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Sector primer: Decentralised Finance (DeFi)

Sector primer: Decentralised Finance (DeFi)

Sector primers

This article is part of our sector indices primers. Find out more about this series here and get the full report here.

Definition

Decentralised finance (or DeFi) is the replication of various financial products and services on decentralised platforms, often with innovative enhancements that the technology enables.

Decentralised platforms have several advantages. They operate without the need to trust a central counterparty. The transactions are executed automatically or peer-to-peer, with a transparent, decentralised record. They are designed to preserve privacy. Overall, transacting on decentralised platforms removes the need for middlemen, with the potential for greater efficiency and cheaper fee models.

History

Some of the concepts that enabled DeFi projects predated the crypto market. For example, automated market making (AMM) systems were initially adopted in the early 1990s by Shearson Lehman Brothers and specialist firm ATD (later acquired by Citi). AMMs were created to eliminate the problems presented by human market makers, such as lags in price discovery, certain market manipulations and some of the slippage.

Users becoming “their own banks” figured into Bitcoin’s concept of decentralising finance. From the outset, the Bitcoin Core wallet allowed people to store their (crypto) money in a decentralised fashion rather than in bank accounts.

Although DeFi sector projects did not become widely used until 2020, the first DeFi project was proposed well beforehand, in 2013. The BitShares whitepaper described a decentralised platform to create stable assets backed by the platform’s native token and trade them peer-to-peer on the platform’s decentralised exchange. BitShares went live in 2014. Although the platform was initially well received and experienced a revival of interest with the launch of version 2.0 of the platform in 2017, it has since been overtaken by other DeFi projects.

The first prominent DeFi project was Bancor, a decentralised exchange launched during the ICO boom in 2017, followed shortly thereafter by 0x (another decentralised exchange) and the launch of decentralised lender Aave, one of the most successful DeFi projects to date.

Innovation continued during the 2018-2019 crypto winter. During this period, leading decentralised exchange Uniswap launched its platform in late 2018, and Aave rebranded and significantly revamped its platform.

The institutionalisation of crypto was aided by DeFi, as it was the first crypto application sector to find a significant user base during what is referred to as the “DeFi summer” of 2020, and the number of DeFi projects grew rapidly.

Subsectors

Decentralised lending platforms and decentralised exchanges (DEXs) are currently the two main sub-sectors within DeFi. Decentralised brokers known as DEX aggregators have emerged to further serve the needs of crypto traders.

Decentralised alternatives to asset management have also gained prominence, including decentralised yield farming platforms, decentralised staking protocols and even decentralised venture capital.

Decentralised alternatives to various banking services are also being experimented with, and decentralised insurance is another promising subsector.

Decentralised asset creation is an additional prominent DeFi activity; for example, the maintenance of stable assets such as algorithmic and other decentralised stablecoins or wrapped (tokenized) assets, as well as derivatives.

Users

There are several ways users can interact with DeFi platforms.

Platforms are primarily used to address the same business needs as their traditional finance counterparts. For instance, the customers of DEXs are traders who may choose them as alternatives to centralised exchanges; the primary customers of decentralised lending platforms are the borrowers; and customers looking for insurance may choose decentralised insurance platforms. Other DeFi sub-sectors provide a parallel service, similar to their traditional finance counterparts.

Becoming the de facto providers of services is another way users can interact with DeFi platforms. In traditional finance, service providers such as banks, exchanges and insurance companies offer their skills, expertise, labour and capital to earn revenues. In a decentralised system, the skills and expertise are coded into the smart contracts that are freely available for use. The underlying blockchain protocols provide the labour and charge transaction fees. Users who choose to become liquidity providers furnish the capital to earn yields in a decentralised system. The primary users of the platforms pay the fees that generate the yields.

As most financial services involve risks, traditional providers such as commercial banks, investment banks, exchanges and lenders keep reserves commensurate with the risks. Regulators mandate some of these. The ability to backstop losses is also important on decentralised platforms; contributing to those reserves in exchange for yields is another way users can interact with DeFi protocols.

Opportunities & Challenges

The DeFi sector is still very young, and a good deal of product development and innovation lies ahead. The operational and economic models are still experimental and are continually being improved. Accordingly, much of the growth is still to come.

The service offerings from the DeFi sector are still very narrow and primarily serve the needs of the crypto market and crypto traders. Most of the lending is overcollateralised and is used mainly by traders to open leveraged or arbitrage positions. A few smaller DeFi lending platforms offer under or uncollateralised credit, and others also offer loans to real-world businesses and accept real-world assets as collateral. Most decentralised insurance products cover risks relating to DeFi platforms, such as hacks or exploits, stablecoin depegging or vulnerabilities in smart contracts. There are experimental efforts to offer real-world insurance for risks such as crop failures or flight delays, but these are marginal currently. The broadening of the service offerings will be a key catalyst for the next stage of growth.

Regulation can open the way to broad adoption, but it also poses a particular risk for DeFi projects. Regulators are extremely concerned about issues relating to financial stability, financial crimes (in particular, money laundering) and the protection of the general public. They are also concerned about direct competition to traditional financial products that is not subject to the same disclosure and capital requirements. However, regulation that seeks to remove anonymity raises concerns about privacy, and it would de facto require the introduction of a third party – exactly what DeFi set out to eliminate.

A current challenge for projects in the sector is that the revenues of most platforms at this early stage are too low to attract liquidity, and they are complemented from the projects’ treasuries. DeFi projects have not transitioned to a stable state where revenues sustain the platforms.

A related challenge is that liquidity can move quickly from platform to platform if incentives are offered. As projects in this young sector are looking to build market shares, ‘wars’ and ‘vampire attacks’ (sucking liquidity away from a competing platform) are not uncommon.

Tokenomics models pose a further challenge with regard to sharing the economics between liquidity providers, tokenholders and the needs of the platforms ( reserves and R&D budgets, for example).

The governance models are also relatively immature. Projects are typically governed by decentralised autonomous organisations (DAOs) where holders of the governance tokens vote. This structure has been criticised for being too decentralised and lacking accountability, as well as for being insufficiently decentralised, as a few large tokenholders control the votes in many cases.

As the transactions of DeFi applications are processed on the underlying blockchain the application is built on, they need to pay transaction fees to the underlying protocol. As Ethereum has the largest market share of DeFi applications, high transaction fees on Ethereum over the past couple of years have been an issue for DeFi protocols. This encouraged migration to other blockchains or the use of layer-2 scalability solutions for processing transactions.

Interoperability solutions have emerged to allow DeFi applications to be blockchain agnostic, but the bridges thus far have suffered proportionately more hacks than the actual DeFi protocols have.

As the sector matures, the percentage of hacks and exploits have been declining with respect to the volumes executed on DeFi protocols, but they remain a challenge.

Value drivers

As the sector evolves, the following fundamental value drivers merit attention:

  • New and expanding use cases that can broaden the DeFi user base
  • Actual user growth
  • Relative market share versus comparable businesses in traditional finance
  • Regulation can either enable the growth of the sector, or it can render certain activities uncommercial or even prohibited
  • How protocol revenues develop, whether they are sufficient for stable, long-term platform operations and how they are shared between liquidity providers and tokenholders
  • Successes and failures of decentralised governance among DeFi DAOs
  • Transaction costs and speed on the underlying protocols (including layer-2 solutions)
  • The incidence of hacks and exploits, the safeguards against them and the recovery rates for lost funds
  • The development of yields in traditional money markets relative to crypto yields

Disclaimer

This document is purely for educational purposes and has been issued by Sygnum Group. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a marketing communication. It does not constitute an offer or a recommendation to subscribe, purchase, sell or hold any security or financial instrument. It contains the opinions of Sygnum Group, as at the date of issue. These opinions and the information contained herein do not take into account an individual‘s specific circumstances, objectives, or needs. No representation is made that any investment or strategy is suitable or appropriate to individual circumstances or that any investment or strategy constitutes personalized investment advice to any investor. Therefore, you must verify the above and all other information provided in the document or otherwise review it with your external advisors. Some investment products and services, including custody, may be subject to legal restrictions or may not be available worldwide on an unrestricted basis. The information and analysis contained herein are based on sources considered as reliable. Sygnum Group uses its best efforts to ensure the timeliness, accuracy, and comprehensiveness of the information contained in this document. Nevertheless, all information indicated herein may change without notice.

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