Part 2: Once upon a time there was Decentralized Finance (DeFi)…
Are you already familiar with this story and is there a happy ending?
Authors: Bert Staufenbiel (DeFiBert ) & Liane Walker-Meininger
Our Story
We have in common that we both work for the same financial institution but in different departments. Unfortunately, with the Covid-induced home office, co-workers hardly meet by chance anymore. It is all the more gratifying that we have met again through the DeFi Talents and DLT Talents program offered by the Frankfurt School Blockchain Center. As part of our final assignments we would like to share some of our learnings over the 18-week mentoring program in this multi-part, co-authored article that will be published on our joint Medium publication ‘Journey to the crypto space — Our experience and learnings with DLT, DeFi, Token economy, DAOs, crypto investments…’.
Outline of DeFi’s story
1. Description
2. Beginning
3. Foundation of DeFi
Part 2 (current publication)
4. Historical highlights
5. Is there a happy ending?
4. Historical highlights
So far, we have learned where the term Decentralized Finance most likely originated from, what is behind DeFi in terms of vision and its relevance, how decentralized Finance can be classified, and last but not least which building blocks compose its unique infrastructure.
To tell our story of DeFi we will look at some of the main events and how crucial projects developed in the individual layers of the Decentralized Finance stack over time.
2009
The start of the story of DeFi should be dated back to the most important event in the entire crypto space of which Decentralized Finance is a part, i.e. the Bitcoin network went live with the mining of the genesis block, which allowed the first group of transactions to begin a blockchain.
2015
The crypto space has evolved since the launch of the Ethereum network. The decentralized settlement layer laid the groundwork by implementing blockchain-based smart contracts that offer the ability to execute the kind of complex functionality that decentral finance applications require.
2016
Launched in spring and designed as a community-run investment fund The DAO was crowdfunded as Decentralized Autonomous Organization (DAO) through the sale of tokens on Ethereum. Approximately, $150 million worth of Ether, at the time, were sourced this way. Unfortunately, a vulnerability in the code of The DAO led to an unwanted outflow of roughly a third of the funds. After long discussions in summer, the community decided to make a change to the blockchain’s protocol and as a result the chain split into two competing chains. The community’s members backing the ‘Ethereum‘ chain share the belief that the intention of The DAO is to provide funding to projects. In contrast, the ‘Ethereum Classic’ chain followers share the vision that ‘code is law’ and are therefore willing to accept the unintended outflow of funds. Eventually, the latter maintains the original, unaltered history of the Ethereum network and makes up about 1% of today’s Ethereum chain. By the end of the year the DAO token was delisted from major cryptocurrency exchanges and became obsolete.
2017
The Synthetix protocol runs on Ethereum and allows the issuance of synthetic assets. Synthetic assets are financial instruments in the form of smart contracts called Synths that track and provide the returns of another financial asset without actually holding the asset. A variety of Synths, such as cryptocurrencies, indexes, inverses, as well as real-world assets like gold, can be traded on Kwenta, Synthetix’s decentralized exchange (DEX). Synthetix’s native token, the Synthetix Network Token (SNX), is used to provide collateral against issued Synths.
Already formed in 2014, MakerDAO officially launched the DAI stablecoin and its associated smart contracts on Ethereum’s main network at the end of 2017. The DAO MakerDAO and the platform Maker protocol are considered one of the first DeFi projects to gain significant adoption by allowing the users to issue and manage the DAI stablecoin. DAI is a cryptocurrency whose price is kept as close as possible to $1 through an automated system of smart contracts, i.e. the Maker protocol. Thereby eliminating counterparty risk for lenders and borrowers of different cryptocurrencies. Innovatively, backed by digital assets held in MakerDAO’s smart contracts, the DAI’s generation is community-managed through the decentralized governance community. The community is composed of the holders of the Maker governance tokens (MRK) that are granted the right to vote on a number of changes to the Maker protocol in order to ensure the stability of the DAI.
The Oasis brand was born back in 2016. The first decentralized exchange on Ethereum was MakerDAO’s first project OasisDEX. At the time, the decentralized order-book based exchange’s main use was to allow the exchange of the Maker governance token for Ethereum’s wrapped native currency (wETH). As of 2020 OasisDEX has developed into its own entity the Oasis.app with an enhanced and expanded product range.
2018
With its DeFi lending protocol on the Ethereum blockchain, Compound Finance was founded in 2017. By charging variable fees and rewarding liquidity providers based on supply and demand, the platform facilitated lending one digital asset against another as collateral. On the one hand, lenders can earn interest over time by depositing tokens to a compound pool that can be redeemed at any time. On the other hand, borrowers can take out a secure loan from any compound pool against collateral that does not depend on a credit score or income and liabilities. This is made possible through the over-collateralization of loans.
The first decentralized exchange to successfully utilize an automated market maker (AMM) system is Uniswap. As a protocol for automating token exchange on Ethereum it resolves the reliance on an order book which is especially relevant while trading less liquid tokens. Tokens are swapped using smart contracts and a formalized system to pool liquidity reserves is used. In the end Uniswap’s main goal is to offer a free and decentralized asset exchange system that provides an open-source interface for traders and liquidity providers.
2019
One part of the decentralized finance stack that has gotten less attention is insurance. Nevertheless, crypto is no different than any other industry because there are also many risks involved. There are hacks of smart contracts, exploits, Oracle manipulation, data breaches, and thefts from time to time. Founded in 2017 Nexus Mutual is a digital cooperative, which is a DAO with a legal wrapper around it. This decentralized insurance protocol is built on Ethereum. In response to smart contract vulnerability, the first product was a cover that provided protection for these value storing contracts. To ensure this, Nexus Mutual operates a risk-sharing pool that enables anyone to purchase insurance cover or contribute capital to the pool for potential rewards in the future. Anyone is welcome to participate since the mutual is owned by its members. Users can contribute Ether (ETH) to the pool in order to receive the native token (NXM).
The first interoperable component of 1inch was the aggregator protocol that as its name implies aggregates token prices across decentralized exchanges. In doing so 1inch aims to find the best prices by discovering the most efficient swapping routes across all leading DEXes. So 1inch’s algorithm finds the cheapest way to place a trade using all the different exchanges and liquidity protocols that can facilitate the trade.
2020
Curve Finance is a decentralized exchange focusing on stablecoins. Since Curve pools have roughly the same value as Uniswap, it can minimize slippage for traders while reducing or eliminating impermanent losses for liquidity providers. Often, there is a permanent loss of liquidity on other DEXs as the volatility of token pairs against ETH reduces returns to liquidity providers. In addition, Curve’s liquidity pools lend out tokens to DeFi money markets such as Compound and Yearn Finance. As a result, liquidity providers can earn trading fees and return from those lending pools. Compound, DYdX, and Curve Finance are among the protocols utilized. Curve Finance created a liquidity pool through which savers can earn trading fees on Curve in addition to lending fees from their deposits.
Balancer is a protocol for multi-token automated market-making, while being an asset manager and also decentralized exchange built on the Ethereum network. Balancer’s functionality is similar to Uniswap, since it allows for the creation of pools of tokens, which rebalance to keep the same ratio among those tokens regardless of price changes. The key difference is that it allows the addition of more than one token, and it does not require Ether to use it. Here anyone can design an index fund based on crypto assets, similar to an ETF. It is possible to create a private pool in which only the creator has complete control over its parameters and can add liquidity. Furthermore, anyone can invest in smart pools to get an idea of how the portfolio moves. Investors can supply any of the tokens in the portfolio and they receive Balancer’s pool tokens in exchange, which represents their ownership of the pool. The DEX is the other part of the protocol. When liquidity pools become imbalanced, traders are able to swap tokens and take advantage of arbitrage opportunities. The trading fees they pay to exchange tokens go to the pools’ liquidity providers. Balancer can be viewed as an inverse ETF because it allows investors to collect fees from traders instead of paying portfolio management fees.
The aim of YAM Finance is to offer users YAM tokens in exchange for deposits of cryptocurrencies into different liquidity pools. It’s one of the first projects built specifically around the concept of yield farming, where users deposit cryptocurrency and earn the platform’s native tokens, along with lending interest rates. In YAM, the price is pegged to 1 USD, and its supply can be contracted or expanded to control its reference price. As a result of the platform’s success, it sparked an explosion of copycats, as well as so-called meme coins, or tokens linked to an emoji and a funny name often related to food.
Despite the fact that Decentralized Finance has been around for some time, it really took off in the summer of 2020 when the platform Compound issued its COMP governance token thereby introducing the liquidity mining process to reward its users. In the wake of other protocols mimicking this concept, demand for DeFi soared, token prices increased, and Decentralized Finance activity in general surged.
Aave began in 2017 and ranked among the largest projects in terms of the total value locked within its protocol during the summer of 2020. Aave has several distinguishing features when compared to competitors like Compound. Aave lets users borrow and lend in a wide choice of cryptocurrencies. Aave’s flagship products are ‘flash loans’, which are marketed as being the first uncollateralized lending option available to DeFi borrowers. The drawback is that they must be repaid within the same transaction. Another benefit of Aave is the ability to choose between fixed and variable rates when borrowing. In times of extreme volatility in the crypto markets, fixed rates provide some guarantee about costs. However, variable rates can come in handy if the borrower believes that prices will fall.
As a fork of Uniswap, SushiSwap has become synonymous with the DeFi movement, as well as the associated trading boom for Decentralized Finance tokens. Besides diversifying the AMM market, SushiSwap also adds additional features not previously available on Uniswap, including increased rewards for network participants via its unique token, SUSHI.
Total value locked (TVL) overall all DeFi protocols exceed the $ 10 billion mark for the first time.
From September through October a negative sentiment follows the DeFi summer with markets’ all-time highs reaching their lowest point at the beginning of November.
By launching the Phase 0 of Ethereum 2.0, a set of upgrades that lies ahead to achieve more scalability and improve the network’s security, sustainability, effectity and decentralization is set in motion.
2021
The Olympus DAO project aims to install a reserve currency in the Decentralized Finance space. Instead of using Fiat currencies to create stability, Olympus tries to achieve stability over a free-floating reserve backed by cryptocurrencies. This is achieved on the one hand by the treasury of Olympus buying and burning its native tokens (OHM) if they trade below one DAI (i.e. the backing cryptocurrency) and on the other hand by selling, and creating new tokens if OHM is above one DAI.
Unslashed Finance is a decentralized insurance protocol built on Ethereum covering all common risks for crypto assets. Insurance buyers and risk underwriters have access to almost instant liquidity that guarantees constant collateralization. Furthermore, transparency is guaranteed through an unbiased claims process.
DeFi’s status quo
To conclude this chapter, let’s look at the current state of Decentralized Finance.
As mentioned in Part 1, TVL is the total of all assets deposited in the DeFi protocols that are earning interest, new coins, or other rewards.
2021 has been a phenomenal year for Decentralized Finance, starting at a TVL around $18 billion in January, reaching its high at the beginning of December with $256 billion, and ending the year with $238 billion. During January 2022 the TVL declined to $185 billion and we are currently standing at $202 billion.
An emerging trend in the DeFi space in 2021 was that decentralized apps such as Aave, Sushiswap, and Curve extended their services across multiple networks simultaneously, as part of the so-called multichain paradigm. In turn, other blockchains gained ground within this space, allowing the use of settlement layers other than Ethereum. Although Ethereum is still the dominating blockchain with above 60% of usage, other so-called ‘layer 1 blockchains’ are diminishing the network’s market share. Trailing blockchains are currently Terra, Avalanche and Solana.
In today’s financial ecosystem, the main pathways through traditional and crypto finance range from high street banks and challenger banks to FinTech apps offering crypto services, and then onto less-conventional solutions like non-custodial wallets, crypto exchanges, and Decentralized Finance.
The amount of announcements from financial institutions about how they plan to integrate crypto and how they plan to use technology to help them record and validate a large volume of transactions on the blockchain indicate a greater adoption by the financial sector. The DeFi space can support these aspirations of the financial sector by offering the institutions to participate in regulation-compliant Decentralized Finance. For example the previously mentioned decentralized lending platform Aave has just launched its permissioned lending and liquidity service Aave Arc for institutions.
5. Is there a happy ending?
It is important to ask ourselves if DeFi’s vision has already been realized. The opinions on the potential of Decentralized Finance range from the outperformance to the substitution of a part of the traditional financial system. What is consensus is that in terms of mass adoption DeFi hasn’t reached its potential, yet.
‘Typically, traditional finance savers or lenders are skeptical of the crypto space or do not know about DeFi. The influx of capital into DeFi applications since June 2020 most likely stems from idle assets on crypto wallets, i.e. from a redistribution of assets within the crypto space. Nevertheless, the rising use of DeFi protocols proves that the system is scalable and working. Today, the users of DeFi belong to the group of “innovators” or “early adopters” (i.e. a very small proportion of households). Tomorrow, the users might be mainstream households.’³
— Benedikt Eikmanns | Prof. Dr. Isabell Welpe | Prof. Dr. Philipp Sandner
In the end, Decentralized Finance is still an emerging technology with a slow real-world adoption rate compared to its vision and potential. DeFi applications must still overcome some huge obstacles and risks to gain the trust of people and institutions outside of the crypto-native community.
Central risks
Technical risk: In Decentralized Finance, smart contracts and the underlying blockchain protocol play a vital role for the integrity of the system. Users of a decentralized application could suffer massive losses if a flaw in the code was discovered. But coding error-free is almost impossible, especially when future developments in the blockchain protocol must be taken into account. Furthermore, detecting bugs in smart contracts is still quite a difficult task, in part due to the lack of standards for this nascent technology. In order to address code bugs and technical errors, third-party audits and insurance systems, regulation in the form of risk management procedures, capital buffers, and consumer protection could be considered.
Further technical risks relate to the underlying blockchain protocol (settlement layer). The Ethereum blockchain is at the heart of almost all relevant DeFi projects. Therefore transactions can remain in a pending state if this network gets congested, which results in market inefficiencies and information delays. These technical scalability issues tend to be closely linked to liquidity concerns. In this regard, Decentralized Finance is highly reliant on the Ethereum 2.0 update to resolve these technical issues, which is not expected to be implemented any time soon.
Usability risk: DeFi protocols, which are often unintuitive, complicated and designed for crypto-native users, pose a major weak point that is closely related to the technical implementation. In most products, the user is required to manage multiple tokens within its own, non-custodial wallets. As developers address technical and regulatory risks, they will also need to make the user experience of Decentralized Finance products a priority.
Centralization risks: Centralization problems occur in the form of the founding team, possible regulation or even necessary auxiliary services. In most cases, DeFi applications are developed by a team or company and are far from being truly decentralized. Although once established they generally aim to decentralize governance and decision making. Also the majority of Decentralized Finance applications currently depend on third-party, off-chain auxiliary services, like oracles that send and verify real-world data and submit this information to smart contracts. In order to introduce financial regulation, there will be a need for some level of responsibility and a competent counterpart, which could again result in a move back towards centralizing project administration. Incompatible views of responsibility and regulation may persist as long as many DeFi supporters remain committed to concepts around security by design in place of clearly defined regulatory responsibilities.
Liquidity risks: It is important to note that liquidity risk correlates with technical risk, namely the previously mentioned scalability and congestion issues related to the Ethereum platform. During times of crisis, Ethereum becomes so crowded that arbitrageurs and liquidity providers cannot keep prices consistent across exchanges. This causes massive dislocations on exchanges, which results in uncertainty and dropping markets. Liquidity shocks could be addressed with the Ethereum 2.0 update. This update is intended to improve latency and throughput. The situation could also be improved by more experienced and powerful arbitrageurs and liquidity providers with access to all major cryptocurrency exchanges.
Regulation risk: Most jurisdictions do not require a license for decentralized projects, regardless of where the end user is located. In order to carry out financial regulation, there will necessarily be a responsible, competent counterpart. This implies that truly decentralized governance and decision-making for Decentralized Finance products will not be feasible. A possible solution could be the so-called ‘embedded supervision’ by the Bank for International Settlements. By reading the market’s ledger as an active participant in the DeFi infrastructure, financial authorities would be able to automatically monitor compliance with regulatory goals. This includes the ability to intervene or shut down a decentralized project.
As we conclude this chapter of DeFi’s story, we would like to reveal some more thoughts on what DeFi needs in order to achieve the next majority step towards mass adoption.
Tackling technical and regulatory risks that are closely followed by the usability risk ranks high on the expert’s to-do list towards mass adoption.
‘To start the second phase of DeFi mass adoption, we need solutions that simplify onboarding and use DApps that are spread across different chains and scaling solutions.’⁴
— Ahmed Al-Balaghi | Biconomy
‘Across DeFi, Anti-Money Laundering (AML) solutions and wallets with inbuilt KYC and cross border rules checks will help to increase institutional exposure in the year ahead.’⁴
— Rachid Ajaja | AllianceBlock
Bringing more traditional financial institutions to the table could play a vital role in the further establishment of Decentralized Finance. In this case the financial sector could utilize DeFi’s unique infrastructure, ‘DeFi-as-a-service’. Teaming up traditional and new players has been proven to be effective. Even if the example is not entirely comparable, banks partner with Fintechs like NeoBrokers or peer-to-peer lenders. The so-called ‘whitelabel banking’ is therefore equivalent to banking-as-a-service, where banks make their APIs available to third parties to let them create their own financial products on an existing infrastructure. By offering white label banking services, fintechs and third parties can offer a sleek, company-branded frontend, while utilizing an established bank’s license, regulatory compliance, and technology to provide services that rival those of major financial institutions.
However, Decentralized Finance, i.e. a low cost structure, a minimum number of intermediaries, and a high level of automation, could open up new markets.
‘The next decade, he said, will see a billion people, many of them unbanked, get onboarded to financial markets for the first time ever via DeFi applications.’⁴
— Alex Tapscott | Ninepoint Digital Assets Group
Micropayments (payments under a cent) or small scale loans and insurance could be a viable target, as well as pretty much every financial product that has been too expensive for the traditional financial ecosystem.
If combined with wallets for KYC, this could lead to leapfrogging financial systems in less developed countries. Why not just jump right into a more decentralized financial system without going through the intermediate steps first?
Conclusion
In summary, we agree that key factors for the mass adoption of DeFi include a simple onboarding process, a better user experience, safety and the transmission of value and information between different blockchain networks.
In other words: ‘Most of the world has never used a DeFi product. It is up to the entrepreneurs and businesses to build the software tools that make DeFi easy, safe, and useful enough for more people to want to get involved.’⁴
— Roger Ver | Bitcoin.com
We believe that the DeFi’s relatively young story does not end here. Additional characters including further DeFi projects and more central players from institutions to regulators will also join in. In analogy to Part 1 we once more need to conclude with
DeFi’s story is to be continued…
[1]: DefiLlama. (accessed: February 12, 2022 at 18:30h). ‘Overview’
[2]: Jonathan Knegtel. (published: December 2, 2021 on BLOCKDATA). ‘Crypto Banks: The intersection of traditional finance and DeFi?’
[3]: Benedikt Eikmanns, Prof. Dr. Isabell Welpe, Prof. Dr. Philipp Sandner. (published: February 4, 2022 on Forbes). ‘Decentralized Finance Will Change Your Understanding Of Financial Systems’
[4]:Vijay Anand. (published: January 6, 2022 on CNBCTV18). ‘Mass adoption, regulation, other key trends: What’s in store for DeFi in 2022?’
