After the explosive growth of decentralized finance in the second half of 2020, we wonder what the next chapter will look like. What would it take for DeFi to move beyond crypto-native assets and eat communities and financial services as we know them?
The second half of 2020 exceeded much of our expectations and the market has only accelerated since then. Total value locked in DeFi rose from less than $ 1 billion in early June to $ 13 billion by the end of the year and more than $ 27 billion since then. Catalyzed by Compound’s COMP token launch, we saw a wave of it yield agriculture and a rapid inflow of assets.
Perhaps more excitingly, we began to see the foundations of a new financial system take shape – with applications that enable everything from in-house exchanges to lending and borrowing, payments, portfolio management and insurance. New forms of value are being created: not only the promise of returns in a low interest rate environment, but also access to financial services for cryptocurrency-exposed companies and individuals and more generally for underbanking.
Today, DeFi is the domain of a small subset of crypto-native users and assets, and is viewed by critics as the Wild West. Will this change? Here are a few thoughts on what comes next.
New asset types – New sources of liquidity in DeFi
The first iterations of decentralized exchanges were fraught with liquidity problems. Early adopters faced a significant delay in order matching, and token pairs were limited. Automated market makers and liquidity pools have become a widespread solution to this, with daily trading volumes on decentralized exchanges currently in the order of $ 2 billion – and DeFi projects continue to find innovative ways to boost the provision of liquidity. This continues. We believe that there remains a clear need for borrowers to lower collateral requirements and indeed to use alternative forms of collateral.
Perhaps the greatest opportunity lies outside the universe of crypto-native assets. Billions of dollars of potential collateral are up for grabs in real assets: users want to borrow money against the assets they already have and often don’t have access to the liquidity they need with conventional means. Tokenization of real-world assets can drastically increase the size of the DeFi universe.
Scale problems addressed at layer one and / or layer two
Ethereum’s scalability limitations are often cited as a factor limiting DeFi adoption. High gas prices and indeed high Ether (ETHprices can make lower value transactions unfeasible. This limits the attractiveness of non-tangible token marketplaces and other retail services. Meanwhile, professional high-frequency trading requires tier two solutions due to the limited transaction throughput in the chain.
It’s likely we’ll fix this in 2021, with at least three possible paths:
- The successful rollout of Ethereum 2.0.
- The emergence of dominant layer-two scale solutions on Ethereum.
- Wide adoption of cross-chain interoperability solutions.
These three phenomena need not be mutually exclusive, and they collectively give us the optimism that 2021 will be a year of significant advancements in DeFi scalability.
Institutional question – Convergence between CeFi and DeFi
We are starting to see crypto-native institutional investors seeking higher returns through stablecoins. Many of these investors use centralized exchanges, at least initially, but a handful of institutionally focused self-preservation products have hit the market. Regulatory oversight of DeFi is likely to increase as these services gain traction.
Meanwhile, regulators around the world have introduced stricter rules for virtual account service providers, such as centralized crypto exchanges. The Travel rule of the Financial Action Task Force and Europe 5th Anti-Money Laundering Directive demonstrate the move towards stricter Know Your Customer standards in cryptocurrency, and BitMEX costs from October brought this into sharp focus. This will eventually hit DeFi: in the short term, we expect institutional products to implement pseudonymous / zero knowledge solutions for self-sovereign identity.
There are ideological and practical questions to be answered. Is KYC fundamentally incompatible with DeFi? And which regulatory frameworks actually apply to DeFi now and in the future? Reliability will be subjectively defined, and we will see a spectrum of truly decentralized products – built and used by anonymous users beyond the scope of the Banking Secrecy Act – on products with a database of verified counterparties.
Better UXs for Retail Attendees: DeFi That Doesn’t Feel Like DeFi
For many users, the ramp to DeFi is simply too steep. A degree of sophistication is needed to simply set up, buy a MetaMask wallet ERC-20 Tokens, and start borrowing. Meanwhile, many centralized products have grown thanks to intuitive interfaces that resemble traditional digital banking products. We are now starting to see this trend in DeFi, where one could eventually enjoy a faster, cleaner onboarding experience, given the lack of KYC. For example, Yearn.finance pioneered in this regard, focusing on usability and lowering the barriers to entry that existed before launch.
In addition, other Ethereum-based applications – such as NFT marketplaces for collectibles and digital assets – will continue to innovate the user experience. In 2021, we expect a wider emergence of Ethereum-based applications that customers are unaware of performing transactions on a blockchain.
More exploits as more capital flows in: possibly the biggest barrier to growth
Given the increasing amount of capital at stake, it is not surprising that we have seen an increase in exploits. About $ 100 million was lost on hacks in 2020, particularly flash loan attacks, and this trend is likely to continue. For institutional investors, exploits will inevitably change the perception of DeFi’s risk-adjusted return opportunities.
This will be a critical factor influencing the scale of adoption and will lead to an increase in demand for smart contract audits and insurance, both of which have seen limited investment so far. Greater collaboration between DeFi projects is also a possible answer to the increase in exploits. Such partnerships will enable projects to pool and strengthen their talent, security and treasury, preventing and mitigating the impact of future exploits.
The rise of crypto over the past decade has changed the way we think about value stores. The rise of DeFi in 2020 changed the way we think about the future of financial services and true innovation in a space that is very slowly changing. With the dust settled on a remarkable 2020, we now expect massive scaling up and professionalization as DeFi attracts more regulatory and institutional attention.
This article was contributed by Toby Coppel and Chandar Lal.
This article does not contain investment advice or recommendations. Every investment and trade move carries risks, and readers should do their own research when making a decision.
The views, thoughts and opinions expressed here are the sole ones of the authors and do not necessarily reflect or represent the views and opinions of Cointelegraph.
Toby Coppel is a co-founder and partner of Mosaic Ventures, which has invested in several projects across Europe. The future of money is one of their most important investment themes. Toby was previously Yahoo’s Chief Strategy Officer.
Chandar Lal is a research associate at Mosaic Ventures, where he conducts thematic research and due diligence. He previously worked at Sequoia in Silicon Valley as part of the company’s development team.