The future of finance – Decentralized Finance
Decentralized finance (DeFi) has certainly been one of the major breakthroughs for DLT over the last two years. Therefore, we decided to provide an intro into decentralized finance. Since we already wrote extensively about DeFi in our market updates, parts of this intro will be based on those Quarterly reports. In this post, we will look into a few fundamental concepts underlying decentralized finance, such as DAO’s, the technology stack, metrics used to measure DeFi adoption and the various risks associated with DeFi. Finally, we will provide an outlook and envision what’s next for this thriving part of the blockchain industry.
Let us start with the most basic question – what is DeFi and what does it offer? Decentralized finance refers to all financial processes that happen in a decentralized way. This is enabled by blockchains (with all of the DeFi activity currently taking place on Ethereum) and the digital contracts that are executed on top of the blockchains. DeFi removes the need for intermediaries in finance such as investment/commercial banks, insurance companies, brokers and so forth. In essence, this means that a user is not dependent upon any other party in order to access and use the financial services.
An example of this is that in the centralized finance world when a particular entity wants to take out a loan (currently a major DeFi vertical are lending protocols) you interact with an advisor and a bank in order to get access to it. In the DeFi world you’re interacting through a digital contract (also known as smart contract) instead of an intermediary. A capital provider deposits their (digital) asset into a liquidity pool where it is pooled and awaits a borrower. The removal of intermediaries leads to more efficient and effective capital allocation which in turn leads to higher interest rates paid to lenders and lower interest rates paid by the borrowers. For instance, a capital provider in Compound, a decentralized lending and borrowing protocol, can earn ~3% interest on his funds. While taking out a loan charges an interest of ~3,6%. The spread between the maker and taker interest rate is stored inside the Compound protocol, in a so-called reserve. Compound is just one example of a lending DeFi protocol. Other major lending protocols are MakerDAO and Aave and while working differently and making other trade-offs, they all have the same characteristic of not interacting with an intermediary and being permissionless to access.
Decentralized Autonomous Organizations and liquidity mining
Recall the Compound reserve mentioned earlier? Currently, that is just a warehouse of digital assets being stored. However, what happens to these assets is determined through a governance process inside a so-called DAO. The term DAO brings us to the next part of all the DeFi activity. DAO stands for “decentralized autonomous organization” and while this construct has been around ever since 2016, it has started to gain broader traction with the introduction of DeFi. In a DAO tokens are used to vote during a decision making process. This is comparable to shareholders voting in a shareholder meeting. The more tokens (similar to shares) you hold, the more weight your vote gets. As of now, DAO tokens are mostly used to alter various parameters inside DeFi systems, for example, voting on what happens with the reserve inside Compound. An example of a DAO proposal and voting is provided below. These DAO tokens can be distributed in a variety of ways. One of which is an investment, where assets are exchanged for governance tokens similar to any other investment. However, another method also came into existence recently, the so-called liquidity mining which we will discuss in the next paragraph.
Liquidity mining refers to the process of rewarding capital providers, users that deposit digital assets into the liquidity pool mentioned earlier, with respective DAO tokens. In addition, users that utilize the protocol to lend from the liquidity pool can also be rewarded in the DAO tokens. This is a form of a “cashback”. The idea is innovative, but yet rather simple. By rewarding users on both, the supply and demand side of the protocol with governance tokens, you give them the power to make decisions regarding the protocol. This makes sense because these are the people that actually use it and would consequently be the best decision makers. There are various liquidity mining programs, all with different trade-offs and adaptability. Some just give a fixed amount of DAO tokens on a daily basis whereas other protocols use liquidity mining incentives to boost liquidity in a specific part of their protocol. Regardless of the exact specifications, the overarching goal of handing control of a DAO that governs a protocol to the users that make that protocol valuable remains.
Tech Stack of DeFi
The current technology stack of DeFi consists of a number of verticals. The largest one currently is lending and borrowing, of which the aforementioned Compound, Aave and MakerDAO are examples. In these protocols users deposit one digital asset (e.g. ETH) and take out a loan in another (DAI, USDC). For now these loans are usually very overcollateralized, however we invested in a project aiming to allow under collateralized loans. We dive deeper into decentralized lending and borrowing protocols here.
Another vertical with a decent amount of traction are decentralized exchanges, Uniswap, Curve and Balancer are examples of these. These allow permissionless trading on both market creation and trading itself. Anyone can create a market for any Ethereum (ERC-20) token on Uniswap, start providing liquidity to it and any user can trade on this market through their own wallets. Most of these decentralized exchanges utilize an AMM model, more about the exact inner workings of AMMs can be found in our deep dive into AMMs here.
Finally, a vertical which has gained considerable attention and traction are the asset managers of DeFi of which Yearn and the PowerPool Index are two examples. Yearn is comparable to a more “active” asset manager such as a hedge fund. They actively deploy strategies to find the best yields and allocate assets actively, whereas the PowerPool Index is more comparable to a structured finance, ETF like, product. A user can deposit an asset into the index and get exposure to all assets that are included in the index. This is rebalanced automatically. More about these two forms of asset management in DeFi can be found here.
A vertical which is often included in the DeFi tech stack are the oracle solutions. Oracle solutions are used to port off-chain data on-chain. The most prominent example of an oracle solution is Chainlink. While oracles are an crucial part of DeFi, as they are used by almost every project, we deem to be more (critical) infrastructure then a finance protocol in their own right.
Because all these protocols are built on the same technology stack (we deem this to be a major advantage over centralized finance “data silos”), they are also composable. Consequently, you can easily make them interact with each other. Rebuilding entirely new finance processes looks like stacking lego bricks on top of each other. For instance, a user can issue a stablecoin on MakerDAO, pool it in the liquidity pool in Compound, and finally utilize the rewarded COMP governance token in a Uniswap liquidity pool to earn trading fees from the COMP-ETH pair. These fees can be used in another protocol again and so forth. The major advantage from this process is that it stacks the various yields of these products. This process is called “yield farming” and can earn users up to 100% returns annually. Because the system is entirely composable and permissionless users can get as creative as they want with their financial constructs.
Risks of DeFi
However, there is one major annotation to be made, no yield comes without risks especially in an industry filled with innovation and novel products that aren’t like anything seen before. We currently identify a few major risks involved in DeFi;
- The risk of a digital contract bug and/or exploit. With contracts holding hundreds of millions worth of assets they become attractive targets for the hackers. In addition, a buggy digital contract can freeze and lose access to the assets locked inside of it. A famous example of this was when a smart contract with over USD 100M of assets inside it was frozen, because of a user that unknowingly called a function that froze all assets. Caution is necessary when interacting with these contracts.
Source: https://imgur.com/KDi7xyI & https://github.com/openethereum/parity-ethereum/issues/6995
- The risk associated with the lack of custody for the users. By eliminating the intermediary you also eliminate a measure of control seen in traditional financial processes. There is no intermediary that you can hold accountable for mistakes. If a user accidentally loses funds, they are lost (forever). While in centralized financial systems, the reversal of a transaction can be as easy as changing a cell in an excel sheet, this is certainly not possible in decentralized finance.
- The risk created by the composability of protocols. We mentioned this as an advantage earlier in the lego brick analogy. Due to the protocols being stacked on top of each other by users, one of them breaking down can cause the entire stack to fail like a jenga tower falling apart.
- The oracle risk. This might be the biggest risk of them all and is associated with the oracle issue. A simple way to envision the oracle issue is that the data recorded on the blockchain network that DeFi is built on top of every data entry recorded is correct and verifiable by everyone. However this means that the critical point is when outside data is ported into this network from an outside source. Most exploits/hacks in DeFi are currently caused by exploiting oracles and it remains the main weakness.
Data in DeFi
It is also good to introduce some metrics used to measure the size and growth of DeFi. First, the most notable and most referenced metric is TVL. This refers to “total value locked”. TVL measures how much assets are “locked” (or put to work) in various DeFi protocols. In other words, it is a proxy for the size of this part of the industry. A comparable counter-part in the centralized finance world might be assets under management. A few historic data points for context, at the start of 2019, the TVL was equal to USD 300M. During 2019, the TVL more than doubled and increased to almost USD 700M at the start of 2020. Nearing the end of 2020 the TVL of DeFi is currently at ~12.5B. An impressive 1786% growth YTD.
The total number of users in the DeFi space has also shown an impressive growth this year. At the start of 2020, there were almost 100K users. Currently, this is nearing 1M, an impressive ~1000% growth this year alone. One important annotation here is that the “users” in a blockchain context mean addresses that interact with DeFi protocols. One entity can (and usually does) utilize multiple addresses. Nonetheless, this was also the case at the start of 2020, therefore the growth rate could be considered as impressive.
As discussed, lending and borrowing is one of the largest verticals in the DeFi ecosystem. On the chart below, we can observe a clear trend forming in the last 6 months. The amount of assets to be utilised as collateral inside of these protocols is increasing rapidly, from just USD 600M in May to almost USD 8B at the time of writing.
The other verticale we highlighted is that of decentralized exchanges. While it is compelling to compare the detailed specifications of these protocols, from a data point of view it is more interesting to see how they compare to the centralized exchanges (CEXes). This is shown in the DEX to CEX comparison below, where the spot volume on a DEX is shown as a % of the CEX volume. In January 2019, this metric was equal to 0.12%. One year after, DEXes passed the 1% mark and are currently accounting for 6% of the CEXes spot volume. The all-time high was observed in October, when the ratio peaked at around 16%.
The metrics shown above indicate an impressive growth of the more established DeFi projects over 2020. However, a new breed of protocols has also arisen which is discussed in the next section.
What is next for DeFi
As the year is coming to an end it seems in order to provide an outlook of what we expect to see next year. Innovation in DeFi is moving rapidly, we are already experiencing new and improved protocols in the same verticals (lending, exchanges, asset management) being deployed. At the same time the “legacy” names within those verticals are also innovating based on the governance decisions by their respective communities. We also foresee quite some new verticals to take a more major place in the space in the coming months. We want to highlight two of these verticals below as we expect these to see the most traction.
One of those new verticals is the insurance market. Currently there is one major underwriter of insurance, Nexus Mutual. Nexus’ TVL is currently equal to only ~USD 90M which should be perceived as a small value taking into account that the total size of the DeFi industry is over USD 10B. We are currently seeing an upcoming trend in the industry for new insurance protocols. We expect these protocols to go live during the first half of 2021. The market demand for insurance is rather clear (emphasized in our previous DeFi piece), smart contract hacks/exploits are one of the biggest risks in DeFi. This has also been proven numerous times over the last month alone. As a risk management tool, insurance of DeFi assets is of the utmost importance which will be shown by an increased adoption of products offering this feature.
The second new vertical also entails a risk management tool and a cornerstone of traditional finance. However, this time it is a risk management tool for the price fluctuations. We are seeing the start of options and derivative trading being deployed onto mainnet. There is a wide range of derivative protocols being developed at the time of writing. Some have yet to come out of stealth, but the overall demand for them seems to be justified, due to the high volatility of crypto markets. Peer-to-peer issuance and underwriting of options and derivatives is an exciting market to explore and we are eager to see all of the innovative solutions that various projects come up with.