Blockchain technology is disrupting every sector of the global economy with its limitless opportunities and innovative products. Decentralized finance is one of the sectors that has been trying to shake the traditional financial ecosystem. The multitude of DeFi applications emerging all over the fintech space has provided solutions, such as lending, staking, exchange of derivatives, among others.
The current craze is justified, as DeFi attempts to build an alternative to the rigid banking systems. Also, government regulation (or lack thereof) and a flawed financial infrastructure have allowed DeFi projects to blossom. However, the concept of DeFi has also faced several hurdles, such as liquidity issues and everyday usability, which have prevented it from moving into the mainstream financial market. Moreover, 32% of those who took part in a Blockfolio survey have no idea what DeFi is.
The DeFi market cap has exploded in the last few months, indicating the growing interest in this niche of the crypto industry. So, could this prove to be the financial revolution that the world has been waiting for?
DeFi numbers don’t lie
The latest statistics by DeFi Pulse indicate that over $7.7 billion is tied up in the DeFi market, with close to $4 billion added to the market cap in the last two months. Various DeFi projects and platforms have recorded outstanding growth. Compound, a decentralized lending protocol, has a current market cap of $540 million; however, it was only at around $100 million in mid-June.
Token Insight’s Q2 2020 report revealed that DeFi users have more than doubled from 100,000 to 230,000 since January 2020. However, industry experts are worried that the hype around these astronomical figures could be temporary because it might be based more on speculation rather than the use case application of DeFi products. Johnson Xu, the head of research at TokenInsight, told Cointelegraph:
“In the short term, the high-interest rate and the incentivized liquidity mining mechanism has created a hype in the space, which directly pushes up the DeFi market, resulting in a speculative push in the DeFi space. Without any further applications and use cases to be created in order to accrue meaningful value within the space, we believe the recent DeFi hype could be short-lived.”
Overall, there’s a number of factors in the DeFi ecosystem that are contributing to the radical growth of decentralized finance.
DeFi tokens are the craze right now in the crypto space, with new projects seeking to offer value to crypto users. According to DeFi Pulse’s token list, there are a variety of projects, most of which offer their native tokens. The increased adoption of DeFi products derives from the purchase of these tokens, especially those intended for lending and borrowing, such as Compound’s COMP token and Aave’s LEND.
Lending calls the shots when it comes to the rampant adoption of DeFi products. And rightfully so since the crypto loan industry is well past the $10-billion mark. Debt is an integral part of the financial economy, which is the driving force behind the increasing adoption of DeFi loan products. There’s also the benefit of earning interest for people on DeFi lending protocols. Vadim Koleoshkin, the chief operating officer of Zerion — a DeFi interface — told Cointelegraph:
“Lending is one of the easiest to understand financial instruments in the DeFi space. It promises to earn passive income on your assets protected by the collateral of debtors. Other products like AMM pools (Uniswap, Balancer, Mooniswap, Bancor), trading strategies (TokenSets, Melonport) or yield farming all have way more risks associated with both market conditions and complex smart contracts. However, even lending may not be 100% secure.”
DEXs surge in popularity
Since decentralized exchanges eliminate the need for middlemen, their popularity has increased steadily over the last few months. Decentralized platforms such as Curve, Uniswap and Bancor have recorded phenomenal growth. Uniswap’s daily trading volume recently surpassed that of Coinbase Pro since most of its operations are automated.
Increased liquidity and security of DEXs have made DeFi attractive, which has enhanced its adoption. These exchanges are finally seeing some remarkable volume as they ride the Defi mania.
Decentralized prediction markets and insurance
DeFi products are also being used by people to bet on or predict certain outcomes. Platforms such as Augur have attracted a large number of investors. At the moment, these DeFi platforms are used by investors to protect their assets against smart contract bugs. However, in the future, such products will expand into vehicle and natural disaster insurance.
The DeFi token economy is robust and has been thriving due to its incentivized structure that encourages market participation. Right now, one of the hottest tickets on the DeFi market is Compound’s COMP governance token, which has taken the idea of liquidity mining to a whole new level. With yield farming and staking, investors hope to reap the benefits by having COMP tokens, which allow them to make returns from different portfolios. Despite this, yield farming entails risks, as recently pointed out by Ethereum co-founder Vitalik Buterin.
Currently, lending protocol Aave is giving MakerDAO a run for its money since the latter is the king of the DeFi token market. LEND now holds the top position in the DeFi token list with the highest total volume locked. Additionally, governance tokens give investors the power to determine protocol changes, which may spell doom since most tokens are currently controlled by a handful of whales. That said, buying DeFi tokens can’t be compared to the 2017 ICO craze because most of the projects already have live products.
While DeFi tokens are an integral part of disrupting the financial sector, other key market makers have been slowly and steadily redefining the finance world. Platforms such as Uniswap provide the DeFi ecosystem with innovative mechanisms such as automated market making, which settles trade automatically. Others, like Augur, are based on a prediction protocol that lets you vote on event outcomes.
Challenges before going mainstream
Despite the buzz around DeFi, this niche of the crypto industry is still in its infancy, and there are still several things that have to be addressed before DeFi can move from its novice stage into a full-blown financial market shaper. A key concern regarding DeFi products is the vulnerability that comes with smart contracts. A case in point is the attack on the bZx protocol in March where a hacker took advantage of the system’s flash loans feature to exploit a flaw in the program. Buterin noted during a podcast episode of Unchained: “A lot of people are underestimating smart contract risk.”
Since most DeFi contracts are built on the Ethereum blockchain, the network’s high fees are a major challenge to the uptake of products. Responding to this issue, Koleoshkin noted: “DeFi allows you to access a range of financial products from anywhere in the world, but it is accessible to the people ready to pay tens of U.S. dollars for each operation.”
There’s also a major concern that the latest craze of yield farming is sending the wrong message about decentralized finance. The high-interest rates that are being offered could blind parties to the systematic risks facing the lending protocols. The focus should shift to other building blocks of the DeFi ecosystem, such as oracles for prediction markets, synthetic tokens and decentralized exchanges.
Improving the usability of DeFi products is necessary to make them intuitive and enjoyable for users. The protection and privacy of data, as well as addressing the issue of liquidity, should be the main focus of DeFi protocols to prevent loss of funds.
Additionally, ideas such as sustainable liquidity mining models will help cushion DeFi products from the effects of price volatility. The DeFi ecosystem also needs to solve the issue of interoperability among the networks to help drive adoption. For improved usability and liquidity, every smart contract and decentralized application should interact seamlessly with each other. Koleoshkin noted:
“The whole market is a playground for financial geeks who are way more comfortable to manage their wealth on their own rather than open a brokerage account. Still, the DeFi space is very fragmented, and there are many gaps in the market infrastructure that increase development and maintenance costs.”