On The State Of Adoption In Decentralised Finance

Published in

Coinmonks

21 min readApr 15, 2020

The rise of technology ventures providing financial solutions on a decentralised peer-to-peer network has caught widespread media attention. Is Decentralised Finance (DeFi) the new kid on the block, and what are the market trends to watch?

Written by Michael Guzik, Max J. Heinzle, CEO of area2Invest and Hugh MacMillen, founder of Instimatch Global

Executive Summary

DeFi is emerging, and the first growth numbers turn the spotlight on a new financial market system. The value locked in DeFi applications by users has briefly surpassed USD 1 billion as of February 2020 while it has temporarily dropped to around USD 650 million as of mid-March 2020. Cumulated investments from 2017–2020 in DeFi applications and protocols have grown to more than USD 290 million worldwide. However, the current DeFi user growth rates are disappointing.

The main DeFi applications are developing across infrastructure, marketplaces, and protocols, surprisingly, with a limited user base. The key barriers to adoption are the high volatility of the cryptocurrencies locked in (absence of regulated stablecoins), unstable market infrastructures, proof of consensus mechanisms, insufficient user experience as well as a lack of regulatory certainty.

Looking ahead, the two market forces of traditional and Decentralised Finance are merging and will bring more regulatory clarity and market resilience. Volatility will decrease as soon as the concepts around stablecoins continue to mature, hence, facilitating market adoption towards professional and institutional buy-side and sell-side.

Disruption is facilitated through regulatory changes; the blockchain was accepted as an independent third party by the Financial Conduct Authority in the United Kingdom within a regulatory sandbox. Hence, the role of licensed financial intermediaries (e.g. Central Securities Depositaries) in turns of blockchain is becoming a more significant question mark.

Introduction

Banks and intermediaries are facing severe pressure in times of unlimited quantitative easing and increasing competition from so-called FinTech companies. The central bank imposed negative interest rates and stiffing compliance requirements deteriorate the value proposition and cost-structure of banks and financial intermediaries. FinTechs eat-up the market shares of incumbent banks by offering faster and cheaper solutions or simply because they deliver a better user experience. On the customer side, finding alternative savings and investment options for wealth preservation and growth becomes a challenge in times of an ever-increasing risk of a global financial meltdown unless investors’ risk exposure increases significantly.

No wonder our generation Y is looking for alternative solutions if the yields offered on the traditional savings account look so grim. For example, UBS offers an interest rate of just 0.25% for its “UBS savings account for young people CHF”.

Among others, these macro and microeconomic developments are fuelling the debate for alternative financial market systems and alternative investments. In particular, Decentralised Finance is emerging out of the ashes of our centralised financial market system. The promises of a peer-to-peer network in which blockchain serves as the new trusted third party, providing an immutable and transparent history of transactions, are endless.

Commonly labeled as a new open finance ecosystem in which the control of the assets moves from the banks to the customer, the sharp increase in interest and market growth has been remarkable. Applications spanning from marketplaces, infrastructure, staking mechanisms and stablecoins; the open finance ecosystem is flourishing across all dimensions.

Just in February 2020, the amount of total value locked in Decentralised Finance passed USD 1 billion, where lending platforms such as MakerDAO, Compound, and EOSREX account for ca. 80% of the total market value. This number signals an undeniable interest from users in alternative financial solutions. This comes by no surprise if lending platforms such as Compound attract users with attractive annual borrowing percentage yields of 4–8% on average.

*Source: Defi Pulse: Total Value Locked (USD) In Defi*

Although the total value locked in represents an impressive growth, the total number of unique DeFi users per month remains surprisingly small. In 2019 alone, the average monthly number of unique DeFi users ranged between 40’000 and 60’000 worldwide and showed no growth rates.

In comparison, in May 2019 alone, the non-custodial wallet provider Metamask which is commonly used as a gateway to DeFi applications boasted more than an estimated 250’000 monthly active users with 1.5 million estimated transactions within this same period. If we dig into the number of investments in the period of 2017–2020, however, the cumulated investments made worldwide in DeFi start-ups have reached more than USD 290 million in this period. This marks an impressive commitment from investors when compared to the cumulative funding of USD 336 million in the widely attractive FinTech sector “Banking-as-a-Service”.

In summary, the absolute market adoption of Decentralised Finance applications within the cryptocurrency market still looks moderate when compared to the total market capitalisation of all cryptocurrencies, worth USD 160 billion in mid-March 2020.6 In contrast, however, the risk capital deployed into DeFi represent the non-negligible attention of investors. To better understand the reasoning behind the widespread media attention on DeFi, this paper introduces three trends in the Decentralised Finance market, which will cause seismic shifts in financial infrastructure and financial solutions. We will look deeper into each solution and explain its disruptive potential.

DeFi I: The transition from bank accounts to non-custodial wallets

Cryptocurrency wallets are serving as the base infrastructure for future DeFi applications
Non-custodial wallets are preferred over custodial wallets by the crypto market due to costs and ownership reasons
Third party custodians ensure the safekeeping of funds as non-custodial wallets do not satisfy security standards at present
A new financial market is emerging in which the ownership of assets is transitioning from banks to the end consumer

One of the most underrated, and in the news an underrepresented infrastructural revolution, in DeFi came with cryptocurrency wallets that allow the storage and management of cryptocurrencies or tokenised assets of any form. Most blockchain and crypto users might roll their eyes when reading this DeFi trend as wallets are not new. However, the impacts on the traditional financial market systems due to cryptocurrency wallets are unprecedented. Internet users have been given open-source tools to generate wallets for Bitcoin, Ether, Stellar Lumen, EOS or any other protocol-based token to manage their digital currencies and digital assets on their own.

Dreams of a new financial market infrastructure might come true if we consider wallets as the next generation of bank accounts in the future. Stablecoins and tokenised securities made accessible within open-source crypto wallets are already the first signs of a paradigm shift, where strictly regulated financial assets such as cash and securities can be personally stored and managed by the end-user in a wallet as opposed to in a bank account.

To go even further, non-custodial solutions are getting widespread attention. In simple words, non-custodial wallet solutions mean that no third party provider oversees the users’ funds and ultimately, places the responsibility for the assets directly on the wallet owner. The growth of non-custodial wallets in the market is remarkable. Over 46 million wallets on Blockchain.info alone have been generated by crypto users over a period of eight years, adding on average one million to that number every month since 2019.

*Source: Blockchain.com, Blockchain Wallet Users 2012–2020*

However, non-custodial wallets have become an incredibly attractive target to hackers. More than USD 4 billion worth of cryptocurrency had been stolen by August 2019 worldwide. This number is undoubtedly a direct representation of the immaturity of blockchain-based infrastructure to date, as wallet security has not been resolved to the confidence level of a mass market. Hence, a new industry of enterprise custody providers has emerged to increase the level of security available for the safekeeping of crypto assets by third party solution providers. By February 2020, more than 40 banks have applied to the German financial regulator BaFin for a custody license in order to step into the market of safekeeping cryptocurrencies and digital assets on behalf of clients.

Still, the question remains if the value of a third party custodian charging fees for securing funds will outpace the movement of open source and free of charge wallet providers in the long-term. As an example, take the concept of a “Dead’s man switch” in Metamask wallets which allows users to create a smart contract wallet as an additional account and, whenever a user stops using their original account (i.e. in case of loss of keys or passwords), funds can be sent automatically to a predefined wallet. For this specific case, no third party custodian is required.

“…If our goal is to get our grandmothers to use crypto, we might want to focus on open-source ledger technology and what we need to do for it to mature. The aim should be that no client, private or institutional, would have to deal with keys and security…” Dr Marc Fleury, Open-Source Pioneer

At this time, however, the learning curve and responsibility that comes with using a non-custodial wallet are still too high to facilitate mass adoption. User experience in applications will become the key which makes wallet generation, management and recovery easy-to-handle.

In summary, the emergence of wallets will put further pressure on banks and financial intermediaries in the future as the power will continue moving towards the end-users. The transition from today’s bank accounts to the user wallet is the new paradigm shift realised through a decentralised future; however, it will only gradually progress if regulatory and legal certainty increases. Still, maybe just for these reasons, wallets will be the main catalyser for real Decentralised Finance applications.

DeFi II: Algorithmic money markets — lending & borrowing through collateralisation of everything

Traditional money markets pose significant inefficiencies in capital distribution due to antiquated SWIFT payment networks, KYC procedures and manual methods
Algorithmic collateral ratios enforce rules that each account must have a balance that more than covers the outstanding borrowed amount, eliminating counterparty risk
Marketplaces offer algorithmic money markets which automatically match borrowers with lenders
Borrowers can withdraw funds at any point in time without waiting for a specific loan to mature
DeFi opens up new opportunities into the “collateralisation of everything.”

Money markets today are predominantly dominated by banks, large corporates and fund managers. The antiquated SWIFT network system is used for interbank payments, while trading is conducted via Bloomberg and Reuters chats, voice brokers and other manual means. The shortest trade duration in the interbank money market is the overnight (1-day duration) with various cut-off points for payments around the world. Fixed dates such as three months deposits are typically traded T+2 to accommodate the slow and cumbersome payment system.

In addition to the antiquated payment system, as typically these transactions are OTC and unsecured in nature, a lengthy KYC (Know Your Customer) process has to be implemented between prospective counterparts before a transaction can take place. This process can take weeks, if not months in some cases. Cross border transactions are less common due to the above restrictions. Counterparties tend to stay within their borders as they are better known to each other.

Money Market platforms using a blockchain-based payment system are happening. Take the company Instimatch Global as an example which has begun to undermine the traditional money markets by creating a network of borrowers and lenders, combining a social media approach with a transaction interface through their platform. The aim of Instimatch Global is to grow the community aggressively by inviting counterparties such as banks, corporates, family offices, cities and municipalities from all over the world to participate in this market. By enabling counterparts to meet and exchange Know-your-Customer, and then also transact in all areas of the money market over a single venue, Instimatch Global aims to lower the barriers to cross border transacting.

Their main catalyser for change in the money markets is the underlying payments system, combined with a platform to match borrowers with lenders. If a large community of institutional participants can exchange payment flows instantly using blockchain or distributed ledger technology (DLT) within the community, then massive nostro/vostro savings can be achieved compared to the SWIFT system using SSIs. This internal payment network would then allow Intraday lending and borrowing to take place as payments would take less than three seconds.

Adding the margining mechanisms of the R3 consortium and the notary, as a trusted third party, would facilitate new methods of securities lending and Lombard credit type approaches. Many smaller banks sit on securities which are too small (such as private placements) and are not easily pledged as collateral. According to Instimatch Global, by using the DLT approach, trust can be added easily to the network. Decentralised Finance marketplaces are even going one step further when trying to address these weak points in the money markets. Their power of automatically pooling and distributing cryptocurrencies through a marketplace solves today’s issues in traditional money markets without the need for any trusted third party.

Total money lent on such DeFi marketplaces surpassed USD 850 million in February 2020 on applications such as Maker, Compound, InstaDApp or dYdX.10 DeFi applications such as Compound are marketplaces for institutional and retail lenders and borrowers of cryptocurrencies that establish algorithmic money markets. These are pools of cryptocurrencies, with algorithmically derived interest rates, and based on the supply and demand for such currencies. Lenders and borrowers of a currency interact directly with the marketplace, earning and paying a floating interest rate, without the need to manually negotiate terms such as interest rate, maturity or collateral with a peer or counterparty. Money markets of each cryptocurrency are unique as each has its own collateralisation ratio majorly determined by its volatility. In the following paragraphs, we describe the mechanics and the resulting advantages of such algorithmic money markets.

Supplying Cryptocurrencies

Unlike in crypto exchanges where the cryptocurrencies of users are matched and lent to another, such money market protocols pool the supply of each lender. When a user supplies or lends a cryptocurrency to the marketplace, it becomes a fungible asset. This algorithm enables significantly higher liquidity as borrowers can withdraw their cryptocurrencies at any point in time and do not have to wait for a specific loan to mature. This liquidity is a powerful benefit as, in today’s traditional money markets, participants are bound to set maturity dates, and hence cannot withdraw their cash at variable times.

According to the Compound whitepaper, balances in a money market accrue interest based on the supply interest rate that is unique to that asset. Users can view their balances (including accrued interest) in real-time; when the user makes a transaction that updates their balance (supplying, transferring, or withdrawing a cryptocurrency), accrued interest is converted into principal and credited to the user.

Borrowing Assets

Algorithmic Money Markets allow any user joining a marketplace such as Compound to borrow cryptocurrencies directly from the pool of cryptos if their collateral is locked in. As stated by the marketplace Compound, borrowing from such marketplaces simply requires a user to select the desired asset from the list of cryptocurrencies and lock in the collateral. There is no need to bilaterally negotiate terms of the deal as smart contracts algorithmically set the contractual frameworks. When borrowing assets, each money market has a floating interest rate which determines the borrowing cost for each cryptocurrency.

These markets establish an algorithmic collateral management system which enforces rules that each account must have a balance that more than covers the outstanding borrowed amount. This rule is called a collateral ratio, and a user can take no action (e.g. borrow or withdraw) that would bring its value below the desired ratio. Users are free to repay a borrowed asset in whole or in part, at any time. Balances held in such a marketplace, even while being used as collateral, continue to accrue interest as normal.

Risk & Liquidation

If the value of a user’s supplied assets divided by the value of their outstanding borrowing declines below the collateral ratio, the user’s collateral becomes available to purchase (with the borrowed asset) at the current market price minus a liquidation discount.11 Such algorithmically set liquidation functions allow the market participants to terminate a deal at any time and decrease risk when supplying assets. Borrower’s collateral will be automatically transferred to the lender in the case of a default situation as the money market protocols enforce such transactions. This liquidation event enables frictionless markets as the problem of counterparty risk is eliminated due to smart contracts locking and releasing collateral. The role of a trusted financial intermediary present in today’s world then becomes obsolete.

These mechanics reveal the even more powerful idea of the “collateralisation of everything”. Through fungible asset settlement, any crypto asset can be collateralised in order to enable borrowing and lending. Each crypto asset will possess its own floating collateral ratio. What if decentralised financial markets will allow market participants to collateralise their tokenised watch or tokenised properties against a short-term loan? The opportunities for such markets are endless.

“Since the last bull run started, we have seen a dramatic increase in stablecoin loans followed by more deposits of different cryptos — a strong indication that our borrowers are using our product as a means of diversification and hedging. This trend has increased since the start of 2020, with a rise of 41.9% in new depositors. Once users join there is very high retention, and on average depositors add to their existing balance 1.5x a month.” S. Daniel Leon, Celsius Network

In summary, today’s algorithmic money marketplaces depict a utopian world of the future for financial markets as DeFi applications have solved most of the frictions we are experiencing in today’s financial industry. Counterparty risk in borrowing and lending is erased; borrowers and lenders can exit contracts at any point in time; and finally, a global liquidity pool is being built up, which eliminates fragmented markets. Such money marketplaces will be one of the main catalysts for DeFi mass adoption as capital allocation becomes frictionless, and efficient and will facilitate an increasingly liquid asset market for further DeFi applications. The key adoption, however, will start with a blockchain or DLT based payments system.

DeFi III: Synthetic assets will open an untapped derivatives market

Synthetic assets are a key building block for DeFi market infrastructure to be able to mature and grow liquidity breadth and depth
New types of derivatives/synthetic assets will emerge due to new asset underlying
Synthetic assets promise a decrease in origination costs while eliminating counterparty risks in the derivatives market

The value of the derivatives market in traditional finance is estimated at around USD 1.2 quadrillion — more than ten times the world’s gross domestic product.12 It is no wonder that the Decentralised Finance movement spotted this market opportunity and created financial instruments using crypto-related underlying assets. However, derivatives are not new to the crypto market. Back in 2014, BitMEX was among the first to offer futures contracts based on crypto to its traders, the leading crypto exchanges such as Binance, Huobi and even enterprises such as CME Group then followed.

Source: skew., CME Bitcoin Futures –
Total Open Interest & Volumes (USD)

In February, the total amount of CME Bitcoin Futures contracts exceeded USD 1 billion in daily volume trading on average while recording 23’000 futures contracts on February 18th 2020.

Such derivatives traded on the exchanges operate in almost the same way as traditional derivatives. A broker provides the contract and leverage. Then, these contracts can be traded on exchanges. In the case of BitMEX and CME Group, these intermediaries act as both the broker and the exchange.

DeFi’s ambitions, however, are to introduce programmable derivatives contracts, or synthetic assets (synthetics), which do not require an intermediary such as a broker. The promise is not only to decrease the origination costs but also to eliminate counterparty risks. Instead, the terms of the contracts can be defined in smart contracts, making third parties redundant in the transactions. Settlement automatically takes place using the blockchain as a source of trust when the terms of the contract are fulfilled. Hence, decentralised smart contracts facilitate a vast unlimited derivatives universe which can be created for virtually any underlying asset.

Synthetic assets, like algorithmic money markets, are a key part of the entire DeFi industry. The reasons are simple. Synthetics not only help the investor and trader in hedging risks and diversifying the portfolio but also in diversifying and hedging against inflation and deflation of the crypto assets. Such economics can only evolve if a critical mass of liquidity is providing the underlying assets. Otherwise, the economic benefit of creating a decentralised derivative/ synthetic asset will decrease if the market is too illiquid.17 On the other hand, a performing synthetics market will further inject liquidity into the market and boost the adoption of DeFi applications. This development, however, will not appear overnight. It took decades for derivatives in the traditional financial world to grow to such heights, whereas the DeFi synthetic asset volumes have just emerged over the last couple of years.

The key price drivers of these new asset underlyings are speculation; however, this was and remains the key foundation of today’s traditional financial markets. The DeFi industry has already created new asset classes in the form of tokens which have proven to succeed as a store of value. Bitcoin, Ether, Tezos and other tokens in which network participants are economically incentivised to host and/or maintain Nodes through Proof of Work, Proof of Stake or other consensus algorithms, have proven its capabilities. As a result, new virtual assets are emerging, of which we would never have thought. Consequently, synthetic assets can now be constructed from programmable assets without the help of third parties such as brokers.

In summary, the growing need for the diversification and hedging of risk shows that crypto markets are maturing, and synthetics will further grow into a key building block of Decentralised Finance infrastructures. Streamlining the origination process, while eliminating counterparty risks, fuel the vision of synthetics in a purely decentralised financial market infrastructure.

What’s holding back DeFi from mass adoption?

This whitepaper introduced the emerging trend of Decentralised Finance. Although the raw numbers look promising, the DeFi trends described above also reveal that the fundamental building blocks of the new decentralised financial infrastructure are simply not yet well established. This trend provides unprecedented opportunities for new ventures but also risks for the traditional financial industry trying to enter into the crypto market.

Infrastructure instability

Over the last few years, numerous blockchain ventures have been founded to build crowd, peer-to-peer or autonomous based applications and infrastructure for the DeFi market. While the disruptive potential of the business models is substantial, most of the blockchain protocol layers are, however, still in their infancy. The crypto industry still grapples with the question of on which base protocol will DeFi be built. Although Ethereum has manifested itself as a market-leading protocol in the DeFi market, this blockchain is still in a critical transition stage as it moves towards Ethereum 2.0. At the same time, we currently have blockchains such as Tezos, Stellar, EOS, Cardano, and Tron all competing against each other to become the base layer of the future “internet of value”, or at least become a niche protocol within the DeFi segment. So far, Ethereum has won the fight for becoming the ultimate base protocol; however, due to its implicit governance processes, Ethereum struggles to meet the development deadlines.

Secondly, various DeFi protocols ranging from money markets, synthetic assets to decentralised exchanges are building a utopian version of our current traditional financial market systems. However, such protocols are still too far away from a maturity grade to handle billions, if not even trillions, of USD every day. Just recently, the decentralised lending protocol bzx was compromised twice due to price manipulation of the underlying assets.18 Even MakerDAO, one of DeFi’s biggest projects, faced an emergency shutdown with USD4 million of its dollar-pegged Dai stablecoin not backed by an underlying crypto asset.19 Such events, however, are not a drawback in the development of DeFi protocols, but simply depict the current state of the market maturity.

Volatility remains a barrier to adoption

Over the last few years, more than 5’134 cryptocurrencies have emerged in the crypto market, each with its own reference price and total market capitalisation. These cryptocurrencies have currently more than 20’737 trading pairs on an estimated 314 exchanges.20 The dominant reference currencies for trading remain Bitcoin and Ether. However, the fundamental problem is its price volatility against the USD.

*Source: Bitcoin Volatility Time Series 2011–2020*

While Bitcoin’s average price volatility in US dollars smoothed to 3.32% based on a 30-day estimate in 13th March 2020, such price fluctuations remain a problem in daily trading, borrowing and lending of cryptos or other DeFi applications. In response, so-called fiat-backed stablecoins such as Tether (USDT), USD Coin (USDC), Gemini USD (GUSD) have emerged to provide price-stable trading pairs as viable alternatives.

While these initiatives provide a solution to a market-wide problem, the ever-going battle between the worlds of decentralisation and centralisation remains. While DeFi promises the reduction of counterparty risk through the elimination of intermediaries, the above-mentioned fiat-backed stablecoins all are issued by a presumably trusted third party who acts as a counterparty. In response, other crypto concepts such as crypto-backed or algorithm-backed stablecoins have emerged. These, however, have not gained widespread market adoption yet. The reason is simple as such immature monetary concepts do not currently satisfy the regulated financial industry.

“Mainstream adoption of the internet of value won’t come until blockchain is more mature and a regulatory framework is in place, and for this to happen we need to understand better what does decentralisation mean, what are its implications and how we can measure it.”
Pedro Lopez-Belmonte, Blockchain Pioneer Richemont

Outside of the DeFi market, roughly three categories of stablecoin concepts such as central bank-issued digital currencies (Chinese Digital Yuan), bank issued settlement coins (e.g. Fnality, JP Morgan Digital Coin) or enterprise issued stablecoins (Libra) are currently being explored and developed to benefit from the advantages of a peer-to-peer payment system using distributed ledgers. According to Hugh MacMillen, founder of Instimatch Global, mass adoption of Decentralised Finance, however, will only occur if regulated payment networks with digital/tokenised cash can enter the DeFi ecosystem.

Looking ahead, the crypto market is still in a transformative stage of finding the right decentralised stablecoin for DeFi to reduce volatility in the market. For now, centrally issued fiat-backed stablecoins such as Tether as well as cryptocurrencies like Bitcoin and Ether are dominating the crypto exchange segment. However, Bitcoin and Ether have not proven themselves to be a reliable reserve currency yet. Can we expect further centralised solutions in the DeFi market or are we about to see a new decentralised internet currency which will act as a stablecoin?

Financial regulation is designed for financial intermediaries only

Blockchain, as a single decentralised source of truth, has unprecedently shaken up the traditional financial industry in a manner, unlike other emerging technologies. Today’s financial intermediaries are by regulation designed to decrease any types of financial and stability risks. With Decentralised Finance stepping in, these intermediaries are now supposed to be made obsolete by simple code executed on a hash-linked chain of blocks. The crypto industry has undeniably proven that financial markets can mostly function without the intervention of regulated financial intermediaries. Counterparty risks are significantly decreased, fraudulent activities (e.g. in ICO) have organically diminished through market forces and hacks are continuously strengthening the Decentralised Finance infrastructure.

Nevertheless, regulation remains a crucial bridge between the unregulated crypto world and the regulated financial market. As long as cryptocurrencies can be exchanged from or into our current monetary system, financial regulators will impose clear rules to all DeFi ventures. However, a fundamental shake-up in the regulatory frameworks is starting to happen. The government of Liechtenstein passed the blockchain act, called the “Tokens and TT Service Providers Law”, in order to set-up a sound legal framework for all parties involved that wish to engage in blockchain-related business.

At the end of 2017, the venture company Nivaura assisted with the issue of the world’s first cryptocurrency denominated, blockchain settled bond for Luxdeco, an online retailer of luxury furniture under the supervision of the FCA financial regulator in the UK within a closed regulatory sandbox. The results are ground-breaking. With the pilot, the FCA was satisfied that, from a regulatory perspective, the blockchain constituted an independent third party, which fulfilled the requirement for third party reconciliation of the register. The reason behind this stance is that Nivaura took no direct control over the allocation of the assets and money held on that register.

If a blockchain fulfils the requirements of an independent third party, what are the future roles of financial intermediaries which will operate under central securities depository (CSD) licenses? Will the blockchain make certain licenses obsolete in the future? In any case, the transition towards true Decentralised Finance is already happening but it will not come overnight.

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