only on the Ethereum platform. Operating on Ethereum means that DeFi protocols can interact with one another, but it comes at the cost of speed, scalability, and transaction fees. At the peak of DeFi hype in summer 2020, the average Ethereum transaction fee was over $700, excluding all but the biggest traders from the burgeoning DeFi movement.
However, several high-performance blockchains launched on mainnet in 2020, and the result is now that there’s a flourishing ecosystem of DeFi applications on several other platforms. Most critically, the developers of these platforms have taken care to ensure that users can interoperate freely with Ethereum-based DeFi, thus avoiding liquidity becoming fragmented across different platforms.
Examples include Polygon (formerly Matic Network,) which now hosts implementations of flagship DeFi applications Aave and Curve Finance. Polygon also has its own native DeFi dApps, including Uniswap clone, QuickSwap. Similarly, Binance Smart Chain has proven to be a popular chain for DeFi developers, home to the PancakeSwap DEX. Cosmos and Polkadot also have their own burgeoning DeFi ecosystems. Given the benefits in terms of liquidity and user cross-fertilization, interoperability is a trend that looks set to continue.
As with crypto in general, DeFi regulation is a somewhat nebulous topic. The president of the Siam Commercial Bank recently put it succinctly, when he pointed out that decentralization doesn’t lend itself well to regulation.
Nevertheless, regulators have DeFi in their sights, if not quite yet in the crosshairs. In late June, DeFi luminaries presented at an event hosted by the International Organization of Securities Commissions. The event is an inevitable first step in the regulatory scrutiny of DeFi.
Uniswap has already begun to delist coins that could be construed as securities, recently taking down 100 pairs, including options and indies. The move indicates that corners of DeFi are becoming aware of their lack of immunity to regulatory risk.
Bridging to Real-World Assets and Products
During a recent DeFi-focused edition of the Odd Lots podcast, Bloomberg’s Tracey Alloway mused that while DeFi offers some exciting prototypes, it appears to be missing a vital component – a real-world connection.
The afore-mentioned synthetic assets feature is one way that DeFi can connect to the value of real-world assets. However, although it’s early days, there’s vast potential in this regard. Non-fungible tokens are another hot trend in DeFi, allowing the creation of unique digital assets. Now, they’re being used to securitize real-world assets. For instance, Swiss bank Sygnum recently tokenized an original Picasso painting, allowing accredited investors to purchase shares of the artwork, each worth an affordable $1,100.
An inevitable next step is the creation of regulated secondary markets and allowing users to unlock the value in these assets by staking them as collateral for loans. In recent months, projects such as Maker and Centrifuge have been allowing users to stake as a way to mint DAI stablecoins using tokenized versions of real-world assets, paving the way for others to follow.
Uncollateralized Loans and Decentralized Identities
The requirement to overcollateralize loans is a significant blocker to DeFi adoption for those who would otherwise be able to access uncollateralized credit via a bank. However, the requirement to overcollateralize is a necessary risk mitigation stemming from the fact that public blockchains are pseudonymous. With an appropriate credit rating system in place, it would be possible to enable uncollateralized lending.
Credit ratings based on real-world identities are one solution. Although there are developments in blockchain-based digital identities, it’s already possible to have an off-chain identity verified and attested on-chain using zero-knowledge proofs. The zero-knowledge proof acts as an assurance to the blockchain network that there’s a valid identity behind a user without publicly broadcasting the identity documents. In this way, there’s an assurance of privacy.
EY is one firm pioneering the use of this technology in DeFi.
Crypto has its fair share of hype. But based on the rapid pace of development and interest from institutions, governments, regulators, and innovators alike, DeFi genuinely offers the potential to reshape the way that we perform transactions of value. It’s still very early days, and there’s plenty of space for further developments. However, the idea of self-driving banks doesn’t seem so outlandish once you begin to examine the vast possibilities offered by DeFi.