2020 will be known as the year of the DeFi boom but what’s next in its horizon?
by Colbert Low and Jason Chew
What is DeFi?
Decentralised finance (DeFi) is a fast growing financial ecosystem made up of various decentralized, non-custodial financial products. The simplest definition for DeFi are financial products that operate without intermediaries. Instead of interacting with a bank, DeFi users can interact with smart contracts; automated computer programs that are publicly verifiable on an immutable tamper-proof distributed ledger; known as a blockchain.
In 2020, we have witnessed the unprecedented growth of of these financial products that include:
- Lending Protocols
- Decentralized Exchanges (DEXs)
- Synthetic Derivatives
Examples: Aave, Compound, Maker
These protocols let you borrow cryptocurrencies instantaneously.
Borrowing in DeFi, however, requires users to place sufficient collateral before they can withdraw their loan. In other words, you need money before you can borrow money in DeFi. If you cannot pay back your loan, your collateral will be liquidated to pay back the loan automatically.
This is a fundamental difference of DeFi compared to traditional finance, which is based on fractional reserve lending. In short, the DeFi ecosystem is always solvent because there is sufficient collateral to back the borrowings at any time.
On the lending side, these protocols also allow users to earn interest on their digital assets instantaneously. The interest is determined based on global supply and demand calculated in real time. It can be a variable interest (Compound) or a fixed interest (Aave).
Lending protocols have seen unprecedented highs of usage this year. Most notably Maker, Compound & Aave. Maker, which allows you to withdraw a stablecoin loan in DAI, was the first to hit $1 billion Total Value Locked (TVL) milestone in DeFi history. Compound, which launched its governance token in June, saw its TVL surge from $100 million to $1 billion within a month. Aave, which only started with $350,000 TVL in Jan also achieved $1 billion TVL in August 2020.
Decentralized exchanges (DEXs) allow you to trade cryptocurrencies without an intermediary. Earlier iterations of DEXs e.g. Bancor, Kyber Network, did not get significant traction… until Uniswap changed the game entirely this year.
Uniswap allowed DeFi users to trade any Ethereum-based token they like, or add liquidity to that token’s market to earn fees from trades. Users found Uniswap very easy to use and it soon became the market reference. In September, Uniswap turned heads when their trading volumes surpassed top centralised exchanges e.g. Coinbase; became the #1 DeFi protocol with $1.7 billion TVL locked; whilst helping its users (liquidity providers) earn >$56 million in trading fees.
Following Uniswap’s success, both Bancor & Kyber have rebuilt something similar to Uniswap. Meanwhile, numerous DEXs have emerged in the market e.g. Sushiswap, Mooniswap, DODO; offering to solve new challenges to compete with Uniswap.
One major part of DeFi also are synthetic assets, like Synthetix’s tokenized assets; which offers exposure to any real-world asset using decentralized price oracles (e.g. Chainlink, Band Protocol) to peg the prices accurately to its real-world likeness.
In summary, DeFi protocols earn the DeFi tag when they are, at least in principle or ambition, non-custodial and decentralized.
- Non-custodial means the teams behind the protocols do NOT manage your money on your behalf. Unlike depositing money in a bank e.g. Maybank, DeFi users always maintain control over their money, interact with protocols directly from their wallets and can withdraw anytime if the smart contract permits.
- Decentralized means the teams behind the protocols would vote themselves out of power and hand that power over to the community; usually via distribution of a governance token. Holders of the governance token would vote and determine the future of the protocol.
The success of DeFi in 2020 gives a glimpse of what changes can be expected in the near future.
- Financial products that are global from launch day.
- Financial products that are regulated by COD, not human operators.
- Financial products that are governed by communities instead of companies.
- Financial products that operate 24/7, lightning fast and have no downtime.
Finance will not be reinvented overnight though. It took 20 years for the full force of the Internet to be felt on newspapers. In the next sections, we explore:
- What happened in 2020
- Despite success, what challenges took place
- Why DeFi will not replace traditional finance anytime soon
Why DeFi Boomed in 2020
In the previous section, you were introduced to notable DeFi protocols, what they do and how much traction they gained in 2020. In this section, we reflect and breakdown 3 reasons why DeFi exploded this year.
- Liquidity Incentives
DeFi experienced a turning point June this year when the Compound team voted themselves out of power and launched their governance tokens – on-chain assets that allow people to make decisions over the Compound protocol. These tokens can be earned by being a lender or borrower using the protocol. Whilst these tokens do not promise any financial return, they can still be openly traded on a DEX e.g. Uniswap. Within a few hours from launch, speculators rushed to buy these tokens; pushing the COMP price to an all time high of $370. This incentivized a huge influx of usage of the protocol so that they can earn these governance tokens. Thus, ‘liquidity incentive mining’ or ‘yield farming’ was born. Since then, many DeFi protocols followed in similar fashion, issuing native governance tokens to incentivize new users to their protocols. Most notably in August, Yearn.Finance’s native governance token, YFI, became the first DeFi token to exceed the Bitcoin price at that time.
DeFi protocols live exclusively in smart contract code; much akin to a set of instructions that would self-execute based on how it is written. However, these computer codes are empty shells if there is no initial liquidity in them. Imagine if Compound had no lenders providing liquidity, there would be no borrowers. Thus, issuing governance tokens as liquidity rewards has become one way to attract and bootstrap liquidity when a protocol is new.
Where money goes, greed follows. Almost $13 billion in cryptocurrency is currently locked in DeFi protocols as of November 2020. Part of the reason there is a massive influx of money into DeFi is because there is a very huge desire to chase higher yield during a time when traditional finance cannot offer attractive returns.
However, very often, this desire for returns can turn into a bottomless insatiable hunger. At times, some new DeFi projects would project yields of over 1,000%. Most of them, unfortunately, do not last more than two weeks. We will cover this deeper in the next section on challenges within DeFi.
What is important to note is a boom driven solely by greed is never sustainable. Users must learn to identify DeFi projects that will still be around even after the ‘greed phase’ has ended.
- Innovation Overdrive
The financial system we know today consists of century built moats and fortresses with limited transferability or two-way access with iron-clad intellectual properties to overcome as well.
This is not the case with DeFi.
DeFi is built in an environment of open source and permissionless culture. This means when one innovator has successfully built something useful that works, another innovator can build on top of that and create something new without permission.
This freedom of composability is strangely refreshing for innovators. Similar to ‘Legos’, composability refers to the concept that something can be assembled into multiple combinations. Hence, the term ‘Money Legos’ was born.
This led Ethereum, which most DeFi protocols are built on, to pioneer and demonstrate the value of composability at a speed so quick the world has never seen before. Here are just several notable financial innovations that have emerged in 2020:
- Flash Loans – DeFi users can borrow any amount of available liquidity from a protocol if they can return the borrowed amount plus interest within 15 secs (one blocktime).
Why DeFi will not replace traditional finance anytime soon
- High Learning Curve
The single fact that DeFi users must be responsible for their own cybersecurity (e.g. wallet key management) is itself the biggest deterrent that scares most mainstream users away from DeFi. Despite improved user experiences e.g. Argent (wallet), Zerion (dashboard) which DeFi natives enjoy, most beginners will still find it difficult to operate with wallets e.g. Metamask and interact with the correct smart contracts.
- High Gas Fees
- Scams & Rugpulls
Following the footsteps of reputable protocols e.g. Compound, Uniswap, YFI, many copycats emerged in the form of food emoji tokens. Most of these projects, as time of writing, are now defunct (e.g. SHRIMP, GRAP, KIMCHI) with an average lifespan of only two weeks.
In September 2020, many copycats were reported to be rugpulls – smart contracts that contain intentional backdoor scripts to siphon money out; taking advantage of users ‘Degen’ behavior, greed and often inability or recklessness to read the smart contracts before putting money into them.
DeFi natives will need to learn how to separate projects that have long-lasting value that solve real business problems versus projects that only exist to suck liquidity at the beginning, enrich whales and super-sophisticated users before creating a mass bloody exodus later.
Predictions for Year 2021:
- New money market services and instruments for even Central Bank Digital Currencies (CBDC) will emerge as there will be various Government led projects with Digital Asset industry players.New versions of tokenized synthetic derivatives, treasury bonds or even tokenized treasury bills will leverage distributed ledger technologies for faster, efficient, reduced settlement risks, and more secure transactions.
- Bitcoin may experience another run of parabolic growth. Bitcoin is getting more “safe” for institutions to purchase from a legal and reputational standpoint. In 2020, institutions e.g. MicroStrategy, Square Inc, Paypal have bought over $21 billion of Bitcoin in reserves. It’s always hard to be the first to do something but it is not that hard to be the 16th person to do something. Because institutions take time between 6 to 12 months to execute their new buy positions, the actual effects of institutional demand may only be realised in Q3 of 2021 or thereafter.
- DeFi will continue to experience its positive growth trajectory into 2021 as: More bridges bringing Bitcoin to DeFi will emerge; more users from traditional finance will discover DeFi in search for better yields. Existing DeFi protocols e.g. Compound, Aave will continue to churn out new products e.g. credit delegation and improve user experiences; and new incentives will be introduced by neighboring blockchains e.g. Polkadot, Cosmos, Cardano to entice users and attract liquidity to their own versions of Compound & Aave to compete in the DeFi space.