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DeFi Bursts onto the Finance Scene - What is it and why does it matter?

DeFi was around in 2017 and was niche with a few people experimenting in 2019. Some had heard of it, but few people even understood what it was and its ramifications. The second half of 2020 was marked by a DeFi boom, and the total value locked in DeFi contracts surged 40x to $24 billion in December, from $600 million in January 2020 as many tried to ‘put their crypto to work’.

Toby Lewis of Novum Insights explains “2020 saw a launch of many Defi products which started slowly and then exploded as fiscal easing and governments printing and handing out record amounts of their own traditional fiat currencies drove investment. The ‘open-source’ nature of Defi creation of exchanges, borrowing, lending and ‘staking’ ( incentive-driven lock-up) meant that copying the entire code base of say ‘Uniswap’ and launching your own version was relatively easy for a skilled developer.”

This is the beginning of a powerful transformation enabled by automation and blockchain. Currently, middlemen such as brokers, dealers, lenders and custodians facilitate trading, lending, and deposit-taking. DeFi can now enable these activities without the middleman. Nisa Amoils explains, “Take the traditional financial services, distill them into their component rules and procedures, and convert them into self-executing code  on decentralized networks accessible to anyone with a computer and internet connection”. According to Outlier Ventures, DeFi encompasses 1. Issuance: Stable Tokens, Debt, Securities, Insurances, Non Fungible Tokens, 2. Trading: including Decentralised Exchanges, Derivatives, SWAPs, Prediction Markets; and Liquidity Relays; and 3. Ownership: Wallets; Baskets and Fund Management; and Payment Networks.

Some are already describing DeFi as the third wave of Blockchain. “The first crypto breakthrough was bitcoin, a currency followed by Ethereum, a decentralised computer with a currency. The third wave is DeFi, which, while associated with finance (decentralized finance), is in fact the establishment of autonomous, decentralized enterprises that will prove as pivotal to the future of our economies.” As Lee Schnieder pointed out “As the ability to intermingle trading of various asset classes on a single electronic venue becomes more pronounced, market structure will change before everyone’s eyes.”

Notably, DeFi Automated Market Making (AMM) capability has decreased the time to market for people and their ideas. The ERC 20 token has enabled anyone to create a token very quickly. An ambitious developer can spin up an idea on the Ethereum blockchain and test it in the market, almost overnight. People are beginning to realise that AMM is going to transform the creation of ideas and capital markets. The mechanism enabling people in a peer to peer way to lock up their capital in a smart contract and continuously provide a market, means that projects can develop and scale at phenomenal speed. Jesse Walden, Founder at Variant Fund, has called this - the Ownership Economy, where platforms are “not only built, operated, and funded by users - but owned by users too.”

Novum Insights highlight that apart from mouth watering names like Sushiswap, Pickle Finance and Cream Finance, much of the excitement has been driven by the attractive returns for providing liquidity. A liquidity pool is created and funded by liquidity providers(LPs) for both tokens of a trading pair. Take Uniswap, a leading Ethereum-based Decentralised Exchange with 49.4% market share which uses an algorithmic ‘constant product market maker’ model to both set prices and balance the liquidity pool. As a result, anyone can easily become an ‘LP’ by locking their any ERC20 token and an equivalent value of ETH to a pool. This can also be (perhaps a little alarmingly) a token they have just personally constructed.

None of this is without risk. The AMM model is still in its infancy, and there will be more innovative AMM models to come and each model with advantages and disadvantages.

AMMs face a significant risk of impermanent loss. As the prices of the tokens held in a pool are determined by an algorithm which adjusts the ratio of the tokens in the pool, if the ratio between the two tokens changes drastically after depositing them in the pool, there will be a high slippage. Some projects have come up with solutions to impermanent loss. Yield farming risks include liquidation risk, technical risk, price risk and more. The price of the token you put as a collateral to take out a loan could drop below the price of the loan. Smart contracts could be attacked. It is important for users to assess and manage their own risk level and choose the right exchange for themselves.

In response, it is expected to see a fast growth of ‘hedging strategy’ providers. DeFi insurance Nexus Mutual’s active cover amount sits at $136.5M and the most demanded protocols to be covered are Curve, RenVM, and Aave V1, according to Nexus Mutual Tracker.

Ethereum is the number one contributor to the rapid growth of DeFi, but Ethereum has challenges of scaling and increasing gas fees and a complicated but eagerly anticipated transition to ‘ETH2.0’ Blockchains such as Polkadot and Cosmos have recently attracted attention with greater customization, scalability and interoperability.

The Defi total value locked is predicted to exceed $100bn in 2021as users realise that returns can be ‘amplified’ with varying degrees of risk and return as they put their crypto to work. Questions remain about trust and governance, lack of regulatory frameworks, concerns over valuation, scalability and user experience, and a much higher level of individual responsibility is needed from the due diligence in understanding its operation or ensuring the right activity with the right assets is chosen.

This industry is in its infancy. 2020 has mainly been borrowing and lending. In 2021, we're going to see derivatives, and commercialised insurance schemes launched. It is reminiscent of the buzz of the internet boom, in the year 2000. This is the beginning of a powerful transformation enabled by automation and blockchain.

Download the full State of Crypto and Blockchain report by Novum Insights here.

*This article has been featured in City A.M.