DeFi or decentralized finance is the talk of the town today. The term was non-existent a few years back and today it is creating history. A community of defiant individuals came up together with the goal of creation of a novel financial standard where no third party or centralized authority is involved. DeFi started to get proper investor attention in the year 2018-19 and opened a new horizon! DeFi has almost become a movement now. In 2017, we saw the ICO boom. ICO was an innovation to raise funds from the retail investors but the ICO boom didn’t last long. ICO isn’t a preferred method to raise funds nowadays. Is DeFi another hype in the cryptocurrency space or can it be an epoch-making financial excogitation?
“Not your keys, not your coins” – Crypto proverb
The problem with traditional finance
Traditional finance is dependent on various institutional intermediaries. In case of disputes, institutional arbitrators come into the picture. The power in traditional finance is extremely centralized. When people invest, they pass over the control of their assets to the banks or the custodians of the funds. The process ends up at accumulating control and power at the centre of the system. The system fails often. We’ve already seen the 2008 housing bubble burst. Due to the risk accumulation model at the centre of the system, a single failure endangers the entire ecosystem. Traditional finance is the driving force of the global economy, but it has never been an open system. Transparency always remained an issue. The investors often get peanuts of the profit whereas the intermediaries take an enormous cut. Participation in traditional finance was never holistic. The major part of the society doesn’t access the stock market and we still talk about banking the unbanked in the 21st century.
The programmable money
DeFi aims to create an open-source, permissionless, participatory and transparent financial ecosystem that operates without any central authority. The users always control ownership of their assets and interaction with the ecosystem happens through the peer-to-peer process and decentralized applications (DAPPs). DeFi smart contracts are publicly auditable and thus provide immense transparency. These smart contracts are interoperable also. DeFi’s modular framework allows interoperability and amalgamation of different parts of DeFi to create new functions. DeFi is dynamic and ever-evolving. DeFi’s trustless feature is attracting both individual and institutional investors nowadays. New opportunities are being created every day. DeFi can be broken up into different categories – lending & borrowing, DEX (Decentralized Exchanges), derivative, layer 2 payment networks (ex- Bitcoin lightning network, WBTC), tokenized assets and asset management (ex-WBTC, Set protocol). The smart contracts managing DeFi are financial robots.
Image Source - Components of DeFi
8.62 Billion USD locked in DeFi
The total ecosystem of DeFi got developed on Ethereum. Ethreum, often dubbed as ‘the world computer’, found its hottest use case in DeFi. $8.62B is locked in DeFi now across different platforms. One year back, the total value locked in DeFi was only $565M. That is 1425% growth almost. Aave, having 17.08% market share, is the most dominant player in DeFi. Total 3.3M ETH is locked in DeFi. Bitcoin’s layer 2 solution lightning network didn’t work well and smart contracts don’t run on the Bitcoin platform. Bitcoin had to arrive on Ethereum to take part in the DeFi game. ETH wrapped BTC token can run on Etherum platform. Total 101.1K BTC is locked in DeFi now and the majority movement is happening on Ethereum only. If we take the current market price of BTC at $10,500, the total BTC value locked is approximately 1.062B USD.
Image from DEFIPULSE - TVL growth 1425% in 1 year
“Global zero-bound interest rate is potentially re-directing the money flow from the traditional market to the DeFi ecosystem where the interest rate is significantly higher than the one in the traditional system, although attracts higher risks compared to the traditional regime.” – Tokeninsight report
The first half of 2020 was financially depressing and global financial market turmoil spread to the cryptocurrency industry too. There was stress on all kinds of asset classes and DeFi TVL dropped to $500M during the ‘Crypto Black Thursday’ crash on 12th March 2020. Since then DeFi TVL has jumped 840% to reach $4.7B. The parabolic growth of DeFi was fuelled by the higher interest rate of DeFi than the traditional financial system.
Image Source – Change of DeFi lending TVL ($ Million)
Lending is the most prominent DeFi activity and governance of the lending protocols is key to the success of DeFi. Governance tokens of different lending protocols like Compound, MakerDao etc. did wonder in H1 of 2020. It is expected that more governance tokens will be issued in H2 of 2020.
Image Source – H1 2020 lending DeFi token performance
There wasn’t a significant difference in 2018 & 2019 DEX trading volume. 2020 saw the exponential growth of DEX trading volume. Only Q1 2020 DEX volume ($2.3B) was equivalent to 2019 figures. Q2 2020 DEX trading volume reached a record high of $3.7B.
Image Source – DEXs historical trading volume
Bitcoin was envisioned as ‘decentralized money’ by Satoshi. DeFi comes with a broader approach to decentralize the traditional finance industry. Yes, DeFi is experimental in nature and it has some inherent risks but so far it is able to provide a real and compelling value proposition to access financial services and applications by eliminating the intermediaries. It is difficult to say how long the present trend of ‘yield farming’ and ‘growth hacking’ of the yield farmers stay! Most probably, we may observe a normalization curve down the line. Change is only constant in this world. The nascent eco-system of DeFi is improvising at lightning speed. We are observing the true power of automated decentralized finance. Experience true innovation and witness the most dynamic revolution of the financial world. DeFi is here to stay! The next-generation financial institutions are going to be smart contract factories only.