Where is DeFi Headed

Edward Wong
Oct 16 · 6 min read

DeFi platforms are gaining in popularity, particularly in lending and borrowing such as Compound and Curve. But is the DeFi craze already over?

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Disclaimer: The article is meant solely for educational purposes only and is not intended for use as an investment directive. By viewing any material or using the information within this page you agree that this is general education material and you will not hold any person or entity responsible for loss or damages resulting from the content.

The DeFi Index Perpetual Futures (DEFI-PERP), a basket of popular DeFi coins, is trading at about 1923 points at the time of this writing, which is about the level when it started its late August meteoric rise. The chart is trending towards some consolidation (lower) to go.

But if you are a fan of DeFi, this is actually a good thing as the spectacular rise in September was simply not sustainable, and would have led to inevitable bubble. This gives the industry time and space to do create real innovation and progress without being influenced by external hype.

A good indicator is that the total value locked (TVL) is stable near its all-time high of $11B. Unlike the DEFI-PERP index, TVL tracks how much external asset is locked into smart contracts. TVL is a better indicator of the health of the DeFi as it eliminates a lot of the speculative noise. Other more complex metrics are underway such as velocity which gauges crypto transactions and provides analysis on the where and how the currency is performing.

Is DeFi the same as Crypto

I often get asked if DeFi is synonymous with crypto to which I say No. The two are strongly correlated like banking and money. There are more formal definitions of crypto but basically it is currency that is based on blockchain and cryptography. Meanwhile DeFi is a financial system which facilitates the use of cryptos without an intermediary but instead is administered by computer code in the form of smart contracts. In fact, Ethereum, because of its smart contract platform and infrastructure is the real core of DeFi and not Bitcoin.

Meanwhile most of the DeFi assets are locked in borrowing/lending pools such as Compound and MakerDao, and in exchanges such as Curve and Uniswap. Other financial areas include derivatives (Synthetix), assets (Yearn), and payment (Lightning Network). Developments are underway in insurance, estate planning (Octowill), and tangible assets.

Wait, but how can tangible assets be digitized and transacted on the blockchain? Good question. Physical assets can be registered, and then tokenized. These tokens can then be sold (subscribed) as shared ownership. But why do this as traditional finance is already capable of doing this?

One word — liquidity. Real estate is notoriously illiquid. How long does real estate ownership transfer normally takes? Months, years? That is a lot time to undergo market risk just to complete the legal transaction of the sale, much less the time table for matching up buyers and sellers. In the end liquidity is just another term for efficiency, albeit a very important one.

DeFi and crypto are not synonymous as there are centralized exchanges (CEX) whereby assets in your account are held by the exchange for trading. DEX’s never hold the keys to your assets.

What was the Impetus for DeFi’s Rise?

I consider MakerDao’s introduction of the stablecoin Dai in late 2017 as a cornerstone of the DeFi revolution. Up until then crypto was still merely speculative in nature. But in late 2019 an unexpected thing happened. The covid-19 pandemic threatened major economic disruption on a global scale not seen since WW II.

Governments printed trillions of dollars in an effort to forestall economic collapse as a stimulus package while foregoing the threat of inflation. It’s difficult too early to say if this was a monetary mistake, but the crypto supporters cried foul and focused on a fiat doomsday spurring the interest in crypto and DeFi.

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Liquidity Liquidity Liquidity

By July of 2020, with the pandemic still tenaciously spreading, the conditions were ripe. Ever been to a dance and no one is dancing? Add some alcohol to the mix, and voilà, the party catalyzes very quickly. For DeFi that the popularity of the governance token was the catalyst, and the result was an immediate injection of liquidity. The Compound governance token, (COMP) was one of the earliest kindling but it was soon followed by Curve (CRV), and upstart Yam (YAM).

Is DeFi the New ICO?

There are elements of fraud-plagued ICO in DeFi. When project founders pull a pump and dump play and investors are left holding tokens seemingly weighed by anvils, then yes. But I am happy to say that many of the DeFi platforms are legitimate are intended to provide service and efficiency.

Governance tokens are popular, but industry players speaking to Cryptonews.com warned they come with a number of problems that will have to be solved over time. These include such problems as the concentration of governance tokens in the hands of a few holders, as well as the potential unsustainability of yield farming using governance tokens.

Here are the things to watch for when you contemplate investing with DeFi.

Lumpy Distribution of Tokens

Concentrated number of tokens in a few hands is not necessarily a problem as least not in the early stages of a project’s life. Wait until the project matures a bit and the tokens are distributed more evenly. If the platform still thrives, chances that it was not planned as a pump and dump scheme.

The early stage requires strong incentives to the founders and core team to navigate the project into a success, whether its technical, governance, or marketing for liquidity. But at some point, there needs to be a strong diversification from the core group in order for the project to be viably healthy. And it’s not just the founding group that needs to give up heavy ownership, the distribution needs to fairly evened out to prevent a hostile and potentially fraudulent mutiny of the project.

When is it deem to be safe to invest depends on your risk tolerance and your craving for high returns. It’s a tradeoff. I am a fan of principal preservation although I understand adrenaline junkies.

Value Instability

The mention of liquidity mining, yield farming brings us to another problem faced by governance tokens and the platforms using them. Yield farming returns were skyrocketing and simply were not sustainable. You can only defy gravity for so long.

Because of yield farming, we may potentially encounter a situation where debtors are unable to repay loans, causing a deficit in a particular governance token. Such a deficit could undermine the stability of a platform.

Token holders of lending platform, Aave, can stake their AAVE in the protocol Safety Module to help secure the protocol. In the case of a shortfall event, up to 30% of the stakes can be used to cover the deficit. In exchange for securing the protocol, holders earn Staking Incentives in the form of additional AAVE.

Poorly Defined Governance

A project’s governance is akin to the constitution — the governing rules of a project’s bylaws which effectively manages its operation and maintenance. Administered by the code of its smart contracts it’s what differentiates one platform over another. Although it’s quite easy to clone another successful project, e.g. SushiSwap’s attempt to copy over Uniswap, but that’s another story and an interesting one.

Issues such as how tokens are distributed, how fees are assessed, and voting issues just to name a few are critical in its sustainability just like the laws of nation. The quality and suitability of a platform’s governance is a difficult one to gauge, especially since the industry as a whole is still early and there is not yet a massive adoption.

Conclusion

I have weathered enough abysmal failures and crisis in my life but I believe in the potential of DeFi. Its promises are still unfilled but I am reminded the DeFi industry is still in its infancy. The breather for now will allow for sanity to help stabilize and plan for more innovations. At least gas (gwei) prices have dropped.

Yet innovations are progressing rapidly in areas such as security, usability, scalability just to name a few. Regulatory body is undergoing planning stages and is difficult to predict. The growth side is that institutional players are getting ready to enter, although at a cautious foray as balance to their existing position in traditional finance.

My suggestion is to take your time and invest in learning. There is plenty of time to invest and a lot of development is still ongoing. Be safe!

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