DeFi: The Next Frontier in Consumer Banking Infrastructure
From the issuance of bitcoin’s genesis block on the 3rd of January 2009, the financial world, whether it knew it at the time or not, was in the midst of being turned on its head. Embedded in the block, an article, “Chancellor on Brink of Second Bailout for Banks”, Nakamoto more than vaguely hints, that the time for a new financial system is upon us. Despite this being the genesis of a decentralised asset, it hints at the larger vision of a decentralised global financial system that will disrupt legacy finance. 12 years on and most cryptocurrencies are still traded primarily on centralised infrastructure (such as Coinbase and Binance) and are still heavily reliant on traditional banking architecture. Decentralised Finance is the next frontier of financial services that aims to decentralise banking infrastructure and disrupt the legacy banking system along the way.
What is Decentralised Finance?
Decentralised Finance (DeFi) is a catch-all term for the industry sector, within the cryptocurrency ecosystem, that is building peer-to-peer and non-custodial financial services infrastructure on public blockchains. DeFi protocols are built using smart contracts (self-executing code) that are programmed to execute the functions of traditional financial services. This represents a new paradigm in financial infrastructure in which startups are building infrastructure for financial services — representing bottom-up innovation that is disrupting the legacy financial system. In layman’s terms, DeFi represents the provision of permissionless financial services that are not reliant on third party intermediaries, and instead are reliant on software applications that execute the same functions as traditional finance such as borrowing and lending, saving, investing, asset exchange, payments, derivatives, and synthetic assets. With DeFi, closed financial systems can be transformed into an open, global financial economy based on open-source blockchain protocols that are accessible to anyone, anywhere at any time.
Liquidity Pools: The Backbone of DeFi
One of the key innovations to come out of the DeFi phenomenon is the advent of liquidity pools. DeFi applications are composed of smart contracts that form liquidity pools (pools of liquid capital). These liquidity pools are the mechanisms that allow DeFi applications to offer their services. In the case of a decentralised exchange (DeX), a user of the exchange can trade with the pool of capital. In the case of a borrowing/lending protocol, the user can borrow funds from the liquidity pool or lend to the liquidity pool. Inherently, these liquidity pools rely on liquidity providers (which can be anyone), who issue tokens to the pool, and in return for this liquidity provision earn a fee. This process of providing liquidity is known as ‘yield farming’ (or liquidity mining). Yield farming has been one of the key drivers of growth in DeFi as it creates a new way of generating returns. Liquidity pools allow for idle capital to be put to work — generating yield opportunities that far outweigh the returns generated through traditional banking savings accounts. Returns from yield farming liquidity pools can vary greatly dependent on key factors such as type of asset being provided to the pool, length of time the asset is used by the liquidity pool and the DeFi protocol in which the liquidity is provided on. Note: Typically, APY (annual percentage yield) is measured for the period of time in which the assets are locked up for (i.e one month), after which the APY for the specific liquidity pool may change.
Approximation of Yield Farming rates (Coingecko Rankings)
DeFi Creates a Fundamentally New Financial System
The opportunity that DeFi presents is to replace back-end banking infrastructure, creating benefits such as:
Overview of Types of DeFi Applications
Market Size & Opportunity
The primary opportunity that DeFi presents is to replace back-end banking infrastructure for consumer banking and fintech: Market size for retail banking ~USD 2,254b in 2019 developing at a 5-year CAGR of -1% — 2.8% (subject to effects of COVID-19). Market size for global Fintech sector ~USD 150b in 2020 growing at a 5-year CAGR of 11.7%.
DeFi Traction to date
The meteoric rise of DeFi in 2020 allowed the fast-growing industry sector to establish early stages of product-market fit. This is evident from a venture capital perspective as VC investment in cryptocurrency and blockchain startups hit a record $3 billion in Q1 2021 across 239 deals.
DeFi Total Value Locked (TVL): One of the primary metrics for measuring DeFi’s growth is the total value locked in liquidity pools of DeFi applications. TVL reached its peak in May of ~USD 86b, however currently TVL is ~USD 60b. This is an exponential increase from the beginning of 2020 in which TVL broke the 1b milestone. Over the last year TVL in DeFi has experienced a 39x increase in value.
Market Capitalisation of DeFi: Similarly, DeFi’s market capitalisation reached a peak of ~USD 140b in May and has stabilised to current value of ~USD 82b. Nevertheless, DeFi’s market capitalisation has experienced a 15x increase over the last year.
Number of Users (Unique Wallet Addresses): Globally there are currently 2.8m unique wallet addresses interacting with DeFi applications. This is an ~ 12x increase from the 215,000 active DeFi users just a year ago. Note: some users have multiple addresses the DeFi numbers are overestimates.
Key Drivers for Mainstream Adoption of DeFi
Q4 2020 to Q1 2021 represents the period in which the crypto market ‘crossed the chasm’ and entered the early stages of mainstream adoption. This has largely been driven by institutional adoption of Bitcoin and Ethereum, whereas DeFi is a sector at a much earlier stage of adoption. Nevertheless, the developments of yield farming and liquidity mining in 2020 through the proliferation of governance tokens has progressed DeFi from ‘innovators’ stage to ‘early adopters’ stage of development. Thus, the question arises — What are the key drivers that could take DeFi mainstream? Two key drivers for DeFi to go mainstream are 1) improving user experience and 2) bringing real-world assets on-chain.
User Experience
One of the key challenges for mainstream retail adoption of DeFi is user experience. Quite simply, novel DeFi applications currently require an understanding of how crypto-assets, liquidity pools and cryptocurrency wallets function. This is not a simple task for the average consumer. Additionally, it is crucial to understand the new risks that arise as a result of these novel systems, such as rug-pulls, impermanent loss and the challenge of understanding the cost of using DeFi applications in terms of gas fees paid to the network. The next frontier of user experience in DeFi applications will be software infrastructure that functions as an additional technical layer, serving as the front-end for what will allow a DeFi back-end to thrive. Enter the DeFi mullet. Fintech in the front, DeFi in the back. These will be companies tackling the heart of the user experience issue in crypto. These companies will aim to simplify user experience whilst leveraging the composable and interoperable nature of DeFi applications to provide access to a suite of DeFi applications in the back-end. We can look to internet applications for examples of this. Nearly every internet-based company utilises technologies such as HTML, TCP/IP, MySQL, however the average internet consumer does not need to understand this back-end infrastructure to utilise the internet-based applications. This is largely due to the development of front-end applications that mask back-end technology whilst providing a value-driven service to the end consumer. We can already see the beginnings of the DeFi-Fintech convergence through leading fintech players who have made quick developments to seize the opportunity of crypto. There is a varying degree of adoption from purely providing access to purchasing and trading cryptocurrencies to fintech companies who have begun to adopt crypto/DeFi infrastructure as their back-end:
This trend will continue to occur until we have fintech applications adopting DeFi applications as their back-end infrastructure. For instance, the hypothetical scenario of a neobank that adopts a DeFi back-end — creating the ability for a consumer to build their own customised consumer banking experience with their own personalised financial capabilities, such as borrowing/lending, savings (yield earning) and payments. In theory, the user of the application could choose between various service providers such as Aave or Compound for borrowing/lending, what APY they would like to receive for their savings account and which stablecoin they would like to use for both local and cross-border payments.
Example of Companies:
Bringing Real-world Traditional Financial Assets On-chain
The next major driver of mainstream adoption of DeFi is utilising synthetic assets to bring real-world and traditional financial assets into the world of crypto. Synthetic assets are financial instruments minted on a blockchain that track and provide the returns of another asset without requiring the owner to hold that asset. These are digital representations of traditional financial assets that exist on a blockchain (such as Ethereum) and thus are standardised (in Ethereum’s case to the ERC20 token standard) which allows these assets to interact with smart-contract enabled DeFi applications. This can allow on-chain versions of traditional assets to access the benefits of high-yield opportunities that exist in DeFi. Currently, it is primarily cryptocurrencies that are utilised as collateral in liquidity pools. However, with the advent of synthetic asset exchanges traditional publicly listed equities, indexes and ETFs, debt products, real estate and other secure collateral can be used as collateral in liquidity. This concept of traditional financial products being used as collateral in DeFi liquidity pools has key benefits of providing easy access to additional yield via liquidity pools, enhances interoperability of traditional finance and crypto-finance and provides greater access to secure collateral for liquidity pools. Ultimately, synthetic assets provide retail investors with unprecedented access to yield opportunities that may serve as the catalyst for incentivising mainstream participation in the crypto-economy. It is important to note that this is not an easy process for the average retail banking consumer, however this only emphasises the vitality of user experience as mentioned above.
Example of Companies:
What is the VC Investment Opportunity
To capitalise on the meteoric rise of DeFi, VCs should focus on investing in companies tackling the key drivers of mainstream DeFi adoption: i) incorporating user experience and ii) providing solutions to bring traditional financial assets on-chain. To address the challenge of user experience, VCs should focus on companies at the intersection of Fintech and DeFi that are looking to incorporate DeFi architecture as back-end infrastructure whilst providing a personalised consumer-focused banking experience. These companies are strategically positioned to capitalise on the promise of DeFi in retail banking. The other salient investment opportunity of bridging crypto-enabled finance with traditional finance is enabled through synthetic assets. VCs should focus on companies who are tokenising real-world traditional assets. These companies have the potential to accelerate the mainstream adoption of DeFi by bringing crypto’s superpowers and high yield opportunities to traditional asset classes.
How can EU-based VC funds capitalise on this opportunity?
Outlined above is the ‘what’ of the DeFi investment thesis, however the ‘how’ also carries significant importance. Cryptocurrency markets present an alternative to traditional VC-style equity investing while providing greater accessibility to private market investments. This is a fundamentally new model of investment for a traditional VC fund. However, any EU-based VC fund, subject to regulatory uncertainty of cryptocurrencies in the EU, should focus on investing in traditional equity in companies who do not plan to issue a token, or alternatively invest in companies pre-token issuance. This will allow any VC to capitalise on the opportunity of DeFi while mitigating potential regulatory risk for the time-being. Nevertheless, with the advent of the European harmonisation of digital asset regulation, the Markets in Crypto- Assets (MiCa) framework, European VCs will have a greater opportunity to consider deploying a token fund investment structure in the coming years.
