Decentralized Finance (DeFi) is a set of blockchain-based applications that together form an alternative financial system intended to replace the current centralized financial system.
In 2020, interest in DeFi surged to dramatic heights with record numbers of funds locked in smart contracts and wild sudden price swings for DeFi tokens traded across exchanges.
The frenzy is reminiscent of the 2017 ICO craze which led to the boom and bust of alt tokens and signaled the start of a crypto winter that lasted deep into the following year. The question is whether this time things will be different.
Is the market moving towards bubble territory that is simply waiting to pop, or are we seeing the growing pains of what is to become the answer to the calls for a better, more equally accessible financial system?
To develop a view on the future of DeFi, we must first understand its past and how it evolved to become a dominant factor in the crypto space.
The rise of DeFi
The concept of decentralized finance did not start with the DeFi industry as we know it today.
In the early days of Ethereum, developers were already building decentralized applications for financial use cases. Using blockchain, projects were building services that did not require middlemen to oversee transactions and manage interactions. Instead of centralized authorities, self-executing code referred to as ‘smart contracts’ would facilitate efficient transactions, which at once maximized efficiency and lowered costs.
Those early projects eventually paved the way for more developers to build decentralized applications, adding to the total number of projects aimed at serving financial use cases.
As the Ethereum blockchain underwent fundamental upgrades, its capacity to process transactions efficiently improved which together with the ability to work with smart contracts made Ethereum the primary blockchain protocol for the fledgling DeFi industry.
In hindsight, the crypto winter offered the perfect conditions for DeFi projects to make a name for themselves. ICO scammers had largely retreated from the scene and investors finally took a more critical approach towards assessing the viability of ‘businesses that do blockchain’.
There was less interest in a project with a whitepaper releasing a coin to create the next ‘Uber for Spotify’ and more interest in projects with a real-world use case. During this time, DeFi on the whole refined its narrative as offering a better alternative to the centralized financial system, with real applications that served a practical purpose.
DeFi as an alternative to traditional finance
For centuries, financial services have been delivered using centralized authorities who act as trusted intermediaries.
Part of the role a financial agent plays is assessing the risk-return profile of investments and conduct cost-benefit analyses. That has led to SMEs, specific industries, and even entire populations to be excluded from traditional finance.
Without rapid innovation, a centralized system that must comply with stringent KYC and AML protocols simply can’t serve a developing market where companies can’t meet regular credit checks and many people don’t hold government issued identification documents.
DeFi aims to provide an alternative financial system that is equally accessible across the world.
All you need is an internet connection to engage with the many different protocols and projects available. That is the goal of a financial system built in an open, permissionless and decentralized manner.
Other unique traits of DeFi include:
- Lower costs: Transactions that rely on blockchain and smart contracts rather than centralized institutions are cheaper to process.
- Enhanced security: decentralized systems have no single point of failure which makes data breaches less likely, provided smart contract are constructed in a robust fashion which is where regular technical audits come into play.
- Censorship resistant: As there is no single authority in charge of operations, services cannot be shut off or censored by any government authority.
- Composability: DeFi is interoperable which means different applications can be built on top of each other and customized in new ways. It’s often compared to Lego blocks – each application exists on its own, but several can be combined to create something entirely new.
- Dynamic: Anything can be executed following the pace of mining blocks. For example, interest payments can be made every 15 seconds, instead of every few months.
- Open-source: Anyone can audit open-source code to test protocols for vulnerabilities, and the whole community monitors ongoing development efforts.
The expanding DeFi universe
Besides the many other things 2020 will be remembered for, it was also the year DeFi really took off. Ethereum block size increased from 20MB to 40MB, and fees increased by 10x.
As activity increased in DeFi, the daily transaction fee rose to $3.68 million in August 2020. But perhaps the most important metric is the total value locked in DeFi. It is considered an indication of active user engagement as using a DeFi service usually requires locking funds into a smart contract construction.
As of writing, the total value locked in DeFi stands at $11.21Bn, with decentralized exchange UniSwap taking the leading position with $2.75Bn locked.
All of these funds are locked across several protocols operating in the DeFi space. Generally, they fall in the following categories:
- Lending: Using liquidity pools, anyone can lend crypto assets to earn interest fees, and anyone can borrow crypto assets by providing more collateral than the amount borrowed. There are many variations on the model and we have covered a few projects previously including Compound, Aave, yEarn.
- DEXs: Decentralized exchanges are available worldwide for crypto-to-crypto markets. Some major players include UniSwap, SushiSwap, Bancor.
- Derivatives: decentralized derivatives trading, assets that derive value from the performance of an underlying asset. Synthetix, Nexus Metal, and Erasure are some of the biggest names in the space.
- Payments: No financial system would be complete without a sizeable payments component. Sablier, Flexa, Lightning Network and xDai are notable players in DeFi payments.
- Stablecoins: Much of the interaction with DeFi protocols is done using stablecoins pegged to fiat currencies such as USD. In terms of market cap, USDT, USDC and DAI are the largest stablecoins pegged to fiat currency, with WBTC being the largest stablecoin for BTC.
It’s not only total value locked in DeFi that seems to be boiling over now. Some DeFi tokens have surged rapidly in the past few months with the global crypto community jumping on the opportunity to make some serious gains.
Those massive increases were made during August and September when markets went into overdrive. Since then, DeFi token trading has cooled down a fair bit with some tokens such as UNI close to the original price when trading began. It does speak to the intense frenzied nature of DeFi trading and begs the question whether we are in bubble territory and what the future holds in store for decentralized finance.
The future of DeFi
Putting FOMO-fueled trading aside, DeFi needs to address a number of key challenges if it is to really present a viable alternative financial system.
Blockchain throughput remains an issue despite the recent Ethereum upgrades with network congestion a recurring issue as transactions globally increase.
High network fees for on-chain transaction are also rising, so much so that at times they can be disproportionately high compared to the size of the transaction. This severely lowers the appeal for the many businesses and people that the alternative system is supposed to serve.
While a decentralized network using smart contracts is perhaps more secure in one way, it does still pose a security risk when detractors find bugs to exploit.
Attackers have been able to steal funds escrowed in smart contracts or manipulate external price feeds for assets within protocols. Arguably the most famous attack occurred in 2016 when an attacker drained over 3.6 million ETH (worth $72 million at the time) from a decentralized protocol’s smart contract. Funds were returned to investors by way of a hard fork which is why we have two Ethereum protocols today and since then smart contracts go through more rigorous audits and security testing.
Further security can also be achieved if the DeFi space diversifies the blockchain networks on which is operates. Currently, most activity takes place on Ethereum, with the Bitcoin blockchain, EOS and other smaller networks playing a negligible role. That means by extension that any technical issues with Ethereum can affect the entire DeFi space at once.
All of these challenges are widely recognized by the development community working on improving DeFi, which brings us to perhaps one of the most unique and promising traits: distributed governance.
Many of the DeFi tokens have been created with a governance utility in mind. Holders of the token are able to participate in shaping the future of specific DeFi protocols by way of voting on development proposals, setting fees, enabling listings and more.
For the first time, a global financial system is not only designed for a worldwide population, it is being shaped by that population. Anyone can participate in the governance of DeFi protocols and by doing so have a seat at the table where the future of DeFi is actively created.
The trading floor of DeFi tokens certainly does rhyme with the ICO frenzy of 2017 and it can’t be denied market ‘melt-ups’ of this nature look like a bubble about to pop. But perhaps that distracts from what really matters.
DeFi is on a path to create an alternative financial system and despite some of the growing pains which can only be expected when you operate on the bleeding edge of innovation, technology and system-design, there is more than enough reason to believe the future for decentralized finance is indeed bright and prosperous. For everyone.