Explosive DeFi: where we are and where we are going

The entire cryptocurrency space continues to develop at a rapid pace, surpassing the $3 trillion market cap for the first time in 2021. Additionally, global blockchain spending has grown seven-fold over the past four years to an estimated $6.6 billion in 2021 and is set to more than triple by 2024 as forecast. That’s impressive considering the seeds of the crypto industry were sown with the introduction of Bitcoin just over a decade ago.

Today we have come a long way as the blockchain industry has grown beyond peer-to-peer transactions as various sectors such as NFTs, GameFi, Metaverse and Decentralized Finance (DeFi) have emerged. But none has captured the attention of the traditional finance industry quite like DeFi.

DeFi = decentralized finance

DeFi is an eclectic mix of blockchain technology, digital assets, and financial services that aims to disintermediate funding. The market experienced explosive growth in 2020, dubbed by many as the “Year of DeFi.” That means it’s still early in its maturation.

According to Defillama, the total locked value (TVL) in DeFi has increased from $625 million in April 2020 to now and remains above a whopping $211 billion but below a peak of over $255 billion in December 2021. Currently, It is dominated by the likes of DEX Curve, which accounts for 9.6% of this TVL, staking platform Lido, money market Anchor and lending protocol Aave.

DeFi is revolutionizing finance, starting with exchanges, derivatives, wealth management, credit, insurance, and stablecoins. Unlike traditional finance, which relies on intermediaries to manage and process financial services, DeFi operates in a decentralized environment. Decentralized applications (dApps) are built on public, permissionless blockchains, and services are generally encoded in open-source software protocols and smart contracts.

As a result, investors are pouring more money into these DeFi and Web3-focused startups, according to a report by deal-tracking firm Pitchbook. Young Web3 and DeFi startups made combined investments of $1.26 billion in Q3 2021, which are seen as “highest growth opportunities.”

The basics

In the DeFi sector, dApps offer financial services without the need for centralized intermediaries or institutions. Open protocols enable a flexible programmatic combination of services. This is the complete opposite of what the traditional markets stand for. In traditional financial markets, intermediaries serve as agents of trust, liquidity, settlement and security which have made the current system increasingly complex. The 2008 global financial crisis exposed the flaws, inefficiencies, structural inequalities and hidden risks of these intermediary financial systems.

In addition, the legacy financial infrastructure remains riddled with shortcomings in the form of slow settlement cycles, inefficient pricing, liquidity issues and a lack of security in relation to the underlying assets. Remedy is the advent of decentralized finance, which aims to address these challenges by using blockchain technology to enable alternatives to traditional service providers and market structures.

Aside from using distributed ledgers as a settlement layer for transactions, DeFi leverages various other technologies such as smart contracts, which are programs that run when predetermined conditions are met. Here, digital assets represent value that can be easily transferred. In DeFi, governance systems give a protocol’s token holders the right to vote on its future.

Wallets, on the other hand, are used to manage assets stored on a blockchain. While custodial wallets are much easier to manage and interact with other applications, non-custodial wallets allow exclusive control over funds through their private keys.

The good and the bad

The opportunity that DeFi presents is fairly simple and much talked about. It eliminates high fees charged by banks, brokers and other financial institutions. DeFi enables faster and more efficient transactions, reduces counterparty risk, increases functional interoperability for transparency, improves accountability, gives stakeholders more control, and grants permissionless and rapid innovation.

Being open-source protocols, anyone can build on the platform while providing opportunities for additional juicy returns on investments that far exceed returns in legacy markets.

DeFi has enormous potential in terms of efficiency, innovation and financial inclusion, but at the same time it also poses risks. Some of these are scalability, throughput, transaction fees, limited interoperability between blockchains, over-collateralization, and regulatory challenges.

Due to its early stage of growth, DeFi is currently promoting short-term returns and attracting ruthless players. For example, rug pulls, scam projects, bad actors, and hacking are also fairly common in DeFi. Numbers speak for themselves.

According to a report by Elliptic, DeFi users actually lost $10.5 billion to theft in 2021. Among the biggest DeFi hacks is Poly Network, which lost $611 million. Then there was the cyber attack on Axie Infinity’s bridge to the Ronin protocol, where hackers siphoned off $522 million. The most recent DeFi hack took place on April 17th. Beanstalk, a stablecoin protocol, lost $182 million in a flash loan attack. Then comes the infamous $326 million wormhole hack.

These are just some of the cyber attacks that have garnered media attention and become the talk of the town on social media platforms. The actual numbers are far higher. Such cases show that the DeFi sector is far from an easy and safe way for the masses to deploy their capital.

The latest developments

Despite the risks of using DeFi, the sector is growing and evolving, with several new trends emerging.

Liquidity mining is one of DeFi’s hottest trends, where the protocol allows users to provide liquidity and be generously rewarded with native tokens. Yield farming is another popular practice that combines staking, lending, and borrowing to optimize revenue.

The rise of non-fungible tokens (NFTs) has also paved the way for the launch of new products on the market that merge NFTs with DeFi, such as GameFi or play-to-earn games like Decentraland and The Sandbox. The advent of 5G is also expected to benefit DeFi as it will provide significant high-speed connectivity.

Then there are Decentralized Autonomous Organizations (DAOs), whose growth can be attributed to the rise of DeFi innovations, which get a lot of traction as they reach mainstream consciousness. DAOs are used for everything from arts and sports to crowdfunding and finance.

Some of the most exciting DAOs are BeetsDAO, a collective focused on buying music-based NFTs; ConstitutionDAO, a group effort to buy a copy of the US Constitution; FriendsWithBenefitsDAO, a members-only social club for crypto; and RaidGuild, a Web3 marketing and design agency for hire.

However, the discussion of DeFi is incomplete without Ethereum, on which most of these applications are built due to its capabilities and developer acceptance. Ethereum is currently undergoing a transition to ETH 2.0 to improve its scalability. But with other Layer 1 blockchains like Terra, Avalanche, Solana, BSC, and Polygon, and Layer 2 solutions like Arbitrum and Optimism catching on in 2022, cross-chain technology has emerged to enable the smooth exchange of information between allow different networks.

For example, the DEX Mangata Finance is built on the Polkadot network and bridged with Ethereum to offer low fixed fees and MEV-free trading.

Last word

Overall, DeFi has immense potential for users as it is available 24/7 to everyone worldwide. These decentralized protocols offer new and diversified investment opportunities. Not to mention the double-digit interest rates that many DeFi protocols offer, which are much higher than the sub-1% rates of regulated banks.

This, of course, has giants like Morgan Stanley urging the DeFi industry to stay “pretty small.” But DeFi, while still new, is growing fast, attracting investment and users, and working to bank the billions of unbanked people.

Peter Kris is the CEO of Mangata Finance.