The DeFi industry was the talk of 2020 and is predicted to continue its strong upward trajectory in 2021. The recent gains in well-known cryptocurrencies, and support from trusted public figures such as Elon Musk means that the crypto world is gaining more legitimacy by the day. Despite continued derision from some established finance gurus, blockchain and crypto’s strengthening reputation is having a flow on effect to DeFi. Investors will soon be less sceptical about this burgeoning sphere.
In this post we are going to examine why decentralized finance has become so popular, which DeFi platforms are thriving at the moment, the benefits and risks to investors, and finally, the DeFi trends that are predicted to shape 2021. We have a lot to cover, so let’s dive into it!
A DeFi recap
For those that are new to the topic or need a refresher, DeFi, or Decentralized Finance, is a set of services built on a particular blockchain. The aim is to decentralize traditional financial services, providing an alternative to conventional institutions such as banks and credit providers. The current DeFi household names have built their products to run smart contracts on the Ethereum blockchain, executing all manner of financial operations. Exchanges and lending operations are the most common, but there are also asset, payment and derivative trading options helping to expand the DeFi landscape.
Why do people want a decentralized alternative?
One of the central questions we need to consider when talking about decentralized finance is: what is wrong with traditional, centralized financial services?
If we are talking about bricks-and-mortar banks, it is common knowledge that they are operating with old systems that are slow and vulnerable to attack. While security has always been a priority, data breaches do occur. In 2020, we saw Fifth Third Bank, an American institution spanning 10 states, subject to a hack that revealed among other things, customers’ Social Security numbers, addresses and account numbers. While this was high profile, small scale breaches are constantly occurring. As far as more modern, centralized platforms are concerned, limited lending and staking opportunities are offered, as well as being subject to region blocking, fragmented liquidity and limited financial instruments.
Another point that must be taken into account is the fact that trust in centralized financial institutions is low. Banks’ reputations have continued to suffer as information about malpractice and misconduct continues to come to light. While payday lenders and credit services were always viewed with a mixture of contempt and suspicion, the previously respected big banks and their services have been revealed to be just as predatory, starting with the 2008 banking crisis, which highlighted the lack of accountability in the sector. With recent reports of UK and US banks housing illegal money, to Australian banks charging fees to customers that had passed away, it is clear that people have had enough and want an alternative.
We’ve seen a bright example of anti-establishment sentiment recently in the exploding popularity of wallstreetbets, as trust in institutions is low and people want greater control over their investments, while removing some of the barriers that usually prohibit entry. For bigger players that don’t normally encounter these barriers, they may anyhow want to diversify their portfolio, taking on something that is potentially riskier, but brings exciting returns and gives them a feeling of taking part in something revolutionary.
Benefits of DeFi
Even when there is appetite for an alternative, people aren’t going to reject traditional, centralized financial services unless there is a credible offer on the table. The fledgling world of decentralized finance is still working out some of the kinks, but offers the following general benefits:
- No barrier to entry (theoretically: see risks section below) – No matter who you are, no matter what your credit score, you can participate. No large entry thresholds and a level playing field are big drawcards.
- Transparent source code – DeFi markets are peer-to-peer and publicly available, with all transactions transparently shown in the blockchain.
- No third-parties – You don’t need to rely on third-parties, simply the unbiased code that executes whatever smart contract was set up to facilitate your financial operations.
Thriving DeFi projects
The DeFi market went from something basically non-existent to a large player in the blockchain world, all within the space of a year. Throughout 2020, the TVL (Total Value Locked) rose from $US 671 million on January 1, to $US 13.95 billion at the end of the year. As of February 2021, that number has more than doubled, reaching 32.16 billion at the time of writing.
What helped initially boost such frenzied investment, but also caused more cautious investors to stay away, was the hype around liquidity mining and yield farming. This generally involves generating income by locking up crypto assets in a smart contract based liquidity pool. Users who engage in this practice are rewarded with a greater share of crypto and/or governance tokens, which gives them a say in the future of the project and can be exchanged on DEXes. The promise surrounding Ethereum 2.0, along with decentralized price oracles also helped the sector expand.
According to the website DeFi Pulse the top three DeFi projects are lending platforms (Maker, Aave and Compound) with DEXes (Decentralized Exchanges – Uniswap, Curve Finance and SushiSwap) close behind. We’ll take a look at Maker, Uniswap and Compound to give you a good idea of what they do, and why their benefits are fuelling investment.
The Maker lending platform is a DAO (Decentralized Autonomous Organization), meaning that it is run by, and for the collective. The central tenet of DeFi lending involves putting up a loan and getting a USD pegged stablecoin in return. Maker is no different. Users lock up Ethereum tokens and get a loan in Dai, Maker’s stablecoin.
The central appeal is that loans through this system have lower interest rates, as opposed to the 20-30% you might get when going to banks. Those with a low credit score or who want to borrow anonymously, can finally get a loan with agreeable terms, and as mentioned above, people with funds who provide liquidity are rewarded with governance tokens.
Like other major DeFi projects, Uniswap is built on the Ethereum blockchain. It facilitates the swapping of ERC-20 tokens without having to link buyers and sellers, or needing to rely on enough liquidity in the system, a common problem for decentralized exchanges. It does this through a pool of tokens, ETH, and an equation that aims to balance value depending on demand. Once again, those that help provide liquidity are rewarded with a proportion of fees that are paid when swaps are made.
Following in the footsteps of Maker DAO, Compound is a lending protocol that also utilizes governance tokens. For the use of its financial services, it accepts most of the major cryptocurrencies in the DeFi space and, like Maker, interest paid by lenders fluctuates based on the amount of liquidity in the system. Compound is credited with helping fuel the DeFi boom, due to the fact that in June 2020, it started to issue its COMP token to borrowers as well as lenders. As the token skyrocketed in value, people were able to make money even when borrowing money through the protocol.
What are the risks and downsides?
So far so good, right? Well, not exactly. The greater the financial opportunity, the greater the risk. People have made a lot of money through DeFi, but entering this world is not for the faint of heart.
Volatility – A recurrent feature in the world of blockchain technology and cryptocurrencies, volatility is a risk that needs to be taken into account as rates can change without warning.
While interest rates on Maker’s lending protocol at the start of 2020 were very low, in times where there has been low liquidity, rates have substantially increased, with nothing borrowers can do about it.
What’s more, as the financial markets took a dive in the wake of Covid-19, crypto was not immune, with Dai’s stablecoin dropping below parity with the USD. While governance measures were taken in the aftermath of this event to ensure greater stability, operating with decentralized protocols that are completely outside of government control is inherently risky.
Speculation – While this ties into volatility, we believe speculation deserves its own special category. Compound, currently the third largest De-Fi platform, received lots of attention last year for giving out governance tokens to borrowers, as well as lenders. A shortage of these tokens drove the price up so high that at one point borrowers were making money through taking out loans, leading to massive speculation in the DeFi sphere, not seen since the ICO boom of 2017-2018. Of course, with meteoric rises, there are subsequent drops that can occur seemingly instantly.
High fees – One of the promises of DeFi is the fact that anyone can invest. In principle this is correct, but it doesn’t count for the realities of Ethereum, a blockchain that is showing strain under the increasing number of apps that are built on it. Ethereum 2.0 is expected to solve some of these problems, but in the meantime, slow confirmation times and large fees mean that often larger amounts of money need to be invested in order to get a substantial return.
Security – Not relying on human intervention or centralized systems is one of the big DeFi drawcards, but this comes with its own security risks. Essentially, you are entrusting your funds to smart contracts executed by a computer. Vulnerabilities in these contracts can result in hacks, as was seen with MakerDAO last year. It was tricked into giving away 4.5 million DAI, pretty much for free.
2021 DeFi trends
Despite the risks, there is obviously enough incentive for investors of all stripes to continue piling in. 2021 DeFi trends involve nurturing the development of the market in general and encouraging profits, while providing more stability for those that are still hesitant to invest, due to the risks outlined above.
Omni-chain DeFi – We talked above about the problem with the Ethereum blockchain supporting so many complex applications. Some projects are branching out, building their applications on other blockchains that can connect to Ethereum, but there is still a problem in that these other blockchains cannot connect to each other. Enter omni-chain, offered by projects such as Polkadot, which makes different blockchains interoperable, meaning quicker transactions and lower fees for users.
Greater safety through umbrella tokens – In addressing the issue of having no recourse in the event of flash crashes or data breaches, protocols such as UNION are offering umbrella tokens, similar to insurance policies that give a measure of security to the investor. With different benefit structures, UNION can offer a level of protection in the event of collateral optimization issues, fluctuations in transaction fees and the failure of smart contracts.
Liquidity for staked ETH – As the first part (Phase 0) of Ethereum 2.0 went live, over USD$3 billion was staked in order to help the network stabilize and grow. DeFi solutions have quickly cropped up, with companies like LiquidStake and Lido offering ways to get mobility out of the staked cryptocurrency.
Central Bank Digital Currencies (CBDCs) on blockchain – There is talk of CBDCs being built onto the Ethereum blockchain. This is incredibly exciting as it brings the reputation of centrally controlled money into the world of blockchain. This is huge for developing trust among the wider community.
DEX dominance – A 2020 crypto review released by Kraken Intelligence points to sustained DeFi growth in 2021, specifically that of decentralized exchanges, which it expects to soon tower over lending protocols.
As we can see, in the scheme of things, the DeFi space is just getting going. Despite the risks and fluctuations, solid solutions are being put in place to improve efficiency, interoperability and usability. Investors are recognizing this, with huge gains month on month pointing to a strong 2021. If you are looking to develop something within this growing space, contact INC4. The team has serious form in delivering secure and reliable DeFi products, both on time and with great communication throughout. Get in touch with INC4 now!