Limitless Potential – Is DeFi Coming Of Age?

Article Overview

Decentralised finance (DeFi) is a catch-all term for protocols and applications (dapps) in the cryptocurrency space. Where Initial Coin Offerings (ICOs) looked more generally at decentralised versions of traditional applications (e.g. social networks, food delivery and more), DeFi focuses on specific areas of finance.

Interest in DeFi has peaked in recent months. The total value exchanged via decentralised exchanges reached $1.6bn in July. In this article, we look at what DeFi is, its benefits and the associated risks.

‘Permissionless’ and Disintermediated Finance

Bitcoin (and cryptocurrencies more generally) appeals partly because transactions can avoid going through a centralized entity. For example, when buying a product at Macro Hive in a digital hard currency (i.e. a credit card), a financial institution intermediates the transaction. In the crypto space, no such middleman exists. Transactions are decentralised and noncustodial. That is, buyers and sellers trade directly and hold their own private information via keys.

This permissionless and dis-intermediated way of doing business has existed for several years now. More recently, however, it has extended to include almost every financial service we use today: savings, loans, insurance, exchanges (for trading assets), betting markets and so on.

Instead of relying on traditional banks or financial institutions, ‘smart contracts’ make trades on applications offering these services possible. Simply, these are just contracts under which transactions between two counterparties occur according to transparent and predetermined mathematical conditions. In other words, a dapp (an app in the decentralised financial space) is designed based on a protocol that has specific constraints and requirements. Once certain conditions are met, an application will execute functions according to the rules of the contract.

Take MakerDAO as an example (credit Nathaniel Whittemore). It is a protocol that allows people to mint stable coins. In this system people can mint their own coin, or ‘dai’, by taking out a collateralised debt position. For instance, if a user deposits $150 of Ether, and the contract requires a minimum collateralisation ratio of 150%, he/she can withdraw up to 100 dai. In essence, they have minted their own stable coin by using another crypto as a deposit.

In this example, the smart contract stipulates a minimum collateralised ratio. If your deposit falls below this, the contract is liquidated. No middleman, no bank.

Another example is travel insurance. Say your contract stipulated that if a flight was delayed by 45 minutes, ticket prices would be refunded. A dapp running this smart contract would automatically reimburse any user immediately, without the hassle of a claim.

These examples are simple. However, they illustrate the diverse menu of applications and protocols that exists in the decentralised financial services world – a space referred to as DeFi. We include more examples in the Appendix.

Understanding the Trajectory of DeFi

Total value lock (TVL) has been one of the main measures by which people understand the trajectory of growth in decentralised finance. It tells us how much capital is in the DeFi space. Simply put, it is equivalent to the amount of collateral or assets that have been locked away on each of the different DeFi protocols and applications. One can also think of it loosely as a measure of liquidity and volume. A rise in TVL is equivalent to a rise in total locked assets. Broadly speaking, a rise in total locked assets means more people are involved in the space.

Interest has peaked in the DeFi space mainly because of growth in TVL. It took more than a year for DeFi platforms to get to $1bn TVL, a further five more months for it to get to $2bn, and then just two weeks to get to $3bn. On-chain data from data analytics hub DeFi Pulse indicates that the TVL of the DeFi market is now above $10bn (Chart 1). For context, the total global market capitalisation for crypto is upwards of $365bn.

Source: DeFi Pulse

What Has Been Driving the Growth?

Yield Farming

There is demand for dapps beyond the very interesting financial engineering that underpins them. Similar to any financial market, liquidity plays an essential role in the functioning of a decentralised application. A lack of it can generate arbitrage opportunities for investors, make it hard to exchange tokens or, more fundamentally, stop users from coming to the platform.

Similar to market makers in the traditional financial services space (e.g. brokerages), ‘automated market makers’ generate liquidity in decentralised markets. Essentially, similar to Bitcoin mining, a token issuer, exchange or application can reward a pool of miners to provide liquidity for a specified platform. The incentive is that they are paid according to transparent, algorithmically defined rules.

Different platforms offer different reward systems to liquidity providers. Some take a share of transactions and add it to a pool (staking). Others pay users based on the number of tokens they can store on an application. These reward systems have given rise to yield farming. That is, individuals moving money to exchanges where they get paid the highest yield. These yield farmers can often receive free tokens and/or interest on the liquidity they provide (see Appendix for more on yield farming strategies).

While the yield farming has provided liquidity and demand for various dapps, it has also generated much volume between exchanges. In other words, while the underlying technologies of the apps are exciting, growth appears to be coming from the financial rewards of providing liquidity rather than from users benefiting from the engineering.

Regulation

Regulators began taking an interest in ICOs in 2017 following a significant spike in prices and demand. The idea that decentralised applications were completely ‘off-the-grid’ is in practice no longer true. Tether, for example, keeps a blacklist of 39 addresses worth around $49mn based on law enforcement requests from US agencies.

One reason for regulators intervening was to disincentivise fraudulent ICOs. Part of the allure of crypto was the ease at which potential investors could buy tokens. This created an environment in which uninformed yield-seeking users would fund projects that were bound to fail. The rise in regulation, however, opposes the very fundamentals on which crypto was designed: privacy and decentralisation.

But regulators in the DeFi space have been behind the curve. As such, anonymity between lenders/sellers and borrowers/buyers is preserved. Transactions are based on mutual trust, preserving privacy, and understanding the smart contracts on a particular protocol.

This lack of regulation might partly be due to the structure of protocols and applications in DeFi. Specifically, users must participate in both the lending and borrowing side of transactions. In some instances, they gain interest from their locked assets as a reward for participation. As a result, DeFi apps require users to actively contribute rather than just hand over money.

Mainstream Players

The third reason for DeFi growth is that mainstream players are getting involved. Many high-street financial institutions are beginning to accept DeFi and seeking ways to participate. For example, 75 of the world’s biggest banks are trialling blockchain technology to speed up payments as part of the Interbank Information Network, spearheaded by JP Morgan, ANZ and Royal Bank of Canada.

Macro Environment

Low global interest rates are pushing investors to seek higher yields. Macro Hive authors Andrew Simon and John Butler recently suggested US tech companies could start buying Bitcoin. Indeed, the current macro environment is conducive for savvy investors looking at alternative investment opportunities. These include larger institutions, but also retail individuals excited by the potential of decentralised applications. Indeed, such individuals form DeFi’s core.

Risks for DeFi

High gas fees (transaction cost) resulting from higher Ethereum transaction could stop small investors from capital rotation to maximise returns (in yield farming). The initial glitter of DeFi was to bank the unbanked, but it may just facilitate the rich getting richer as earnings are relational to the amount an investor stakes.

While yield farming generates the much-needed liquidity underpinning dapps, it inflates market values. As the space grows there will be a need to reduce the returns associated with providing liquidity. This will move interest in dapps away from speculators and miners towards users that use platforms for their technological advantages. This will generate price stability and credibility, with users providing the required liquidity. More stable and organic growth will also bring down high valuations. Data from Token Terminal shows P/S ratios for a number of platforms well in excess of the current Nasdaq average of 4.4 (Chart 2).

Technical issues also exist on platforms. Bugs in smart contracts and hacks are pertinent issues. Congestion on the Ethereum blockchain and the resulting higher transaction fees further hinder scalability. There are suggestions, however, that the rollout of Ethereum 2.0 will tackle these problems.

The DeFi space is nascent and so subject to an uncertain regulatory environment, making future changes hard to predict. Despite a lack of regulation, however, not all apps are devoid of large influencers. It is common to assign a high degree of control to the developers for new projects so that they can develop the network and fix any issues.

Most of the DeFi applications or protocols rely on the price of Ether. If the ETH price declines rapidly, it will have knock-on implications. For example, a fall in ETH may liquidate contracts for those who become under-collateralised. Projects that rely on the supply of dai will, therefore, stop. Such events are possible – on Black Thursday (March 2020), the price of Ether dropped 33%.

A Short Word on Bubbles

The 2017 ICO bubble reflected huge asymmetries between the incentives and knowledge of developers and those of investors. Many investments yielded no returns and required no community of engaging users (we recognise there are, of course, many exceptions). DeFi is different because it provides immediate value to users and enables the investor to become a user within the ecosystem as well. The ability of users to benefit from the underlying technology as well as engage with applications (via liquidity and/or locking in assets) aligns incentives more closely.

A quick look at Google trends shows that the contagion of interest around ICOs during their 2017 bubble has yet to move into the DeFi space. Although DeFi interest on its own is at its highest level, it is still far lower than that of ICOs (Chart 3). This could reflect the user base (generally better informed) or its lower uptake. Whatever the reason, this relatively more muted rise in interest can only be healthier for long-term growth prospects in the space.

Bottom Line

There is great potential in the DeFi space. According to World Bank estimates, 1.7bn adults are non-banked, yet two-thirds of them own a mobile phone. Decentralised financial applications have the ability to make financial services easily available for all.

Whether DeFi can live up to its potential depends on liquidity, incentives, diversity, transparency and, most importantly, on remaining decentralised. The engineering behind these platforms is limitless, and with the onset of the pandemic, it appears large players in the global financial network are taking note.

Appendix

DeFi Applications

Most DeFi applications are built on Ethereum because its programming language (Solidity) was designed for constructing and deploying complex smart contracts. There is, however, a growing use of other cryptocurrencies and even virtual real-world commodities. Here are some examples of DeFi applications:

• Decentralised exchanges (DEXs): Online exchange, where users can exchange or trade cryptocurrencies without any intermediary. One such example is Uniswap.
• Stable coins: A cryptocurrency whose value is pegged to an asset outside of the crypto realm (the dollar or euro, for example) to stabilise the price. Chart 2 below compares the Bitcoin volatility with Tether (tied to USD).
• Lending: These platforms use smart contracts to replace intermediaries, such as banks that manage lending. Investors can deposit cryptocurrencies and start earning returns instantly (to check different lending and borrowing rates on offer, click here). Borrowers do not need credit checks to obtain a loan; however, borrowers need to over-collateralise their loans (deposit more than they can borrow).
• Margin Trading: Like traditional finance you can use borrowed funds to increase leverage in a certain asset whilst trading. The main apps in this space are dYdX and Fulcrum.
• Tokenisation: This is the process of issuing a token that digitally represents a real tradeable asset. They include financial securities (equities, bonds, loans, and funds), tangible assets (real estate, artworks, precious metals), or intellectual property (copyright to works of authorship). The benefit of this is that investors can take advantage of fractional investing, where they can build a diversified portfolio without being constrained by their capital or geography.
• Payments: Peer to Peer (P2P) payment transfer systems are the most popular applications in the DeFi space (and crypto currency in general). In the current financial system, global remittance fees are costly – around 6.75% on average, according to the World Bank. Dapps aim to reduce both transaction costs and time to transfer payments.

Source: Mycrytptopedia

Yield Farming Strategies

Lending: Farmers can deposit stable coins and start earning returns instantly. The 10-year US Treasury currently yields less than 1%, while DeFi platforms offer significantly higher returns. For example, Compound has been offering, on average, an annualised interest rate of 6.75% if you invest stable coin Tether.

Liquidity Pools: Farmers can supply capital to decentralised exchanges (DEXs) and start generating additional money by collecting fees on trades which go through that the pool. Uniswap, Balancer or Curve are some examples of these kinds of pool.

Liquidity Mining: Yield farmers are also being rewarded with additional incentives to become either the user of the protocol or provide liquidity by distributing extra tokens on the platform itself. These extra tokens can later be sold and exchanged to generate profit. For example, Uniswap’s UNI token liquidity mining program yields around 23% in their ETH-DAI liquidity pool. Investors can supply their ETH and DAI to this liquidity pool and additionally also receive UNI tokens, which can be later exchanged for ETH or a stable coin and subsequently liquidated to generate profits.