Decentralized finance (DeFi) has been the hottest sub-sector within the cryptocurrency space over the past few months and has captured the lion’s share of attention from investors and industry pundits.
But what is DeFi and what has caused the sector to experience such explosive growth in recent months? Let’s dive in.
What Is DeFi?
At a high level, DeFi is essentially the trustless automation of financial instruments through an ecosystem of financial applications built on blockchain networks. It refers to a decentralized, peer-to-peer (P2P), and censorship resistant financial system that is freely available to anyone and operates without a central intermediary. Users would interact with protocols and decentralized applications (DApps) in a P2P fashion allowing them to do nearly everything from traditional finance without having to go through KYC or other middlemen. As long as someone has internet access and a cryptocurrency wallet, he can take part in the world of decentralized finance. It is this openness and ease of access that has put DeFi in the spotlight and turned it into one of the most important nascent trends in the industry. DeFi is expanding upon what Bitcoin started over a decade ago in terms of banking the bankless. It offers the opportunity to gain access to a broad range of financial services that were previously unattainable due to either geographical location, income level, or social status. Blockchain technology allows us to create a financial ecosystem without the need for central authorities and gives everyone - including those isolated from the traditional financial system - an opportunity to gain access to financial products and services.
The Current State Of DeFi
DeFi is democratizing access to financial products while at the same time paving the way for the creation of entirely new financial instruments and new ways to interact with them. For instance, it gives the end users the ability to earn interest on their holdings, take out loans, and trade complex financial instruments on decentralized trading platforms. Yield farming, liquidity mining and trading volume on decentralized exchanges (DEXs) have gained traction in recent months, causing the total value locked (TVL) in DeFi to surge over 560% YTD from US$680M to US$4.5B.
Although DeFi applications and concepts have been in the works for a number of years, 2020 has kicked off the summer of DeFi due to innovative product market fit. In particular, it was the launch of Compound’s liquidity mining program that launched DeFi tokens into a full on bull market.
What is Liquidity Mining and Yield Farming?
Liquidity mining and yield farming go hand in hand. Liquidity mining is an incentive program whereby DeFi protocols distribute governance tokens to users in order to attract liquidity and bootstrap their networks. These governance tokens give users rights, such as voting on the decisions that affect the future direction of the protocol. What makes liquidity mining unique is that DeFi protocols are offering an implied claim on the future cash flows from the networks in the form of a native token. It would be similar to a public company offering shares to its customers for helping bootstrap and grow the network (which is what Jet.com successfully attempted in 2014 by offering 100,000 shares to whoever could get the most people to sign up with their referral link). The idea is that by garnering early support and usage of the protocol, the tokens would create an incentive to participate in governing and improving the networks. Liquidity mining is essentially the crypto version of a growth marketing campaign that has been used successfully in achieving rapid growth.
Yield farming is a strategy of putting idle crypto assets to work in order to generate yield on those assets. Oftentimes it takes the form of lending or staking cryptocurrencies through DeFi apps in return for interest payments, market making fees, and rewards from each protocol. There are currently over $25M worth of native tokens distributed each month through yield farming opportunities. Humans have a history of following incentives so the success of these programs should come as no surprise. As such, yield farming has become quite popular due to liquidity mining and has proven to be an extremely effective method for enticing assets onto a platform.
Use Cases For DeFi
Real world DeFi applications have grown significantly in recent months. Some of the more common DeFi apps relate to stablecoins, DEXs, and lending/borrowing.
Stablecoins: are digital assets pegged to a fiat currency and are one of the fastest growing segments within the crypto space. Decentralised stablecoins are primarily used as a form of digital cash that is not issued or controlled by a central authority. Additionally, stablecoins allow: people to send value to anyone in the world 24/7 and with minimal fees; individuals in countries with capital controls to store money outside of the regulated banking system; investors to store their digital asset holdings in a nonvolatile token pegged to a fiat currency of their choice without having to deal with banks or other intermediaries. Furthermore, in this past year, stablecoins have become the base asset for many DeFi apps.
DEXs: are another popular DeFi application that allow users to trade digital assets without the need for a trusted intermediary to hold the funds. DEXs are digital asset exchanges that utilize smart contracts to execute trades between users. DEXs have no registration or identity verification, and typically have lower fees than centralized exchanges.
This past year, a new wave of exchanges have arisen known as automated market makers (AMM). AMMs are giant liquidity pools that allow investors to trade against algorithmic curves rather than order books on DEXs. Liquidity providers to these pools are rewarded with transaction fees and interest payments. These platforms allow anyone to list any token they want with no listing fee - democratizing the power that centralized exchanges once held.
Borrowing & Lending Platforms: are perhaps the fastest growing sector in DeFi at the moment. These platforms connect the lenders to the borrowers via smart contracts and allow users to deposit their digital assets and earn interest from users who borrow their assets. Since these platforms are built on the blockchain, it minimizes the amount of trust required in order to facilitate these types of transactions. As such, it reduces the counterparty risk by cutting out the middleman, making borrowing and lending faster and cheaper for everyone involved.
One of the more successful platforms in this sector is Compound, which is essentially a decentralized money market for digital assets. Compound allows lenders to deposit their digital assets to earn interest (paid in cryptocurrency + COMP governance token), while at the same time giving borrowers access to collateralized loans. There are no trusted third parties to rely upon since it is all done via smart contracts. Since the launch of the COMP token in June, Compound has accumulated over $800M in assets on its platform. In entirety, decentralized borrowing and lending platforms have currently amassed over $2B in assets - indicating a strong demand and appetite for such offerings.
Is It Still Early In DeFi?
Although DeFi has garnered significant attention and activity in recent months, it still remains a small fraction of the entire crypto market. In fact, the combined market cap of all DeFi projects of approximately $8B accounts for just 2.3% of total cryptocurrency market cap of $343.8B.
Ripple (XRP) alone has a valuation of $12.7B and is valued at 59% more than the entire DeFi sector. For an even starker contrast, when compared to traditional financial assets such as gold ($10.5T) and U.S. stocks ($35.5T), DeFi is many orders of magnitude smaller than these massive markets.
Needless to say, it is still quite early in terms of DeFi adoption and development. However, the DeFi sector is growing rapidly and smart money is beginning to trickle into the sector. At a modest $8B valuation, even a small reallocation of capital could drive prices significantly higher and continue the DeFi bull market. Things are just getting started in this nascent space.
Where Does DeFi Go From Here?
Building in DeFi is comparable to smart contract Legos. Each new product, program, or service such as DEXs, stablecoins, or lending platforms is like a Lego block that can be pieced together in different combinations to create innovative financial tools. Interestingly, nearly all of these DeFi projects would not have been possible to build just a decade ago.
Today, however, DeFi development is reaching an inflection point as new projects appear in a matter of weeks or months. The acceleration in growth can be attributed to better development tools, higher on-chain liquidity, more interoperability between platforms, and better education amongst community members.
In the end, DeFi is focused on creating a more resilient and transparent financial system that is separate from the traditional system. Blockchain technology is allowing developers to remove the middleman from financial transactions resulting in lower fees, less delays due to banking business hours, and increased accessibility to financial services for anyone with an internet connection. These are much needed changes that the current financial system has overlooked. If the DeFi movement is successful, it could create a disruptive change and cause a democratization in how the current banking system operates. How it turns out is anyone’s guess but having front row seats to witness the next chapter for the internet of money is certainly captivating.
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