The Summers of DeFi
This is the second part of a series of posts I’m writing on the evolution of the crypto ecosystem. You can find the first post here: Understanding the Decentralized World through the Crypto Winters
Technology changes the world first gradually, then suddenly.
- Tim O’Reilly
The Rise of DeFi
Something unusual happened in the crypto ecosystem in the summer of 2020. In a space where the prices of cryptocurrencies dominate most of the conversations, a new phenomenon called Decentralized Finance (DeFi) started gaining the attention of crypto enthusiasts at a pace never seen before.
DeFi is a blockchain-based form of finance that uses smart contracts to offer financial instruments without having to go through traditional intermediaries such as banks and exchanges. Imagine a money robot with its software running on a peer-to-peer network instead of centralized servers and providing different services such as lending and borrowing without any human or institutional intervention.
YFI, the governance token for Yearn Finance, a DeFi Protocol, grew from just $6 to over $30,000 per token in less than 2 months. That is a 500,000% growth in value. This phase was called the DeFi Summer of 2020.
MakerDAO, a Decentralized Autonomous Organization, is considered the pioneer of DeFi. The Maker Protocol uses over-collateralized loans to create DAI, a stable coin pegged to the US Dollar. In December 2017 when DAI was launched, the total value locked in DeFi protocols was about $100 Million. Today, close to $100 Billion of crypto assets are locked in DeFi Protocols.
Lend, Borrow, Trade, and so much more
There are over 150 protocols listed on DeFi Pulse. The actual number of protocols is probably much higher. These protocols mirror offerings present in traditional finance but operate in a very different way.
Lending Protocols
As the name suggests, users can deposit crypto assets and earn yield or borrow cryptocurrencies from the protocol in exchange for repayment with an interest.
A simple question that had perplexed me early was who were the people lending from these protocols and why. These are typically crypto native entities such as traders, miners, and DAOs that hold crypto assets. For instance, a crypto mining company might be interested in expanding its infrastructure but is not willing to liquidate its holding. They can instead take a loan from a lending protocol to fund their expansion.
The deposits are held in a smart contract with the protocol. The user in return receives an interest-bearing token¹ to keep track of the funds they have lent. These tokens are created when a deposit is made and burned when the deposit is redeemed. e.g. When you deposit say 100 USDC on Aave, a popular lending protocol, Aave issues you 100 aUSDC that gets transferred to your wallet. In contrast to your traditional term deposits, these tokens are liquid and instantly transferable. This means when you transfer say 50 aUSDC to a friend of yours and from that point onwards your friend will start earning interest equivalent to a deposit of 50 USDC.
The protocol computes in real-time the interest rates for depositors and borrowers and the collateral required by borrowers based on the demand and supply.² Unlike loans from a traditional bank, there is no defined payback period and instead, the protocols maintain a health factor against each wallet that has borrowed from the protocol’s pool. If the health factor falls below a certain threshold, users are required to add more collateral or pay back a portion of the loan. In case that doesn’t happen, the collaterals are liquidated at a discount. This is how the protocols ensure the safety of the user’s deposits.
Lending Protocols have grown significantly over the last few years. Aave, Maker Dao, and Compound are the three largest lending protocols. Aave managing over $25 Billion worth of crypto assets. To put it in perspective, Revolut, one of the leading Neobanks had $7 Billion of assets in December 2020.³
Decentralized Exchanges
Decentralized Exchanges or DEXes enable the trading of crypto assets without the need for a central intermediary. Centralized exchanges operate by matching buyers and sellers with help of market makers. In contrast, DEXes enable trading by using liquidity pools created by individuals and bots. Liquidity Pools are deposits made as pair of tokens to the protocol that can then be used for trading purposes. Liquidity providers earn a percentage of the trading fees. Uniswap, one of the leading DEX, generates between $1–2 Million as fees every day.
Uniswap, Curve Finance, and Sushi Swap are some of the largest DEXes. Uniswap which was launched in November 2018 currently has about $2 Billion of trading volume per day. Coinbase for comparison does about $4 Billion trade per day.
DEXes are permissionless and have a larger number of coins listed on them as compared to centralized exchanges. DEXes fees are also generally lower than what centralized exchanges charge. Moreover, the assets are in your custody, unlike centralized exchanges where the exchange holds the assets on your behalf. DEXes are the true embodiment of a global financial platform with no central authority where any person, anywhere in the world with an internet connection and smartphone can participate.
Derivatives and Other Protocols
Beyond Lending Protocols and Exchanges, a plethora of protocols has emerged ranging from Perpetual Contracts to Insurance. Synthetix is a trading platform that brings real-world currencies, stocks, and commodities exposure to the crypto ecosystem without having to own the underlying asset. On Synthetix, you can trade in assets such as Gold, Apple Stock, and Bitcoin. Nexus Mutual provides insurance in a community-owned format. Members can buy insurance to protect themselves against smart contract failures.
Why DeFi
Cryptocurrencies made money programmable. DeFi provides the building blocks that enable communities to come together and form an economy.
DeFi Protocols are often termed as money legos. The common underlying principle is composability. People can bring together multiple protocols to build for interesting use cases. A simple example can be a crypto trader who writes a program that spots opportunities on a DEX such as Uniswap, takes out a loan from Aave, completes the trade, and then pays back the loan all in a matter of seconds.
We park our surplus money with different instruments so that they can be utilized by entities who know how to use it better than we do. When we put our savings into a term deposit, traditional banks connect it to companies willing to loan money to expand. Similarly, when we buy a stock, we buy ownership into a company that we expect to grow.
A robust DeFi ecosystem increases the velocity of the money.
The Programmable aspect of DeFi enables money to move between multiple individuals and institutions algorithmically, thereby automating the movement of money, both large and small to the most optimal points. This also considerably brings down the time required to move money and the minimum duration for which the money needs to stay with any particular entity.
The open nature of DeFi Protocol enables a maker-checker process. It ensures that independent audits can be done to confirm that a protocol does what it says it does. Additionally, the fact that it is decentralized means no single entity can influence how the protocol works.
Traditional finance is technology-enabled. In DeFi, technology lies at the center of everything. DeFi operates at a much higher level of efficiency and automation. A comparative analysis done by Dmitriy Berenzon⁴ illustrated that how the profit margins of Maker Dao (99%) contrasted with that of Lending Club (-50%). Similar comparisons have been made between DEXes and centralized exchanges. For instance, how Uniswap has about 70% of trading volume as that of Coinbase with 33X fewer employees.
The way forward
These are still very early days for the DeFi Ecosystem. Much akin to the cryptocurrency space during its infancy, DeFi has been impacted by scams and protocols has that have wiped out millions. In its current state, it is an incredible piece of technology. But as a product, it still has a long way to go.
Having shared this, I am optimistic that these hurdles will be overcome with time. The number of DeFi users while much smaller, when compared to overall crypto users, is growing at a rapid pace. It took close to 2 years for the number of DeFi users to get to 1 Million, 5 months to reach 2 Million, and then just 3 months to reach 3 Million. While this is an approximation, it illustrates the growing trust in DeFi.
Looking a bit further, a facet that is especially intriguing is the path of integrating DeFi into the real-world economy. Today, to a large extent DeFi is limited to crypto native people, institutions, and use cases. I’m hopeful of a future where a small business can get a loan from these protocols in a matter of seconds, an exchange where stocks of all companies across the world can be traded by anyone, anywhere, and a student who can take a loan to complete their education without having to deal with bureaucracy.
A decentralized infrastructure that will create a more economically connected world.
If you liked the post, please drop a few claps. The will help get this post to more people. Do share your thoughts in the comments. I’m still learning the space and any feedback is welcome.
Also, if you find DeFi interesting, check out something new that we’re building: Brew
Acknowledgments
- Zoltan for the beautiful pic
- Mehul for having the patience to explain to me the intricacies of DeFi over the last few months
- Pritesh for sharing feedback on the draft
- Vitalik for Ethereum
Footnotes
[1] Aave Interest Bearing Tokens
[3] Revolut AUM
[4] DeFi is eating Finance [Must Read]
