We expect explosive growth and substantial investment pouring into the space and the trend towards alternative protocols, scaling and infrastructure solutions to continue. Progress will accelerate due to increased DeFi Exchange offerings, regulatory evolution and NFTs and GameFi momentum overlapping with DeFi.
2020: The Year of Defi
2020 proved to be a seminal year for Defi, as it grew from $700 mn in Total Value Locked in the system in December of 2019 to $20bn by year end 2020 and $230 bn today, as per Defi Llama data. Bulls believe Defi will eventually replace the old financial system, with its antiquated and costly layers of intermediaries, although now it is a fraction of the trillions of assets residing within traditional institutions. It is hard to pinpoint exactly how the landscape will look at this early stage in the cycle, much like it was in the first days of e-commerce.
A Large Total Addressable Market to be Unlocked with Better User Experience, Regulation, Institutional Adoption and GameFi
What is certain is that there is explosive growth and substantial investment pouring into the space. The trend that kicked off in 2020 accelerated in 2021, with a steady rise in TVL and users despite market prices of many projects well off their highs. Expect growth to continue given the size of the total addressable market is in the trillions and access is still cumbersome for individuals who are not crypto natives. Costs on the main blockchain Ethereum are high, appealing more to smart money. As access gets easier, regulation improves in the areas of stablecoins, KYC/AML and consumer protection, adoption will spread. Moreover, banks are also experimenting with digital ledger technology, with SocGen bonds issued on the blockchain and some on-chain FX settlements by HSBC.
2022 should be a pivotal year as progress is made on several fronts. Exchanges are already looking to offer DeFi products to their customers, such as the recent Coinbase announcement to offer yield on stablecoins to users. While tentative and offering relatively low yields, it will grant access to millions of people (ex US for now). A clear regulatory framework with defined roles for the various agencies will likely emerge in the US, with lawmakers potentially passing legislation to fill in the gaps. The hearings this month showed that authorities are more well versed and keen to move forward. Finally, the widely popular NFT and Gamefi applications that have emerged as well as investment into the Metaverse by players such as Facebook, will blur the lines between DeFi, Gaming and NFT’s. New applications that combine elements of finance in gaming, such as the case of Axie Infinity, will crop up. Already, traditional gaming companies are vying to mimic Axie Infinity’s success, with $200 mnn in transactional volume per week.
Total Value Locked in the Defi Ecosystem
TVL is the sum of all assets deposited in decentralized finance protocols earning rewards, interest, new coins and tokens, fixed income, etc. Because blockchain services are developed on peer-to-peer networks, there is no central authority to govern, build, or improve the ecosystem. Therefore, cryptocurrency investors themselves receive consideration for building these networks from the bottom up with their coins and tokens (Nasdaq).
DeFi Investments reach $2bn as of Q321
Ethereum has emerged as a clear winner, will it continue to dominate?
Ethereum emerged as the go to protocol for open source defi applications because it was the only viable option a few years ago given Bitcoin’s limitations. This first mover advantage created a network effect, as it became a building block for these apps. Ethereum’s edge was that it was the first to allow for the creation of smart contracts —a piece of code that executes according to a pre-set rule, so that the terms of the contract can be set in the code and allow for its execution, without the need for a trusted third-party.
As we’ve seen, the pace of growth in the Ethereum ecosystem has been blistering and transaction volumes frequently reach 40 million per month. Hundreds more interlinkable apps will be developed over the next few years. There is a race to replicate the traditional financial primitives of trading, lending and insurance onto the blockchain and unlock value to a larger group of users. Even so, the number of people who have interacted with these apps is still low (around 4mn users, although that is up eightfold in a year), so the growth potential is immense. Anyone who can create a safe and easy user experience will be a winner, so the infrastructure or “picks and shovels” are key to the wider adoption of DeFi and can also make for interesting investment opportunities.
While Ethereum continues to be the protocol of choice, it also faces risks. From a dominance of 95% at the beginning of 2021, it has fallen to 64%. This trend is likely to continue, though as the whole system is growing, in absolute terms so will Ethereum. Ethereum has been a victim of its own success with slowing transaction times and high fees, despite the London hard fork in 2021 . The NFT craze over the summer added to its woes. An upgrade, Ethereum 2.0., has been in the works for years, but if it is delayed, developers may choose to move to competing platforms. Etherereum 2.0, slated for 2022 will make the network more secure, scalable,and meaning it will be better equipped to handle larger amounts of work.
Competition from other smart contract blockchains like Solana (6% of TVL), Binance Smartchain (10%), and Terra (5%) mean it is not certain that Ethereum will ultimately prevail or there may be room for several competitors, as in any industry.
Ethereum dominance has fallen but is still high, that should improve when it moves to Proof of Stake in mid 2022
Ethereum fees are still high despite the London hard fork which set fees based on supply and demand rather than auctions, but allowed tipping to speed up transactions
Main DeFi Use Cases Will Eat Away at Traditional Markets
Decentralised Exchanges or Dexes (Curve, Uniswap V2 and V3, Pancake Swap, SushiSwap) This area of Defi commands the most users. Liquidity providers deploy capital to earn a share of trading fees and liquidity rewards. The users are attracted to the platform by market depth and availability of their tokens of interest. A positive feedback loop is created where more users create more fees and more fees attract more liquidity. Sufficiently high users and revenue from fees keeps liquidity in the protocol when liquidity rewards expire.
Uniswap, launched in 2018, is a leader in this area and allows users to swap any token on Ethereum. In September, Uniswap airdropped 15% of its supply to past users. Today, UNI can be earned by providing liquidity to select pools and will eventually be used for governance as a larger portion of the supply is issued. Uniswap V3 was launched last spring to resounding success. It offers up to 4k times better capital efficiency and high returns. Concentrated liquidity offers liquidity providers increased control over price ranges. Those positions are then aggregated together into one pool, allowing users to trade against one combined curve. Multiple fee tiers allow liquidity providers to be more fairly compensated for the level of risk they take on.
Curve, a decentralised exchange and automatic market maker that has the most TVL on Ethereum, at $21 bn, designed for efficient stablecoin trading.
Lending (MakerDao, Compound, Aave)
MakerDao, launched in 2017, was the first to allow something more than simply sending payments. It is an Ethereum-based protocol that allows users to issue a cryptocurrency (dai stablecoin) that’s pegged to the value of the U.S. dollar by using digital assets as collateral. This mechanism effectively allowed anyone to borrow Dai against Ether. It created a way for anyone to take out a loan without relying on a centralized entity. It also created a dollar-pegged digital asset, which didn’t rely on holding dollars in a bank, like other stablecoins.
Compound Finance, released in 2018, created a market for borrowers taking out collateralized loans, and lenders to obtain interest paid by those borrowers. The platform is open for anyone, anywhere in the world to use and financial contracts are executed automatically by computer code. Securing loans doesn’t depend on credit score or the person’s income and liabilities, but on the assets they deposit in the system to cover for the value of the loan. Loans on Compound, as in most of DeFi, are over-collateralized. It’s not the most capital efficient system, but it allows loans to be permissionless and automatic.
Aave has several unique selling points. The project allows people to borrow and lend in about 20 cryptocurrencies, meaning that users have a greater amount of choice. One of Aave’s flagship products are “flash loans,” the first uncollateralized loan option in the DeFi space. Another selling point is how those who borrow through Aave can alternate between fixed and variable interest rates.
Derivatives (DyDx)
Exchanges both in traditional markets and crypto are very profitable, derivatives even more so. In the traditional financial markets, the total value of financial derivatives is estimated by some to be 10x larger than global GDP. The DeFi derivatives market, on the other hand, is still a drop in the ocean. DyDx is the largest player in this market, where users can get exposure to assets and commodities without having any exposure to an intermediary.
Yield Aggregators (Convex Finance, Yearn Finance)
Yield aggregators manage users’ capital with a variety of strategies designed to maximize yield. They move pooled capital around protocols with advantages of scale and ease of use
Insurance (Armor, Nexus Mutual) The DeFi insurance sub-sector was one of the highlights of DeFi in 2020 but is smaller than other areas. These insurance contracts are similar to traditional insurance in many ways, matching DeFi users looking to earn income with those looking to reduce risk.
Nexus Mutual is a platform that allows ETH holders to pool their funds in order to provide insurance for other smart contracts. The purchasers of insurance pay a premium to this pool and receive a payout if the covered risk comes to pass. Nexus Mutual has grown from roughly $4 million TVL in July of 2020 to $573 million TVL by December 2021.
NFTs, Gaming and the Metaverse – Since the popularity of NFTs on OpenSea took off in August, with record sales of $3.3 bn that month alone and Axie Infinity attracting millions of users seeking to supplement their incomes by earning tokens which they can monetise or trade, investment has kicked off. This should be one of the key new trends for 2022, combined with Metaverse experiences and brands bringing their products into the virtual world. Buying, staking and lending and borrowing will not be limited to coins, but will increasingly encompass land, goods and services in the digital economy.
Axie Infinity emerged this year as a popular app combining gaming with defi, expect more Dapps in this area in 2022
Risks
Scalability and security: One of the problems associated with the rapid growth in DeFi is the increasing transaction costs, leading to rising Ethereum gas fees, the price paid to execute a transaction on the blockchain, making it ineffective for smaller transactions. The network has also slowed down. To address this issue, many projects in the crypto space are starting to offer cross-chain functionality, which would allow smart contracts to cross from one chain to the next. Two of the main ones are Binance and Avalanche. For Ethereum, Arbitrum and Optimism are two key Layer 2 solutions and Polygon has recently acquired a zero knowledge roll up, MIR for $400mn which should help reduce fees as they reduce on-chain contact. The long awaited upgrade of Ethereum to proof of stake and sharding should improve throughput.
Another potential weakness of this Lego-like system, where apps are stacked on top of each other, is that they are only as strong as the weakest link. Only with time will confidence grow in the infrastructure, if smart contracts and oracles, that report off-chain data on-chain, prove robust and safe from hacking.
Regulation: The SEC and other US financial regulators are increasingly focused on cryptocurrencies and blockchain technology as the space continues to evolve. For example, firms are tokenising shares of companies, and the trading, clearing and settlement are all regulated areas so the authorities will need to consider whether additional oversight is necessary.
Conclusion
We are far from mainstream adoption of Defi but it reached a tipping point in 2020, when to quote one of the founders of Compound “it became visible from the satellite of traditional finance” and can no longer be brushed aside. At this juncture, some clear winners can be identified. Because of the network effect, the incumbents will tend to draw the most talented developers and the most capital. The community nature of many of the protocols, which incentivise token holders to invest in their communities, also creates a positive feedback loop. However, things can change quickly as we have seen in 2021. There is a general land grab and a lot of capital coming into the ecosystem, meaning many projects will ultimately fail so due diligence and diversification is key. As for the incumbents, how nimbly they react and how regulation evolves will determine whether they will ultimately play a big role or be pushed aside. What seems clear, is that even in five years time, the Defi landscape will look very different and the ultimate beneficiary should be the consumer.
