Brioni-suited investment bankers and executives no longer dominate finance. Instead, we now have an eclectic group of characters overseeing an explosion of innovation within this space (while also trying to get rid of the incumbents altogether).
Decentralized finance (DeFi) is essentially a digital financial infrastructure that (in theory) eliminates the need for a centralized authority. So, you don’t need a government agency or a central bank to monitor and approve transactions.
This concept has quickly gained traction, and Defi had a seminal year in 2020. According to Defi Llama, the ecosystem grew from $700 million in Total Value Locked (TVL) in December 2019 to $20 billion at the end of December 2020. Today, its value is hovering around $196.8 billion.
What is decentralized finance?
DeFi is essentially an umbrella term for a wide range of digital financial services innovations closely intertwined with the blockchain. As such, no single entity can ever alter or exert control over the ledger of transactions.
This means that using decentralized apps or dApps, just about anyone can borrow, exchange, lend, or trade directly without involving third parties. All of this is enabled by blockchain technologies and, of course, smart contracts.
There is growing optimism within this space that DeFi will eventually disrupt and replace traditional financial systems. However, at present, DeFi only represents a fraction of the trillions of assets held by conventional financial institutions.
Like the world before e-commerce, we’re nowhere close to replacing old-school economic models, but we certainly might get there. So, what’s next for DeFi? Will 2022 be the year that DeFi protocols go mainstream? Let’s take a look.
DeFi will go mainstream with explosive growth
Although the markets are down (and many projects are far off their all-time highs) at the time of writing, we certainly expect explosive growth in the months ahead. With substantial investment pouring in from both institutional and retail investors, you can expect a steady rise in TVL and users, and you can bet that scaling and infrastructure solutions will accelerate. At the same time, the trend moves towards alternative protocols.
Right now, access to the addressable market that’s in the trillions is still a challenge for non-crypto natives. As such, it has been dominated over the last couple of years by smart money.
However, access will become easier, and adoption will accelerate. As efforts to improve identity-focused know your customer (KYC) and anti-money laundering (AML) protocols and regulations get better, various areas surrounding stablecoins will also be optimized.
Over the last couple of years, banks have also experimented extensively with digital ledgers. For example, HSBC and Wells Fargo recently started using the blockchain to settle bilateral foreign currency trades. There’s a lot more going on from an institutional perspective, and we can expect to see the fruits of their labor in the months ahead.
Crypto-native DAOs will boost investments
Experts predict that decentralized autonomous organizations (DAOs) will boost investments to diversify treasuries this year. This approach will help reward their growing communities and help attract more capital from all walks of life, including venture capital.
As DeFi has something for everyone, many can expect to get a piece of the pie (minimizing their fears of missing out). Some even claim that 2022 will be the year of the DAO. While it all might sound like a lot of hot air and hype, it’s the next logical step.
For example, we can build a “smart organization” through a trust-building process that’s bundled in a series of smart contracts. In this scenario, predefined inputs will dictate everything from operations, management, inventory control, pricing, and more.
Just as businesses operate on simple inputs such as the cost of raw material, manufacturing costs, level of interest in the product, and shipping and logistics costs, the same can be done with predetermined inputs.
However, unlike traditional business models, the DAO eliminates managers who tend to make bad decisions, making it even more attractive to investors. When the DAO calls the shots, investors are better protected from business owners who can make suboptimal decisions because of potential personal gains, nepotism (for example, switching to a higher-cost shipping company because the owner of the new company is related to the CEO), and so on.
With a DAO, the whole business can be run autonomously, powered by a series of smart contracts. For example, whenever a particular line of products fails to sell, production automatically decreases and maybe the price as well (or vice versa). All of the profits will accumulate and go directly to the DAO investors who made smart business decisions based on preset (and preapproved) smart contracts.
Decentralized exchanges will attract more users from traditional markets
Decentralized Exchanges or Dexes boast the most significant number of users within the DeFi space. Popular Dexes like Curve, Pancake Swap, and Uniswap (V2 and V3) are essentially liquidity providers who deploy capital to gain liquidity rewards and earn a share of trading fees.
Dexes attract users because of the availability of tokens they are interested in and market depth. It’s a lot like a positive feedback loop where more users equal more fees, which in turn attracts more liquidity. Whenever there are a high number of users, there is more revenue from fees to ensure liquidity in the protocol when the rewards expire.
Dexes can also provide liquidity to selected pools and use it later for governance when a more significant portion of the supply is issued. As these platforms evolve, they offer enhanced capital efficiency and more control over price ranges with concentrated liquidity.
Whenever these potions are aggregated together in a single pool, users can trade against a combined curve. This approach ensures adequate compensation to liquidity providers who take on all the risk. As such, it proves to be a highly attractive option for investors in traditional markets who are tiptoeing into the crypto space.
However, for DeFi to cement its place as the future of finance and realize all these predictions, security will be vital. When all of these dApps are stacked on top of each other, the stack is only going to be as strong as the weakest link. In theory, one security breach could bring the whole stack tumbling down. So, it’s critical to secure the infrastructure, audit smart contracts and oracles, and prove that the DeFi ecosystem is robust and safe from hacking.
DeFi protocols will also need to address rapidly growing transaction costs driven by (sometimes insane) Ethereum gas fees. When we have scenarios where the price to execute a transaction far exceeds the transaction itself, we have a serious problem. The good news is that Layer 2 solutions are entering the equation to help reduce gas fees.
In 2022, DeFi won’t be mainstream, but it’s safe to say that it will be bigger and better than ever before. Even with the looming threat from financial regulators and the Securities and Exchange Commission (SEC), DeFi can’t simply be brushed aside. However, the evolution of current regulations will determine if DeFi will play a significant role in global finance or if its impact will be muted.
