While Bitcoin’s recent impressive rally to a new all-time high has been widely publicized and covers most of the crypto-related media, 2020 was the year where Decentralized Finance (DeFi) emerged and caught the attention of the crypto community.
Beyond this popular “Bitcoin” buzzword, there is growing attention for the burgeoning ecosystem and adjacent blockchain protocols developing in tandem. These new infrastructures are now boosting the momentum for mainstreaming blockchain adoption. A new emerging phenomenon known as DeFi is looking to take both the blockchain industry and traditional finance one step further.
The DeFi market has proven to be thriving. Early 2020, the total value locked (TVL) within DeFi protocols amounted to around $680 million. In just over a year, that amount grew by more than 50x to hit more than $40 billion of value invested in DeFi projects
Designed for the use of cryptocurrencies, DeFi is unique as it allows investors to borrow funds, take loans, deposit money into a savings account, or trade complex financial products among themselves, all without any intermediary. This is possible thanks to the smart contract features of the various decentralized blockchain protocols on which DeFi services are built on.
“Investors face the same conundrum — a desperate desire to deploy accumulated cash and not a lot of attractive traditional ways to invest that cash at the moment. DeFi and the rise of digital assets are offering investors a new opportunity. But this comes with significant risks worth considering”,
said Nassim Olive, Partner at Eterna Capital.
By broadening the scope of use of blockchain, DeFi provides a wide range of services for its users by allowing unlimited, unrestricted and frictionless financial transactions. The total number of DeFi users has grown significantly over the past 12 months and exceeds more than 1.4 million users as of today [2].
In spite of the increasing number of users, DeFi is a complex space and is to some extent a technocracy that belongs to and is understood only by a restricted circle of people. DeFi is an extension of blockchain in the sense that it is no longer just a money transfer mechanism but rather serves as an array of complex financial products. For this reason, many platforms have an interest in focusing on the user experience to make it more accessible to a wider audience.
On the other hand, the DeFi space sits in the heart of FinTech, being a fusion of two chronologically different industries with clearly opposed regulatory environments. Traditional financial institutions are subject to high regulatory scrutiny while Tech is an ever-growing space with a light-touch innovation focused legal framework [3]. It is in this sense that it is worth reflecting on the place of the DeFi space in a macroeconomic perspective in order to know where one sets foot.
What is DeFi?
“DeFi encompasses a variety of decentralized collaborative financial platforms”,
stated Rune Christensen, CEO of MakerDAO.
This new concept aims for the gradual disappearance of financial intermediaries by slowly introducing the transition into “Uberised’’ financial markets. Traditional finance is highly dependent on intermediation — bankers, brokers, clearinghouses and the likes. Whether it is only for trading assets, the transaction has to go through a whole mechanical labyrinth involving a number of different players before being allowed and settled in the market.
Middleman-free DeFi, through its 'permissionless' and open-source structure, offers direct and automated processes between its participants for trades and loans. This in turn massively facilitates individual wealth management regardless of the investment level. In that sense, it becomes clear that DeFi prevents leakage of cash by sparing a good share of transaction-related fees (up to 30%) to the buyers or sellers involved in such transactions.
With low to negative interest rates, the typical investor finds it difficult to fructify its money through a savings account. He or she is left with no choice but to look for other sources of return as the lending and borrowing potential of traditional banks appears less attractive to savers. Through market-driven algorithms, open-source networks such as Decentralized Exchanges (DEX) can nowadays mimic conventional banking financial services by selecting the most appropriate interest rates for the savers, offering them as high as 8–10% yield on certain assets [4].
However, as traditional economic theory would suggest, it is noteworthy that highly attractive interest rates come with significant risks. We will cover some of these risks later on. Not only is DeFi decentralized by nature, but it is also 'permissionless'. In other words, anyone can use it, which makes it all the more attractive to a wide range of people. Say you are living in a country whose sovereign fiat currency has a fast-increasing rate of inflation. Instead of saving in that local currency and effectively seeing your capital shrink over time, you could convert your money into a U.S. dollar-backed stablecoin and get an additional yield on top of that.
By widening its access to the unbanked communities estimated to number nearly 1.7 billion people [5], DeFi has the potential to extend the banking capabilities of traditional finance to new categories of savers and SMEs. DeFi proposes, among other things, micro lending/borrowing and flash loans, both of which are fairly widespread in many developed countries thereby relieving considerable financial pressure on these populations.
How is DeFi possible?
One technological advancement that facilitated the creation of DeFi is tokenization. Tokens are essentially cryptocurrencies or crypto-assets that run on a blockchain such as Ethereum. Tokens can be created and customized with properties that make them similar to certain financial products and services. The most commonly used example is stablecoin, i.e. tokens whose value is stable (i.e. not volatile) and pegged to the value of a real-world asset, such as a fiat currency (e.g. USDC and DAI track the US dollar).
An increasing number of assets and financial products have been tokenized on Ethereum. However, Bitcoin represents the most valuable and highly liquid cryptocurrency asset — making it a very attractive asset for DeFi projects. We are seeing an increasing number of actual bitcoins being locked in as collateral in DeFi platforms and the production of Ethereum-based tokens which track the value of real bitcoins (e.g. WBTC and tBTC).
Stablecoins and Bitcoin on Ethereum are fairly straightforward to understand; but smart contracts features allow for the creation of far more complex products. With the development of new complex products on platforms such as Uniswap — a decentralized cryptocurrency exchange — and FTX — a cryptocurrency derivatives exchange — we see infinite possibilities to access and get exposure to a wide range of new financial products. A few examples:
On Uniswap, one can purchase sETH — a token that tracks the value of shorting an ETH (Ethereum token). The process of shorting an ETH would require a series of steps which can be quite cumbersome. sETH token abstracts all these steps into a token that can be purchased and held within a cryptocurrency wallet. Its value goes up if the value of ETH goes down and goes down if the value of ETH goes up, making it very simple and accessible for any investor to short ETH.
On FTX, one can purchase a token that tracks Bitcoin volatility, or even purchase a token that gives you exposure to Coinbase pre-IPO contracts.
The growth of the DeFi ecosystem has been triggered by the emergence of new infrastructure players:
Decentralized exchanges (DEXs) like Uniswap, 1inch, Sushiswap and 0x. Volumes on DEXs have exploded with the DeFi hype witnessed at the end of last summer to reach close to 20% of all centralized exchanges volumes before settling below 8% which yet represents a very large increase compared to where it stood a few months earlier.
Risks associated with DeFi
Attracting a considerable level of traffic with exponential growth of DeFi-related products and services, it is fair to say that the DeFi sector has proven to be a fruitful venture. While it features a plethora of advantages compared to conventional financial products, e.g. transactional transparency, high-level accessibility and an Eldorado of opportunities, it is worth stressing that the DeFi space is an open-air construction site where everything is yet to be built. To this extent, needless to say that we are not immune to the inherent hazards that come with a sector in the process of expansion.
While we acknowledge that the below does not provide exhaustive coverage of all risks associated with DeFi, we would like to focus on two risks whose features are fairly intrinsic to the space [6]: smart contract risks and liquidity risks.
One important vulnerability associated with DeFi projects is the danger of smart contracts protocol’s exploitation. With their open-source and publicly accessible functionalities, smart contracts are both DeFi’s greatest achievement and its most serious weakness.
As the code underlying smart contracts is an artefact and given human bounded rationality, the written code may very well exhibit errors, thus providing leeway for hackers. This is further compounded by the irreversibility of blockchain transactions. Once the program has been locked into the protocol, the scope for amending it is limited. This results in frequent bugs which can compromise the robustness of the platforms. All these elements are likely to result in loopholes that can be exploited by fraudsters for rogue purposes. To give an idea, DeFi exploitation have inflicted a loss of approximately $86 million to the sector in 2020 [7], representing around 0.58% of the estimated $14.7B TVL in DeFi in that same period.
As the DeFi breakthrough is still recent, some have seen it as an opportunity to swindle the market. Multiple scams have been recorded partly originating from oracles, which represent the interface between the blockchain itself and external “off-chain” systems. The real-time data transiting between the two can be fairly easily hijacked by connoisseurs capable of taking control of such information for vested interests. Case in point, a yield-farming DeFi Protocol known as Value DeFi has suffered a $6 million loss after someone exploited a vulnerability within its price oracle [8]. It is subsequently crucial for any investor to ensure that the smart contract-enabled protocols in which he or she channels his or her funds undergo sporadic independent audits in order to alert to any potential exploits.
The very purpose of a DeFi platform is to provide liquidity — a crucial factor for the smooth running of its transactions. The quality of this liquidity can be assessed as a function of its liquidity providers. Liquidity is all the more important as its set of liquidity providers is diversified and exhibits uncorrelated behavior.
In the event of a liquidity shortage, a well-diversified pool of liquidity contributors is meant to cushion against this short-term risk. For example, a time of crisis can catalyze the risk of a surge in withdrawals which can trigger platform congestion. Therefore, an absence of behavioral correlation is expected to limit the possibility of collective drawings to prevent such unfavorable traffic. When DeFi platforms encounter considerable congestion, the latter disturbs the maintenance of consistent prices across all different exchanges, which therefore engenders uncertainty and market pullback.
The volatile nature of cryptocurrencies is a common risk associated with any crypto-related products, while not DeFi specific, it remains a barrier to many users. Additional risks appear in any financial products and DeFi is not immune to it — lending, borrowing and saving expose investors to governance and counterparty risks.
To give an example, yield-farming relies on secured loans wherein the collateral is a crypto-asset. Given crypto assets are subject to relatively high volatility, odds are that the value of your collateral may no longer suffice to match the loan worth. In that case, your holding is at risk of forced liquidation.
Few Facts and Stats around DeFi
The DeFi market has proven to be thriving. Early 2020, total value locked (TVL) into the DeFi market amounted to around $680 million. The present-day TVL has increased by a factor of 50 in just over a year, locking in more than $40 billion invested in DeFi projects on Ethereum.
The DeFi space appears as a new generator of innovative solutions and technology advances thanks to the recent projects that have emerged in the last couple of years.
According to CoinMarketCap, while cryptocurrencies saw a general downward trend early 2020, the performance of DeFi projects have outpaced the crypto market, generating for their investors up to a 30-fold increase in Return on Investment (ROI) [9] since January 2020, and 7-fold since the beginning of June.
According to Dune Analytics, the number of DeFi users rose sharply by 40% in October 2020 from roughly 555,000 to 775,000, although heavy losses were recorded for certain DeFi tokens.
Closing Thoughts
By leveraging the internet, DeFi solutions represent fascinating conceptual breakthroughs that have proven their ability to offer greater and smoother transactional possibilities for everyone. In fact, DeFi bridges an identified number of shortfalls found in traditional financial operations. Far from just being a speculative instrument, DeFi appears as a complementary element to CeFi.
At the beginning of this new decade, we believe that investing in DeFi is a springboard for improving one’s investment portfolio. Today, we are witnessing considerable and sometimes dizzying increases in earnings while keeping in mind the risks associated with DeFi.
Beyond the recent public hype around crypto-related products, the frenzy surrounding the trading of Gamestop’s shares and the lessons learnt from it have bolstered optimism towards on-chain settlement solutions. Indeed, the Gamestop/Robinhood saga ended with a bitter taste for most Reddit investors. They saw their investment capabilities inhibited by the repercussion of an archaic financial system. These include among others, asynchronism of the markets, clearinghouses’ over-collateralization requirements and the persisting need of custodians as an extra layer of intermediation.
Whilst the very purpose of Robinhood-like platforms was to democratize finance for all, these glaring imbalances have demonstrated that big market players have failed the average investor. This has put blockchain-based solutions such as real-time settlement in the spotlight. By providing intermediary-free settlement in real-time and without interruption, DeFi promises to bridge many of these gaps in the hope of a fairer world with ever-democratized financial access.
References
[1] Source: DeFi Pulse, February 2021
[2] Source: Dune Analytics, January 2021
[3] Source: KPMG: Regulation and Supervision of Fintech , March 2019
[4] Source: Crypto Lending Interest Rates for February 2021, February 2021
[5] Source: The World Bank: The Global Findex Database, 2017
[6] Source: Kraken: Deep Dive on DeFi, February 2021
[7] Source: Crypto-in-Review 2020: The Year of the Bull — Kraken Intelligence 2020
[8] Source: https://decrypt.co/, November 2020
[9] Source: https://CoinMarketCap.com, October 2020
Credit: Eterna Capital https://www.eternacapital.com/