How DeFi Takes Over the World

Stratos Technologies
Apr 27 · 7 min read

In August 2020, (also known as “DeFi summer”) 3 months after the term “DeFi” came into existence, $40 billion in capital was locked into Decentralized Finance (“DeFi”) protocols built on Ethereum, and nearly $100 billion of value had been created for project investors, founders, and liquidity providers. What precipitated this boom that seemingly came from nowhere? When is the next one going to happen?

First, let's observe the developments that have gotten us to where we are in DeFi. Next, we’ll use those observations to map what we think the next major technological milestones are and what the future will look like when we get there.

The Past

1. On-Ramps

On ramps created a way for investors to easily access crypto markets. Coinbase is the most well-known and really started to gain traction in 2017. Prior to this, people interested in crypto needed to use arcane methods to fund Bitcoin wallets and purchase crypto.

The result of accessibility was first a price increase in the core crypto assets, followed by a proliferation of “shitcoins” — cryptocurrencies with no immediate, discernable purpose. This price increase drew a large amount of initial attention and drove a stream of talented developers to begin working on the projects that would eventually become the first DeFi protocols.

2. Stable Coins

The next major development in DeFi was the stablecoin. The utilization of stablecoins grew in the shadows of the overall initial boom of DeFi summer 2020, but their existence was a large component facilitating this boom.

Initially, crypto participants had to stomach the volatility of digital assets as a necessary component of the ecosystem. The problem with volatility, besides the psychological toll it takes on asset owners, is that pretty much any reasonable yield on an asset pales in comparison to crypto’s historical volatility. In fiat terms, earning 8–20% APY on USD is nearly impossible from a liquid investment, but if that APY is denominated in ETH, which has had historical annualized volatility of well over 100%, the 8–20% APY that could be generated by lending ETH is a footnote to the potential gains or losses that could be expected by holding the ETH position itself.

Certainly, there is still demand for volatile digital asset lending and borrowing, as evidenced by the total value locked (TVL) on Compound and Aave. The point is that stablecoins gave market participants an explicit choice to endure volatility or not. The existence of this choice enabled DeFi participants to leave their capital within the DeFi ecosystem without an implicit requirement to stay long ETH or another volatile digital asset.

Stablecoins gave DeFi participants a base asset from which to build an edifice of risk-return from an investment perspective. More importantly, the introduction of stablecoins has created a low-risk platform for non-investors to use the productive features of DeFi like value transfer, lending, and borrowing.

The Future

The future of DeFi will inevitably lead to a generational shift from the fragmented, permission-based traditional finance system to the decentralized, permissionless ecosystem which is currently being built. This generational shift will begin when the primary users of the DeFi ecosystem transition from speculators and investors to consumers who leverage the new capabilities enabled by DeFi to improve their day-to-day lives through an accessible and transparent global financial infrastructure.

In our view, there are three technological advances on the horizon that will enable major breakthroughs in the usefulness of DeFi and unlock the transition to consumers. Just like the widespread adoption of crypto on-ramps and stablecoins, these breakthroughs will spur subsequent waves of development, adoption, and wealth creation for founders and investors. The ultimate beneficiaries of these developments will be end-users who are otherwise underserved by the traditional financial ecosystem.

3. Scaling solutions

The most immediate issue that needs to be solved in crypto is the cost of transacting. Since the beginning of this year, simple transaction fees have regularly hovered above $10, with more complex transactions (i.e. Uniswap) regularly being over $50. Simply put, the construct of the Ethereum virtual machine is not designed to handle the volume of transactions being pushed through the Ethereum network. Some point to this as a shortfall of DeFi, as if it is proof that DeFi is merely a toy object with no real-world uses. However, this is shortsighted. The fact that demand for Ethereum transactions has already outstripped the throughput capabilities of the original design only 5 years after its initial launch proves the potential demand and scale of DeFi applications. How long did it take for 56k modems or DSL to become outdated for most users in the early days of the internet?

DeFi continues to expand in scale and relevance, in spite of transaction fees that can cost hundreds of dollars to engage in trivial transfers of value or to commit simple smart contracts to the Ethereum blockchain. However, this is not sustainable.

Consider the ultimate promise of DeFi — an accessible and transparent global financial network. In order for this future potential to be fully realized, on-chain micropayments must be possible. According to 2019’s Federal Reserve Payments Study, the average credit card transaction was $89 and the average debit card transaction was $38. There are times where Ethereum transaction fees have eclipsed both these numbers.

This is the reason that most view DeFi as a speculative mechanism — because micropayments are impossible, real-world transactions are not economical to conduct on-chain, and thus the ecosystem must look inward. But not for long — new chain geometries like layer 2 and layer zero solutions will launch by the end of 2021.

Scaling solutions enable microtransactions.

Microtransactions enable mass consumer adoption, as the DeFi ecosystem becomes the fastest, lowest-cost avenue for moving value anywhere in the world. This leads to crypto wallets on every smartphone.

The presence of Crypto wallets on every smartphone will drive massive demand and liquidity into the system, on a global scale.

4. Identity

What happens when nearly every human on earth has a crypto wallet on their smartphone?

With the mass adoption of crypto wallets comes a need for an identity system that can determine which wallet is attached to which person and links that on-chain identity to both the on-chain and off-chain behaviors of that person.

With micropayments and identity, you can begin to create a global credit system, a global KYC/AML/AFAC system, and many more transformational capabilities that drive financial inclusion and wealth distribution.

Identity will extend beyond humans, to real-world legal entities and the internet of things, and the attributes of those things. This will enable a seamless flow of ownership, control, and assets between the real world and the internet.

5. Human judgment

The final piece is scaling human judgment in a decentralized way. Computers are great at most things, but sometimes human judgment is the best option for decision-making — observe the success of centaurs (humans + AIs) over all other intelligence constructs.

Blockchain technologies are undoubtedly the best way to solve computational problems frictionlessly and at scale.

Trustless problem solving using human judgment still has not been figured out by humanity — a trial by jury still involves a judge, and the jury selection process involves trusted validators.

Blockchain technologies will solve this by trustlessly importing human judgment through a decentralized base of properly incentivized human deciders. These self-selected deciders are able to prove their capacity for judgment through capital they choose to put at risk and correct prior judgments (facilitated by identity protocols.)

We’re developing the first system of this kind at Goldfinch Finance.

Regulation

Regulation will be the only element standing in the way.

As they say, a river will always flow to the low point, the only uncertainty is the path it chooses to get there.

Blockchain technologies are a river — it is impossible to keep their development from flowing. The only uncertainty is around where this development will take place geographically, which will be a byproduct of global regulatory bodies’ decisions.

There will likely be ebbs and flows in the strength of the river as some regulatory bodies move to curtail the propagation of blockchain technologies, but the flow will continue and regulatory bodies will ultimately adapt to the new possibilities the technology creates. The SEC is leading the way in providing necessary clarity around regulation of DeFi. Wyoming has recently announced that it will recognize Ethereum smart-contract addresses as owners of legal entities (LLCs).

End Game

There is no doubt in my mind that we will wind up with a global financial infrastructure supported by blockchain technologies, and that it will happen sooner than we think (10 years or less). Every person will interact with the global financial ecosystem directly from their personal computing device. The implications for consumer welfare via greater access to financial services and the broader world economy will be significant.

The only question, in our eyes, is whether this system exists in a state that is extra-governmental, or if it is controlled by the U.S. or China.

If you are interested in investing with Stratos Technologies, please email info@stratoslp.com. You can also visit our website to learn more and follow us on Twitter and LinkedIn.

Stratos Technologies

Founded in 2016, Stratos Technologies is a venture capital firm with expertise in financing, operating, and advising technology businesses. Since inception, the firm has executed over $300M in credit & equity transactions in high-growth, technology businesses around the globe.

Stratos Technologies

Written by

Rennick Palley, Founder and Chief Investment Officer of Stratos Technologies — stratoslp.com

Stratos Technologies

Founded in 2016, Stratos Technologies is a venture capital firm with expertise in financing, operating, and advising technology businesses. Since inception, the firm has executed over $300M in credit & equity transactions in high-growth, technology businesses around the globe.

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