Decentralized Finance – Can DeFi weather the current crypto storm and deliver on its promise?
The coronavirus pandemic has seen an increase in the flow of funds to cryptocurrencies and associated decentralized finance (DeFi) projects. But so far 2022 has been disastrous for this space, with words such as “complete collapse”, “perfect storm”, “crash” and “collapse” now used to describe what is happening. Yet it has already happened.
Bitcoin plummeted 80% in 2018, falling to $3,000 in December 2018, then rallied beautifully to an incredible high of $64,000 and a market cap of $1.27 trillion in December 2021. Since then , the price has dropped to sit at USD 20,000 and a market capitalization of USD 398 billion (at the start of July 2022).
Given its volatile price history, you might think it will rally. Why should it be any different this time?
On the other hand, some commentators see things differently this time – and see the fall as part of a broader pullback in risky assets, spurred by rising interest rates, inflation and economic uncertainty. .
This setback is causing a huge amount of collateral damage, with the implosion of cryptocurrencies and DeFi platforms gaining momentum. The most recent high-profile case was the Celsius platform, which suspended withdrawals and transfers between accounts. From this perspective, you could now conclude that crypto is surely lost and doomed.
In this short article, I provide a recap of DeFi, which has become the most active sector in the blockchain space and where the use cases for cryptocurrencies have, shall we say, begun to emerge. DeFi still has a long way to go to reach maturity, but the progress made so far suggests that the crypto is not dead and has a future – perhaps comparable to the dotcom bubble, which correctly predicted the future but far too soon.
DeFi smart contracts and use cases
The goal of DeFi is to use blockchain technology to develop an alternative to the centralized approach of the traditional financial system where central authorities, institutions and intermediaries, such as banks and brokerages, play the role of trusted intermediary to allow two parties to carry out transactions.
The first generation of blockchain-based cryptocurrencies demonstrated that two parties are able to transact without relying on an intermediary to act as a validating agent. The emergence of the Ethereum blockchain, which is considered the foundation of DeFi, has further demonstrated that validation can be programmed directly into the code of the Ethereum blockchain.
These so-called smart contracts on the Ethereum blockchain have certain characteristics that provide potential advantages and allow smart contracts to function as intermediaries, replacing conventional intermediaries and becoming the source of trust.
Programmability – Contracts are scheduled to run automatically. The terms are written in the code of the smart contract – known as algorithmic governance.
Immutability – the terms cannot be changed or modified once the smart contract has been launched.
Interoperability and composability – different components can easily connect and interact.
Transparency – transactions are published on the public Ethereum blockchain and can be verified by other users.
Without authorization – everyone can, in theory, access DeFi applications.
self-guard – users retain custody of their assets and control their personal data.
There are many use cases in DeFi. Some are still quite ambitious – but others are perhaps more concrete and include:
Staking – the process of pledging crypto assets to support a blockchain network and then acting as a validator to verify the transaction for which the user receives interest and other rewards – part of the next generation of ‘Ethereum 2.0 based on proof-of-stake rather than proof-of-work model.
Peer-to-peer (P2P) savings and lending – earn interest on crypto savings accounts – or crypto pledged in a lending pool.
Trade – The DeFi trading space is very broad and encompasses derivatives trading, margin trading, and token swaps.
Marketplaces – NFT and DeFi protocols support an array of online marketplaces that allow users to trade products and services globally and P2P – everything from freelance coding gigs to digital collectibles and real-world jewelry and clothing.
There are now countless DeFi use cases, platforms, exchanges and initiatives:
New conceptual entities have emerged, including Decentralized Autonomous Organizations (DAOs). These cooperate according to transparent rules encoded on the Ethereum blockchain, eliminating the need for a centralized administrative entity.
Stablecoins – a cryptocurrency tied to fiat, gold, or other more stable cryptocurrencies – remittance payments, lending and borrowing platforms, and even institutional use cases like currencies digital central banks (CBDC).
With billions of dollars of value locked away in Ethereum smart contracts, decentralized finance has become the hottest sector in the blockchain space.
DeFi challenges and emergence of DeFi 2.0
All blockchain projects face a similar set of problems, called the “blockchain trilemma,” which was coined by Vitalik Buterin, co-founder of the Ethereum blockchain. The trilemma posits that blockchain developers are forced to make tradeoffs between decentralization, scalability, and security – and are unable to deliver all three at the same level, at the same time.
Specifically, DeFi projects face other liquidity dilemmas. Providing liquidity to a pool requires a user to commit their funds to a given liquidity pool. This so-called “locking in” of funds is a necessarily rigid structure, but it conflicts with the natural behavior of investors jumping between pools of cash to seek better returns. In an attempt to retain the provider, pools will offer rewards in the form of a native token.
However, short-term farm and dump behaviors are common, leading to an inevitable and capitulated sell-off of the native DeFi token, causing huge market disruptions and inefficiencies. A DeFi 2.0 movement is trying to solve these problems by developing sustainable methods that guarantee long-term liquidity. The main one is to help users gain efficiency.
At a conceptual level, the idea of programmable smart contracts with blockchain-enabled immutability and transparency remains compelling. But efforts to convert theory into practice have not been without problems. As in traditional capital markets, the behavior of market players remains irrational for a long time.
But overall, the progress to date suggests DeFi and crypto have a future. It will continue to be a bumpy road and could be much longer than originally anticipated. There is a temptation to dismiss space and consign crypto to the history books of bubbles and fads – but that would be a mistake.
About Martin Koderisch
Martin Koderisch is a principal at Edgar, Dunn & Company. He advises stakeholders in the payments ecosystem with a particular focus on recurring payments and helps e-commerce and subscription companies transform their digital payments capabilities to drive recurring revenue growth. Prior to joining EDC in 2015, he had over 10 years of experience in the payments industry.
About Edgar, Dunn & Company
Edgar, Dunn & Company (EDC) is an independent international payments consultancy. The firm is widely regarded as a trusted advisor, providing a full range of strategy advisory services, expertise and market intelligence. EDC’s expertise includes M&A due diligence, legal and regulatory support across the payments ecosystem, fintech, mobile payments, retail and corporate payments digitization and financial services.