What did we learn during SCB10X’s REDeFiNE TOMORROW 2021
by Tanwa Arpornthip, Blockchain Advisor of SCB 10X and Mukaya (Tai) Panich, CIO of SCB 10X
“DeFi, by definition, cannot be fully regulated. Instead, there needs to be a framework for how DeFi can be integrated with the rest of the financial ecosystem.” — Dr. Arak Sutivong CEO of SCB10X
Last year, during the REDeFiNE TOMORROW 2020, it was clear to everyone that DeFi is a fast-growing space. Since then, the growth of DeFi has exceeded even those high expectations — growing from $13B in Total Value Locked (or assets in the system) at the end of 2020 to $126B today, 10x in the span of 8 months. The number of users has gone from 1 million at the end of 2020 to more than 3 million today. In addition to an increase in the number of users, capital, and innovation in the space, the biggest change we have started to see is the participation of institutions in DeFi. To keep growing, DeFi must improve its capacity, expand its use cases, and improve its infrastructure. How to fund the next phase of growth and attract more talent will also be important factors. Additionally, non-financial factors that could shape the acceptance of DeFi, such as ESG and regulations need to be addressed as well.
Increased Institution Adoption
Even as a nascent technology, DeFi has already attracted significant institution adoption. A few indicators exemplifying this shift include changing institutions’ behavior and increased investor interest.
Diogo Mónica, Co-Founder and President of Anchorage, pointed out the changing behavior of his institutional customers when using Anchorage’s custody solutions. In 2017, their clients such as banks and fintech companies relied on Anchorage to suggest available channels to interact with crypto. More recently, banks and fintech companies have been more active and faster moving than Anchorage would have ever expected. Rather than waiting for Anchorage to suggest available channels and applications, they often come to Anchorage with different use cases to improve their traditional business with crypto tech stacks that Anchorage had never thought of.
Simultaneously, as DeFi becoming more mature, it attracts more investors’ interest. Robert Leshner, Founder and CEO of Compound, suggested that the longevity of some protocols has shown that decentralized smart contract can work safely and function at scale. The long track record of many blue chip DeFi protocols, such as Compound, Aave, Curve, Synthetix, has boosted interest from investors even further. The space has seen tremendous injection of new investment, both in terms of capital and the total number of players. The most notable being A16Z, that has raised another $2.2 billion fund to invest in crypto networks and blockchain technology. This is their third fund focusing solely on crypto, DeFi, and blockchain, as pointed out by both Jason Choi of Spartan Group and Michael Anderson of Framework Ventures. Ben Forman of Parafi Capital also emphasized that A16Z’s crypto fund is now bigger than its non-crypto funds, highlighting how popular crypto space has attracted interest especially among institutions, pension funds and endowments.
Stimulating further growth
The increased number of players in DeFi is stressing the existing technology and infrastructure. To stimulate further growth, DeFi has to improve its capacity, introduce more use cases, and connect its liquidity with TradFi (Traditional Finance) markets.
Capacity improvements in both the transaction speed and transaction fee will help scale DeFi to support more adoption. To this end, multiple solutions are being released. Each has its own strengths and weaknesses. All solutions can generally be categorized into layer 1 or layer 2 solutions. A layer-1 solution (L1) is an implementation of a new blockchain that either competes with existing solutions or enhance them (sidechain). An L1 solution improves upon existing ones by introducing new technologies. For example, Fantom introduced parallel transaction processing through its asynchronous Byzantine fault tolerance (aBFT) consensus algorithm. Solana invented proof-of-history, a method to synchronize clock in a decentralized system without having to relying on consensus.
On the other hand, a layer-2 solution (L2) is not a new blockchain. An L2 solution is typically a new type of cryptographic algorithms or transaction bundling (netting) built on top of existing blockchains. For example, Arbitrum uses a transaction bundling technique called optimistic roll-up to reduce the number of transactions. The most ambitious scaling solutions, such as Polygon, aims to incorporate both L1 and L2 solutions to maximize the throughput of the system.
Only increasing capacity is not enough. For DeFi to gain more adoption, more use cases for DeFi are needed. Multiple approaches have been simultaneously explored. Centralized and decentralized stablecoins, such as USDC and Terra, allow users to interact with familiar and price-stable assets. The introduction of stablecoins has dramatically increase the liquidity of the entire space, as well as enabling frictionless and permissionless cross-border payments. In term of institutional DeFi, Compound and Aave have introduced new products targeting institutions. Compound has introduced Compound Treasury, a 4% fixed-interest product that abstracts away risk and complexity from a protocol and replace with simple process — dollar in, dollar out. Compound Treasury aims to attract financial institutions and fintech companies that have excess cash in their treasury. Aave, on the other hand, approaches institutional DeFi in a different way via Aave Pro, by creating KYC/AML permissioned pools (Aave Pro’s pool), so institutions can do lending/borrowing with counterparties that have passed KYC/AML and have been whitelisted into the pool.
Non-fungible tokens (NFT) enable an expression of scarcity for digital collectibles. As a result, digital collectibles become a new asset class that have meaningful impacts in various areas. Artwork NFTs have increased liquidity through online marketplaces, such as OpenSea and Rarible. In gaming, Illuvium is planning on decentralizing game development process to include community feedback through the use of NFTs. Axie Infinity successfully introduced a new business model for NFT game called ‘play-to-earn’, which was made possible by a combination of NFTs and in-game cryptocurrency. According to OpenSea, going forward, NFTs can be used for music and event ticketing applications, and to create experiences events and experiences around them, something that wasn’t feasible before.
Another possible use case is the connection of DeFi markets to TradFi markets for trading of crypto derivatives, synthetic stocks, through the combination of DeFi protocols (Injective), synthetic assets (Terra, Synthetix), and price oracles (Band protocol).
Infrastructure for DeFi
Obviously, the support infrastructure needs to keep pace with the breakneck speed at which the space is developing. Four areas are dominant: custody, operational intelligence, investment management and cross-chain communication.
A custody solution can be further decentralized with better security using advanced cryptographic technology. Fireblocks has successfully implemented Multi-Party Computation (MPC) in its custody stack. The technology allows fine-tuning of asset custodian policies to satisfy compliance and corporate needs. In institutional DeFi initiatives, Fireblocks, is the chosen custody partner for both Compound Treasury and Aave Pro. Leveraging its MPC technology, Fireblocks can help DeFi protocol like Aave to implement whitelist/blacklist addresses of institutions after KYC/AML process into Aave Pro’s permissioned pool.
Operationally, blockchain transactions can be made more secure by closely monitoring the consensus layer, as is done by Metrika, and employing a more responsive run-time security monitor, as is done by OpenZeppelin. Lastly, market risks can be reduced by having good portfolio management dashboard/information services tool & data aggregation tool for monitoring portfolio and investment such as Ape Board and CoinGecko.
Fortunately, funding, the oil that lubricates it all, comes from many sources. Both endogenous funding (funding within an ecosystem) and exogenous funding (funding across different ecosystems) are available. Many protocols use part of their own equity to fund development in the form of ecosystem funds (Algorand, Celo, Terra, Solana). Some successful platforms, such as Alpha Finance, act as incubators for newer protocols in exchange for equity. Some VC funds like Arrington Capital launched a new fund focusing on specific blockchain, Algorand in this case, to fund the startups only in that particular blockchain ecosystem.
Non-financial factors are also another major area of development. Environmental concerns from blockchain energy usage have been widely discussed. Some newer ecosystems, notably Algorand and Celo, aim to reduce their carbon footprints through a combination of more modern technology and/or trading of carbon credits within their own ecosystems.
Another issue in DeFi right now is limited interoperability among different blockchains. Currently different blockchains are solving specific problems within their own ecosystem. DeFi space today is similar to the internet in the early 1990s when it was just a number of intranets run by companies, universities and governments, with limited interaction across the different intranets. The invention of the World Wide Web enabled “the Internet”, the global network. It is likely that we are at the cusp of cross-chain interoperability in DeFi — to make DeFi industry becoming “the Internet”. At this moment, there is a lot of inefficiency as assets are being used mostly within their native ecosystems and cannot be transferred for use in another blockchain easily, leave alone information transfer. Axelar aims to solve this issue by facilitating dynamic bridge which routes and deliver asset and information across blockchain networks with different consensus rules, smart contract languages, software stacks and governance mechanism. This will allow more efficient use of assets and information across different blockchains. Ape Board is also designed to support blockchain interoperability — currently users can use Ape Board to track their portfolio and assets in 5 blockchains — Ethereum, Terra, BSC, Solana, Polygon.
Regulatory responses
While institutional adoption signifies more acceptance for DeFi, the breakneck speed at which the space has moved has attracted the attention of regulators around the world. In general, all players in the space should work toward more compliance in different jurisdictions. And it is very likely that since the middle of the year we have entered into the period of more regulations and scrutiny by regulators on crypto and DeFi space, and this will continue to stay.
CZ, Founder and CEO of Binance, who had been adamant in the past that his company has no headquarter, indicated that Binance is moving toward more compliance. In the near future, Binance is looking to establish regional headquarters all over the world to interact with regulators in manner familiar to them. More efforts including hiring ex-regulators are being pursued. Sam Bankman-Fried, Co-Founder and CEO of FTX expressed similar attitude and confirmed that FTX will apply for any relevant licenses in all jurisdictions. He showed strong interest in wanting to work with regulators and be responsive to questions and request in order to build out regulatory regime for crypto industry (especially in crypto derivatives). Furthermore, FTX has spearheaded more marketing partnerships recently to gain more public acceptance.
From DeFi protocols’ perspectives, the best defense against punitive regulatory pressure is to be fully decentralized. Michael Egorov, Founder and CEO of Curve suggested that a fully decentralized protocol can withstand regulatory pressure better because the protocol wouldn’t rely on any single entity to operate. Similar sentiments were expressed by other major protocols during the summit. A fully decentralized protocol brings forth a trust in code rather than entities. Both anonymous founders from the summit, 0xMaki of Sushiswap and Scoopy Trooples of Alchemix, reflect the importance of decentralized development when they said that they want their protocols to stay fully functional once they leave the projects.
At the same time, a fully decentralized protocol does not necessarily mean circumventing regulations. Smart contracts can have built-in monitoring systems, with the aid of RegTech companies such as Elliptic, to make sure users comply to existing regulations. A decentralized risk governance model, such as the one being explored by Synthetix for its 8-member Spartan Council, gives enough flexibility to any protocols to respond to changing regulations.
DeFi is eating the world
All eyes are on further disruption that DeFi will bring in the future. Even now, DeFi has already replaced traditional solutions in some areas that it clearly outshines, such as providing liquidity for long-tail assets. However, this does not mean that DeFi will replace traditional finance. Rather, there is a spectrum of financial markets that goes all the way from DeFi-dominated to TradFi-dominated use cases. In the middle of the spectrum is where TradFi and DeFi interface. DeFi is here to stay and there are areas that will be greatly disrupted by its growth. Existing players should pay close attention to, participate in, and reap the benefits from DeFi. The integration of DeFi into the rest of the financial ecosystem is not a question of if, but when.
The video replay link to the 33 sessions (30 minutes/session) of REDeFiNE TOMORROW 2021 is can be found on our Youtube channel.
