The Future of DeFi: Who Will Win the Infrastructure Race? — Part I
Several platforms are emerging to challenge Ethereum’s dominant position.
In part I, we will introduce key concepts related to DeFi and explain Ethereum’s dominant position. We will also analyze Hedera Hashgraph and its growing DeFi ecosystem. In later editions we’ll take a look at the Casper Network, Algorand, and Polygon.
Introduction to Layer 1’s and DeFi
When most people think of cryptocurrencies they think of Bitcoin: the first-generation distributed ledger technology (“DLT”) designed to enable peer-to-peer value transfers without an intermediary. The second most well-known network, Ethereum, was the first distributed ledger to enable information to be transferred securely. This meant Ethereum could disintermediate many economic activities beyond simple payments: one emerging area for platforms like Ethereum is DeFi.
The mechanism for enabling a more sophisticated transaction using a DLT is called a Smart Contract. Smart Contracts are essentially algorithms that execute a cashflow when certain requirements have been fulfilled [1]. While there are many potential applications of DeFi, it is essentially a decentralized mechanism for securing liquidity. Participants can agree to terms such as the transaction amount, repayment scheduling, interest rates, collateralization, and any other relevant terms.
Some common DeFi products include:
Yield Farming [2]
Users can lend tokens into a liquidity pool that other users can borrow from. Lenders earn a yield based on the APY encoded in a Smart Contract.
Staking [3]
Users stake their tokens to a node that participates in securing the network, e.g., a user can stake their HBAR, the native token for the Hedera Hashgraph network, to the node controlled by Google. This action of staking gives Google an increase in voting power proportional to the user’s staked HBAR.
Swaps [4]
Tokens can be minted using a DLT, e.g., USDC, a stablecoin token pegged to the US$ can be minted on several DLTs including Ethereum, Algorand, and Hedera Hashgraph.
The minted tokens are created or destroyed using a smart contract written by the issuing party: USDC is issued by the company Circle which backs each token 1:1 with dollars held in reserve.
These tokens can be swapped through a Decentralized Exchange (“DEX”), e.g., USDC can be exchanged for EURC, another stablecoin pegged to the €, within a user’s Ethereum wallet.
Bridging [5]
Bridging allows a user to move a token they hold on one DLT onto another, e.g., a user may bridge $100 of USDC from their Ethereum wallet onto their HBAR wallet.
These products may sound like fancy ways of doing what people have been doing for decades in the traditional financial world, however, there are several key advantages to DeFi.
Elimination of Gatekeeping
Instead of relying on a bank to hold a balance sheet and disburse credit, consumers and businesses can lend to each other by pooling their funds. This would move financial services from a one-to-many to a many-to-many model. This is analogous to how social media created a many-to-many relationship between consumers and content. Elimination of gatekeeping will make transaction costs much lower and lower barriers to entry for the underbanked.
Enhanced Liquidity
Have you ever tried to buy a fraction of something very expensive like a house or a painting? The reason most people will answer no to this is that there is a lack of liquidity to facilitate such transactions. Traditional financial infrastructure can’t reliably track the high quantity of transactions that fractionalized ownership would generate. This is because we rely on clunky payment messaging systems and huge back-office teams to ensure value flows securely and transparently. It also costs money to employ lawyers to draw up contracts specifying ownership and use rights. With DeFi, these stipulations could be secured by code rather than contracts managed by centralized institutions.
Improved Transparency
By eliminating gatekeeping, market participants will have a more transparent view of how a financial contract operates. The history of ownership and underlying cash flows associated with an asset can be viewed “on chain”. This decreases the possibility of fraudulent behavior.
The Layer 1 Wars Are Only Just Beginning
Since Ethereum launched in 2015, there have been countless competitors looking to displace Ethereum [6]. The term “Ethereum Killer” became a common term to refer to the emerging platforms. In this article I will focus on one of the most promising alternatives to Ethereum: Hedera Hashgraph.
Ethereum’s technical limitations have invited competition from new protocols. Ethereum is much slower and less energy efficient than later generation DLTs. The gas fees paid by users can become exceedingly high during periods of high network utilization. It’s not uncommon to pay fees of several dollars and wait several minutes for a transaction to reach finality [7].
Ethereum is an older DLT and has several legacy issues such as beginning with a Proof of Work consensus mechanism [8], inflexible smart contracts which require users to redeploy when changes need to be made [9], and the need to build using Solidity instead of allowing use of Rust and WASM which are more popular among developers [10].
While paying a few dollars and waiting for a few minutes for a transaction doesn’t sound like a dealbreaker, it presents enough friction to prevent scaling DLT to billions of users. Ethereum aims to resolve its technical limitations when it finally upgrades to Ethereum 3.0 which is several years away at least. While Ethereum 2.0 has dramatically reduced the energy consumption required to secure the network, transaction costs remain prohibitively high [11],[12].
Hedera Hashgraph: “Not a Blockchain” Built for Scale
Hedera Hashgraph is actually not a blockchain. A blockchain requires that transactions be verified within a specific block which extends for a fixed unit of time. Instead, Hedera uses a gossip protocol in which nodes gossip about each other to build a consensus for transactions [13]. This architecture means consensus can still occur even if nodes are being slowed down by Distributed Denial of Service (“DDoS”) attacks — a DDoS attack occurs when a malicious actor attempts to disrupt the normal traffic of a targeted server, service, or network by overwhelming the target or its surrounding infrastructure with a flood of Internet traffic [14]. In cryptography this ability to maintain liveness despite the network being slowed down is referred to as Asynchronous Byzantine Fault Tolerance (“ABFT”). Aside from futureproof security, Hedera is extremely scalable, cheap to use, and energy efficient. It claims to be able to handle thousands of transactions per second, has transaction fees measured in the fractions of a cent, and is ~27,000 times more energy efficient than Ethereum 2.0 [15].
Hedera also has a unique approach to governance. The founders, Leemon Baird and Mance Harmon, govern the Hashgraph through a council including some heavy hitters including Google, LG, IBM, Boeing, Nomura, Ubisoft, ServiceNow, and Dell among others [16]. The founders are represented through their firm Swirlds Labs which specializes in commercialization of the Hashgraph.
Some have criticized this approach as being too centralized, such as Cardano founder Charles Hoskinson [17]. However, the goal of Hedera is to become a truly permissionless network over time. The Council members also need to rotate in and out to ensure diversity and prevent collusion [18]. For now, the network remains in the hands of some very powerful, but diversified organizations.
The Hedera ecosystem is expanding rapidly with several decentralized applications (“DApps”) relating to DeFi.
SaucerSwap is a particularly exciting DApp because it brings a full suite of DeFi products to the retail user. It has ~$24m of total value locked (“TVL”) and offers yield farming, swaps, bridging, and staking of SAUCE — SauceSwap’s native token. While the suite of capabilities are strong, SaucerSwap has a long way to go to build liquidity and scale to millions of users [19].
TVL on the Hedera Network is ~$40m as of late February 2023, up >100% since October 2022. This is still a far cry from Ethereum’s ~$29bn TVL [20]. It is this first mover advantage that will hold Ethereum in high regard even given its technical limitations. Hedera’s market capitalization is only ~$1.9bn at the time of writing compared to ~$198bn for Ethereum [21].
Conclusion
Hedera is a promising project with very strong backing and has excellent technical architecture. While it’s governance remains quite centralized compared to Ethereum’s over 10,000 nodes, I believe Hedera will shine as one of the top layer 1 protocols in the coming years [22]. Some very prominent names are involved in governing the network and they have a sound technical roadmap to become truly decentralized [23].
[18] Hedera
