If your life even fleetingly intersects with crypto, you can’t have failed to hear about decentralized finance (defi). The defi movement has been the industry’s defining trend this year, breaking all records and attracting massive inflows of capital. Investors have flocked to purchase defi tokens and stablecoins before locking them into decentralised lending and liquidity protocols, earning them yield on their holdings.

This inflow of funds has been great for supplying liquidity and granting early adopters outsized returns. But has it done anything to advance the defi narrative, based around open access and universal adoption of P2P finance applications? Is defi really unbanking the unbanked and the hard to bank, or is it simply fuelling another Ethereum gold rush to rival the ICO boom of 2017?

We outline the current state of play within the burgeoning defi economy before considering the case for and against decentralised finance making the world a better, fairer place.

What’s the deal with Defi?

Decentralised finance is an extension of the Ethereum ecosystem, based around using crypto networks to remove intermediaries and facilitate P2P lending, borrowing and trading. Defi builds upon the foundations of Ethereum and other smart contract-based networks. It's constructed from a series of base-layer protocols (Ethereum, Maker, Compound) which support decentralized applications (aka, dApps) for lending, social credit, derivatives trading, token swapping and much more.

At its core, defi is all about bringing products that are synonymous with the traditional financial world to crypto. But there are a few key differences.

With defi, anyone can participate – an internet-connected device and a basic knowledge of cryptocurrency are all that's required – without fear of discrimination, be it due to credit rating, location, or social status.

Defi has transformed crypto - but can it change the world?

Defi promises to create a more egalitarian system in which it's not your net worth that counts but what you do with it. So far, many of defi's early adopters have elected to lock their crypto assets, primarily ERC20 tokens such as ETH, DAI and BTC (represented as WBTC on Ethereum) into liquidity protocols. These enable traders to tap into a deep pool of liquidity and purchase assets with minimal slippage while earning liquidity providers (LPs) a portion of the fees.

With certain defi pools promising an annual yield of over 10%, the attraction for liquidity pools (LPs), at a time when many banks are providing negative interest on savings, is understandable. Two months ago, the total value of all assets locked into the defi ecosystem totalled less than $1 billion. It has now swelled to over $2.5 billion, while defi tokens such as Compound’s COMP and BZRX have seen their value multiply by 10x or more. That last sentence is worth reading again.

Meanwhile, transactions on Ethereum have surpassed the value of those on Bitcoin, thanks in part to the Cambrian explosion in defi activity.

Total value locked in Defi (USD)


The case for Defi growth being good

Make no mistake, there's a defi gold rush underway as retail traders, high net-worth individuals, family funds and VCs allocate capital to crypto's hot new use case. And while the promise of large returns is undoubtedly driving much of this growth, that's not a bad thing.

For starters, defi needs liquidity if it is to offer a trading experience that can rival centralized exchanges. DEX trading in the past involved complex interfaces, slow order placement, low liquidity and high slippage. Today’s DEX traders can execute orders across multiple exchanges using aggregators, enabling them to make large buys at market price. And that's thanks to "liquidity miners" - token-holders who lock their assets into defi protocols.

LINK, the native asset of Chainlink, whose oracles are used by multiple defi projects, is up 362% year to date.

LINK price chart, 2020 ytd

Source: Coincodex

Early investors might gain the greatest rewards if they're lucky, but they also assume the most risk. If they generate handsome returns, they're entitled to them. After all, it takes guts (at the very least) to entrust your funds to decentralized protocols in the knowledge that if there’s a smart-contract bug you could lose everything. Should that happen, there is no consumer protection agency to run to.

Moreover, the high yield offered by certain defi protocols is simply smart growth hacking. High annualized percentage rates (APRs) provide a means of bootstrapping fledgling networks, providing the liquidity that will attract more users and grant them a superior user experience. Who wants to trade illiquid tokens in a veritable ghost town? For defi to change the world, first it must corner the cryptosphere – and it's doing a good job of that so far.

But what about the flip side? High yields and 10x-ing tokens are unsustainable. What happens when the music stops?

The case for Defi growth being bad

Boom and bust cycles are inevitable in emerging markets. But what's going on in defi right now isn't just growth - it's greed. Scammers sharing fake smart contract addresses for Uniswap tokens; gas wars where bots front-run DEX listings to snap up all the tokens like concert touts: it’s hard to see how any of this is bringing open finance to the masses.

Importantly, it is not certain at this stage that the benefits of defi will “trickle down” to those who could benefit from it the most.

Right now, the most successful defi dApps are focused around trading, demonstrating that speculation remains crypto's primary use case. If defi's lasting legacy is merely to transport centralized trading to a decentralized environment, it will have fallen woefully short of the ethos it was founded on.

If the growth doesn't slow, the yields drop and the use cases expand, defi risks going the same way as ICOs - facilitating cash-grabs instead of game-changing crypto/blockchain projects.

The verdict

The truth about the status of decentralised finance probably lies somewhere between the two camps: defi is delivering value, but it's also attracting the avaricious and the malevolent.

Where there’s money, there’s thieves and con artists, and right now defi has its share of both.

Thankfully, however, it isn't all doom and gloom. The current crop of defi dApps boast excellent UX, smooth onboarding and a clear value proposition. The innovation within the industry, from insurance products to derivatives, is staggering and there are user metrics to back the valuations. People are actually using defi for its intended purpose: as a global savings account and digital bank. That's quite an achievement for a movement built on a technology - blockchain - that’s a little over a decade old.

On 15 July, research boutique dGen published a 56-page report on the defi landscape. Based on interviews with industry experts, the report makes a series of predictions for the next decade, including:

  • Stablecoins becoming a critical component of international payments in Europe and beyond.
  • Major audit firms, such as Deloitte and KPMG, joining the defi ecosystem.
  • Effective insurance making defi a trillion dollar industry.
  • Traditional financial institutions offering their first defi-enabled savings and pension accounts.
  • Defi will provide income for thousands of gamers, streamers and influencers.

If even a couple of these predictions come to pass, defi will have exceeded the expectations of its early developers.

Ignore the haters, skirt the scammers and refrain from fomo-ing in - but pay close attention to the defi space: for all its flaws, it's the real deal - and it’s here to stay.

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Jul 16, 2020
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