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Over the last year, the decentralized finance space has been making waves in the financial sector, building on blockchain technology to decentralize a multitude of banking services. The adoption of DeFi services has been steadily on the rise, and all kinds of assets are making their way onto the blockchain.
With nonfungible tokens popularizing digital art ownership representations, blockchain technology is creeping into the most unexpected places, and DeFi is fuelling its expansion. These unique and sometimes quite valuable tokens are especially relevant today, with art galleries closed due to restrictions pertaining to the global pandemic and cultural experiences now taking place online more than ever before.
During 2020, DeFi saw an explosion in the kinds of ways liquidity can be generated, with marketplaces for financial products, community-based social and governance tokens, and unique art pieces. Today, a significant amount of Bitcoin (BTC) is used as a store of value, but that isn’t what it was created for. Slow transaction times, high fees and a history of rising value hinder Bitcoin’s use as a payments system, but that hasn’t stopped the blockchain industry from creating others.
The advent of programmable smart contracts catalyzed the formation of our modern decentralized finance ecosystem, making financial services accessible to anyone with an internet connection. The expensive overheads of centralized banks have made international transfers slow and uneconomical for most use cases. However, by implementing a set of interweaving protocols, decentralized finance delivers alternative ways of distributing value to different communities across the world.
The traditional financial system works for most, but it could be doing a lot better. While blockchain isn’t quite ready to take the mantle from it, today’s decentralized networks have big ambitions, and as access to digital assets continues to improve, people around the world are increasingly engaging with the global economy sans trusted intermediaries, banks or lawyers. With more development resources allocated to DeFi systems than ever before, blockchain is the next frontier for any financial services company worldwide.
Scattered but strong
The internet has changed how data and information flow across the world, and this evolution of communication channels has had a profound effect on the banking system. As the world begins to shift to platforms that offer quicker registrations, faster service and more reliable products, the ways of centralized banking stick out in stark contrast.
Smart contract platforms allow people to interact with several decentralized applications using a single financial identity. With nearly 2 billion people on the planet not having access to financial services, lowering the barrier for entry is in everyone’s best interests.
In fact, even some centralized banks have started offering cryptocurrency custodial services, allowing users to store their cryptocurrencies in a secure manner with a party that can be held responsible for its security. While this might seem like it goes against the ethos of decentralization and blockchain, centralized custodial services might actually be beneficial for the broader industry.
Brian Kerr, CEO of the Kava DeFi platform, told Cointelegraph: “To me, having a bank use Kava on the back end to deliver loans and great APYs safely to their users is a natural progression of banks, finance and the evolution of fintech services.”
According to Kerr, holding cryptocurrencies is much scarier for the average citizen than fiat, since transfers cannot be reversed, making errors all the more costly. “I believe banks supporting digital asset custody is a great step to making crypto available to mainstream users,” he said.
However, as fintech companies continue to improve their products and services to provide better experiences to the end-user, the current schema for development hasn’t been altered much in the last few decades. Furthermore, as pointed out by Anton Bukov, co-founder of the 1inch decentralized exchange aggregator, as banks start to provide huge amounts of stablecoin liquidity to DeFi platforms, APY for lending and borrowing will decrease in the future.
Over time, networks have evolved to cater to different needs, and with Web 3.0, blockchain isn’t just decentralizing power in financial systems; it’s redefining value. In the near future, these systems are likely set to grow stronger and will eventually be seen as a valuable proposition for all kinds of businesses.
Analyzing AMMs
The introduction of automated market makers was a critical factor contributing to both decentralized finance and blockchain’s overall growth during 2020. Before AMMs, decentralized exchanges weren’t nearly as popular as they are currently. Instead of using order books to match trades in a decentralized manner, AMMs make users trade with a smart contract, improving liquidity and removing counter-party risk.
With decentralized exchanges like Uniswap occasionally reporting volumes higher than Coinbase Pro, there’s talk of whether centralized exchanges are sustainable in the long run. However, while DEXs have certainly improved over the last couple of years, replacing order-book exchanges doesn’t appear to be on its agenda.
“Centralized exchanges will always have a leg up in terms of user experience, creativity and trust with their user base,” said Kerr, noting how centralized exchanges offer services that are essential to the space, such as fiat on-ramps, regulatory compliance and better mobile app user experiences.
While trading fees have become increasingly competitive, so too have the services offered by cryptocurrency exchanges. From initial exchange offerings and staking to lending and borrowing services, exchanges could begin to defend their positions by increasing margins from other lines of business and face competition from their decentralized counterparts. “Just as banks don’t earn on deposits, they earn on the back-end services and cross-selling of other financial products — so too will centralized exchanges as the industry advances,” Kerr said. Bukov added:
“Coinbase named DEXs as one of the biggest risk factors for their business during preparations for the upcoming IPO. I think they could try to compete in this space, too, while offering their own L1 solutions or DEXs, for example.”
In a nutshell, an AMM consists of token pair pools, where their ratio in the pool determines the price of the individual tokens. Uniswap is currently the most popular AMM DEX, allowing anyone to join liquidity pools for any token pair. This provides liquidity to the pools while pushing some risk to participants for a share of returns.
As AMMs become more and more complex, some platforms have even incorporated features such as multi-token liquidity pools and more efficient algorithms for calculating asset prices. Unlike IEOs, there are no gatekeepers preventing someone from launching a token or platform, and while this can be exploited by users with malicious intent, it could lead to some very interesting projects over the years to come.
Interoperability is in
While most DeFi applications currently run on Ethereum, interoperability is slowly becoming a reality. This will give developers the freedom to choose different platforms to best suit their individual decentralized applications. With platforms like Cosmos and the Substrate-based Polkadot, developers can now even create interoperable blockchains tailored to their application’s requirements.
Today, developers rely on monolithic layer-one blockchains that provide open smart contracting platforms. “These platforms try to do everything well and nothing great,” said the Kava CEO. “In the future with interoperability, these platforms will remain useful for prototyping, but developers will select the most specialized and optimized services for their app and use cases.”
One of the biggest trends of late 2020 was the heightened demand for access to Ethereum’s liquidity and economic activity on other blockchain-based protocols. From wrapped Bitcoin (wBTC) to blockchain-based data storage, the space has seen a surge in activity on cross-chain platforms.
For example, Kava built with the Cosmos framework has seen significant growth, offering collateralized loans and staking opportunities for various cryptocurrencies. The platform uses its Kava token for governance and to secure the network through staking.
Such governance tokens enable network participants to vote on critical parameters such as the system’s global debt limit, collateral ratio and savings rate. In cases where the system is undercollateralized, the Kava token even acts as a reserve currency to be minted and sold until the system is recollateralized.
Related: Ethereum network in a fee spin: Can the Berlin upgrade save the day?
Both Ethereum and Cosmos require a significantly higher number of validators per chain than Polkadot. Compared to Ethereum’s 111 validators per shard, Polkadot’s claim of offering equivalent security at a minimum of five validators per chain requires more analysis.
Polkadot’s low minimum number more easily allows for collusion between validators for individual parachains, and the DOT slashed from malicious validators is slashed from nominators as well. Along with the lack of a minimum stake requirement, this could lead to some risky situations from a nominator’s perspective.
Cross-chain crossroads
Decentralized finance’s growth has been unprecedented and overwhelming. Monthly DEX volumes have crossed $55 billion, which is also how much the total stablecoin market capitalization currently is. DeFi outstanding debt is over $9 billion, but decentralized finance is still a toddler against the broader financial services industry.
With fresh innovation constantly around the corner, there’s good reason to believe accessibility and variability among DeFi applications will improve with time. As gas costs on Ethereum continue to fluctuate, at times to prohibitive levels, blockchain projects are racing to create better scalability solutions such as layer-two protocols. Ethereum 2.0 promises to solve many of the issues currently faced by its predecessor, but how well the network will perform in practice will only be known in time.
Furthermore, as long as gas costs keep fluctuating, DeFi protocols will continue to attempt to poach users and, in turn, liquidity from Ethereum. Another problem the DeFi space faces as an infant industry is its reliance on an experienced user base. Today’s applications are usually designed for traders familiar with DeFi systems in mind and offer services that aren’t always useful to the average consumer, such as auditing tools and on-chain data oracles.
As the industry continues to extend its functions, projects are continually creating better utilities for DeFi tokens. Some platforms now even allow using nonfungible tokens as collateral for peer-to-peer loans, increasing the liquidity of these digital collectibles to the level of any other monetized asset.
“I believe strongly in the future of NFTs as a primitive or financial construct. However, NFTs today are mostly stupid,” said Kerr. While NFTs are incredibly powerful as a concept and despite bringing the power of blockchain technology to fields such as real estate and intellectual property, DeFi needs deep, liquid markets to consider a collateral asset useful. “It will be a long time before NFTs are useful as collateral in DeFi. By definition, NFT markets are very illiquid and thus make for horrible collateral,” he added.
According to 1inch co-founder Bukov: “Decentralized Finance projects should issue NFTs, sell them at auctions, and donate a significant part of profits to charity.” DeFi’s progress over the last few years shows promise for its future, but while DeFi has accomplished a lot in its brief ongoing lifespan, its best years are likely yet to come.
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