Reading Time: 8 minutes
July 21, 2021

Opinions

A Dive into Decentralised Finance (DeFi)

This article explores the current Decentralised Finance (DeFi) landscape, as well as the existing opportunities and risks. DeFi refers to an alternative, distributed ledger based, financial infrastructure. Most DeFi infrastructure is built on Ethereum, though increasing competition from alternative platforms, such as Cardano, Tron and Binance Smart Chain, means the home of DeFi is still up for grabs.

Introduction

DeFi is a distributed ledger based financial infrastructure, aiming to disrupt the current system of financial intermediaries through decentralised networks and protocols. In general, the term refers to open, permissionless, and highly interoperable protocols built on public smart contract platforms such as Ethereum. The decentralised nature of DeFi comes from the fact that projects disintermediate centralised institutions through Decentralised Applications (DApps), in contrast to traditional financial intermediaries.

 

Being built on public distributed ledger platforms means that transactions are secured and verified by a network of nodes. An immutable and highly interconnected financial infrastructure is built with an arguably unprecedented level of transparency. In addition, being permissionless and decentralised, there is little need for central authorities such as traditional clearing houses.

 

DeFi already offers a wide variety of applications. Perhaps the most interesting, yet controversial, for financial stability and monetary policy are stablecoins. Stablecoins are cryptoassets designed have low price volatility to make them more useful as a means of payment, by linking them to a stable asset or basket of assets. They are usually pegged to fiat currencies such as the US dollar (USD).

 

The most widely used one is Tether (USDT), the first dollar-pegged stablecoin. Launched in 2014 and originally built on top of the Bitcoin blockchain, USDT now underpins most crypto trading around the world. From the perspective of a cryptoasset investor, the key purpose of USDT is for conversion and trading with other cryptoassets on exchanges that do not accept traditional fiat currencies. In this respect, the main reason for investors to hold USDT, aside from potentially storing value, is transacting in the future with other cryptoassets.[1]

Despite still being a niche market with relatively low volume – compared to traditional asset classes such as equity, fixed income, and commodities – the Total Value Locked (TVL) in DeFi protocols has been growing exponentially over the past year. Figure 1 provides a historical

[1] Similar to Eurodollars, USDT is a dollar-like liability which is issued by a non-US entity called Tether Limited and claimed to be backed by real dollar assets on a 1:1 parity basis.

 

perspective on the value of funds that have been locked in DeFi smart contracts since the beginning of 2020.

Figure 1: Total Value Locked in DeFi Smart Contracts (USD and ETH)

Source: Aaro Capital Research

 

Notes: The left panel shows the total value locked in DeFi projects in billions of USD. The right panel shows the total value locked in DeFi in ETH. The sample starts in January 2020 and ends in June 2021. The original data is from DeFi Pulse.

The left panel shows that the aggregate value of USD locked in DeFi projects has exploded from a few thousand dollars in January 2020 to roughly $50bn at the time of writing. Similarly, the amount of ETH locked has grown from 5m in January 2020 to 24m.

 

It is worth noting that this is not money which is spent in transactions or representing market capitalisation. The values refer to the reserves (in USD or ETH) which are locked in smart contracts for use in various ways explained later.


The exponential growth of DeFi protocols along with the truly innovative nature of some of these platforms suggests that, despite the recent market correction in May 2021, DeFi still has the potential to become a major phenomenon in cryptoasset markets over the coming years. In part, this has been already reflected in the increasing focus of policymakers, academics, and financial institutions in this area.

A Breakdown of the DeFi Industry

DeFi uses a multi-layer, or stack, structure whereby each software layer has a distinct purpose and layers are highly interoperable. In this respect, different DeFi protocols often build on each other and create at the aggregate level a highly composable infrastructure. The first layer consists of the distributed ledger and its native protocol asset, e.g. ETH on the Ethereum blockchain. This ‘’settlement layer’’ can be seen as the building block of DeFi and represents the foundation for trustless execution and settlement. For example, more than 85% of DeFi projects are currently built on the Ethereum blockchain while the residual 15% is built on platforms like TRON and Binance Smart Chain. This shows the importance of Ethereum in the DeFi ecosystem. On top of the blockchain layer, DeFi protocols typically issue their own assets in the form of tokens which are traded on cryptoasset exchanges.


Each DeFi project has its own use and purpose within the larger DeFi infrastructure stack. The implementation of the projects is typically in the form of smart contracts which provide the standards for specific use cases, such as decentralised exchanges, debt markets, derivatives, and on-chain asset management. Figure 2 shows a breakdown of the use cases for major DeFi projects at the time of writing.

Figure 2: A Breakdown of Use Cases in DeFi

Source: Aaro Capital Research

 

Notes: The left panel clusters DeFi applications based on their use case, whereas the right panel shows the total locked value for each use case in $bn. The sample starts in January 2020 and ends in June 2021. The original data is from DeFi Pulse.

Except for payment platforms, the number of projects per use case is relatively evenly split within the DeFi space. However, most of the total value locked is in lending and decentralised exchanges, which we discuss below.

 

Loans are indeed a central part of the DeFi ecosystem. Decentralised lending platforms are unique in that they do not require the borrower or lender to be identified. Anyone can potentially access a lending platform and borrow money or provide liquidity / lend to earn interest. Different platforms have different levels of liquidity and therefore different borrowing and lending rates. For example, someone may use BTC as collateral for a USDT loan, allowing people to spend some of their wealth while still having access to the price appreciation of BTC.

 

The lender is protected by two distinct layers of security: credit is provided under the condition that the loan must be repaid automatically, meaning the borrower takes the funds, uses them and repays the loan all within the same transaction registered on the blockchain. If there is no repayment, the transaction is invalid. Second, loans are typically fully or over collateralized and only released when the loan is repaid.

 

Decentralised exchange (DEX) protocols attract the second largest pool of funds in the DeFi space. In most cases, crypto is traded on centralised exchanges, such as Binance, Coinbase, Poloniex, etc. However, once funds are deposited, direct control is lost of the assets. This implies that a certain level of trust is required in exchange operators. The lack of regulatory scrutiny and the operational fragility of some of these presents a strong case for DEXs.

 

In a nutshell, decentralised exchanges remove counterparty and custodial risk and the trust required to overcome this. Users no longer need to deposit assets, and trade executions happen automatically through smart contracts, meaning that both sides of the trade are performed in a single, indivisible, transaction. The purpose of a DEX is therefore to facilitate swap contracts, rather than functioning as a market clearing / market making institution.

 

Some DEXs are also able to list and provide liquid markets for new cryptoassets faster than centralised exchanges, due to their unique incentive structures. This gives them a clear competitive advantage in certain segments of the cryptoasset market.

 

Within different use cases, the DeFi industry is far from homogeneous. The total locked value changes quite substantially across different platforms. Figure 3 provides a snapshot of collateral and reserves across the top 50 projects by funds locked.

Figure 3: DeFi projects by Total Value Locked

Source: Aaro Capital Research

 

Notes: The figure shows the total value locked (in $mn) in the top 50 DeFi projects by funds locked. The sample starts in January 2020 and ends in June 2021. The original data is from DeFi Pulse.

 

There is a significant concentration of funds towards top decentralised lending platforms, such as Aave, Curve, Maker and Compound. However, some of the top decentralised exchanges, such as UniSwap and SushiSwap, have also attract considerable funds.

 

As a whole, Figures 2 and 3 tell a story of substantial heterogeneity across and within use cases. Coupled with the exponential growth of Figure 1, this is an sign of dynamic development within the DeFi space.

Opportunities

The incredible growth of DeFi over the last 18 months stems from a variety of opportunities that the new projects represent for financial transactions and infrastructure. At its core, DeFi may increase the efficiency, transparency and accessibility of financial services. Moreover the building block structure of DeFi, where different DeFi “blocks” interconnect with each other, allows for greater competition between service providers for the benefit of consumers, given the low barriers to entry.

 

Transparency and efficiency are highly interlinked. While much of the traditional financial system is based on trusting third parties, DeFi replaces this with smart contracts. As transactions take place without trusted third parties and are based on smart contracts, all are effectively publicly observable since the code is verifiable by anyone running a node. This observability and deterministic execution allow, at least in theory, an unprecedented level of transparency. Data is publicly available and may be used by researchers and policy makers to prevent systemic failures. This is fundamentally different from standard data sources which are often not available outside the realm of academia and central banks / policy institutions.

 

After efficiency and transparency, accessibility comes as another key value proposition of DeFi. By construction, DeFi protocols can be used by anyone. That is, almost by design DeFi creates an open and accessible financial system. In particular, the infrastructure requirements are relatively low, and the risk of discrimination is almost non-existent due to the pseudonymous nature of DeFi.

Risks

The opportunities that DeFi present do not come without their risks. Among others, operational security, scalability, and regulatory risks are areas of concern.

 

Strictly speaking, operational security covers cyber security and the lack of attention by users. Note here, users here may not necessarily be professional or accredited investors given the open access. Security vulnerabilities in the code are particularly concerning, especially given the break-neck speed of development, lack of regulation and the fact that blockchain-based transactions are irreversible in most senses of the term.

 

The issue of illicit activity and regulation is a particularly delicate one. On the one hand, pseudonymity can be abused by actors with dishonest intentions. On the other hand, privacy may be a desirable attribute for some legitimate financial applications. As a result, regulators should act with care to find reasonable solutions to balance consumer protection with innovation.

 

The exponential growth of DeFi (see Figure 1) create a scalability issue for the industry. Distributed ledgers face a fundamental trade-off between decentralisation, security and scalability. While the Ethereum blockchain is generally regarded as relatively decentralised and secure, it struggles to keep up with the great demand for transactions. Transaction fees and transaction confirmation times are positively correlated with the growth of the DeFi ecosystem. That is, the larger the DeFi space, the more expensive and slower the transactions are.

 

Potential solutions to this include Layer 2 aggregation and netting platforms, similar to those used in traditional finance. On the other hand, moving to a more centralised system does not seem to be a reasonable approach either, as it would essentially undermine the main value proposition of DeFi and cryptoassets more generally. Scalability is therefore perhaps the biggest challenge the DeFi ecosystem will face on its growth path towards widespread adoption.

Conclusion

Decentralised Finance (DeFi) offers many new opportunities and has the potential to create an open, transparent, and inclusive financial system. In anything, DeFi has unleashed a wave of innovation not been seen since the mass adoption of World Wide Web. While the ecosystem has great potential, it does not come without its risks. Regulation, security and scalability are three key challenges that market participants, developers, and regulators at large will face over the next months and years.

Share the love ❤️
Share on facebook
Facebook
Share on twitter
Twitter
Share on linkedin
LinkedIn

All of the content published on this site is strictly for informational and educational purposes and neither does it constitute investment advice nor solicitation to buy or sell blockchain-based tokens or securities. No investments whatsoever should, therefore, be made based upon information provided or discussed by any guests or hosts appearing within this video or audio content.

Any appearance by any company or individual does not infer any kind of endorsement by Scrumline Ltd (trading as Coinscrum) of either their products and/or services or in any related investment opportunity that they may be pursuing from time to time.

Crypto-tokens and equity investments are high risk in nature and you should always take the advice of a professional financial advisor from within the jurisdiction in which you reside before making any investment decisions.

cortex-logo.jpg
Dynamic Crypto Data, Essential Analysis
7 Day Giveaway: Unlimited Streaming Crypto Data for 12 Months