icon
menu menu
Insights |10.03.2022

DeFi: blockchain potential to disrupt traditional finance

For the past decade, the financial sector has been undergoing fundamental change, led by newcomers such as Revolut, a fintech company offering FX at almost no fees and instant payments, or Robinhood, a retail trading platform. Their recipe for success? Offering user-friendly apps, empowered by artificial intelligence, new business models, and to make financial services cheaper, more accessible, and even fun. The global Fintech ecosystem is expected to reach a market capitalization of over $324 trillion by 2026. [1] While Fintechs like Revolut and Robinhood continue to disrupt the financial industry, they still rely on financial intermediaries and legacy banking infrastructure. When paying with your credit card for your groceries at the supermarket or a coffee at the restaurant, several financial institutions sit between you and the business, with control over the transaction. While proponents argue that intermediaries make transactions safe and ensure the stability of financial markets, innovators see them as costly, inefficient, and prone to mismanagement. Enter the recent advances in blockchain technology innovation. Decentralised Finance (DeFi), a sub-segment of the evolving crypto space seeks to remove all those points of centralized control or authority for virtually any kind of financial service.  

What is Decentralised Finance (DeFi)?  

DeFi is an ecosystem of blockchain-enabled products and services that “disintermediates” finance by using public ledgers and autonomous code-based solutions (“smart contracts”) instead of third-party mediators. With DeFi, anyone can lend, borrow, send, or trade blockchain-based assets using easily downloadable wallets without having to use a bank or broker. [2]  

Creating a decentralised financial system was already the idea behind Bitcoin, a peer-to-peer payment system. However, as revolutionary as Bitcoin may have been, its field of application is limited, as it only decentralises "payments" and serves as a store of value. In that sense, Ethereum is fundamentally different. Thanks to this multipurpose blockchain, over 1000 companies and many more projects have emerged, disrupting an increasing number of financial services, like borrowing, lending, insurance offerings, exchanging, and trading including settlement, to name a few. In 2021, the total wealth locked in DeFi has surpassed $100 billion and increased significantly in value, with the majority of DeFi ‘blue-chip tokens’ outperforming Bitcoin. [3] Reason enough to examine the individual trends that make up DeFi. 

  Return of BTC, ETH, UNI, AAVE, COMP, SUSHI, SNX, CRV, YFI in 2021.png (862 KB)

 

















  Graph 1: Return of BTC, ETH, UNI, AAVE, COMP, SUSHI, SNX, CRV, YFI in 2021 [3

 

Decentralised lending and borrowing  

Decentralised lending and borrowing are one of the main pillars of DeFi. In 2021 this market has seen an unstoppable growth in TVL (Total Value Locked) from $7.1 billion to $46.8 billion, which means a 559.2% increase. [3]

Lending and borrowing platforms let users supply and lock their funds into smart contracts from where other users may borrow them under a certain interest payable. Unlike centralised crypto platforms and traditional finance, the DeFi protocols do not require users to provide personal information and allow them to retain complete ‘self-custody’ of their assets (also called non-custodial wallets). The security of peer-to-peer lending is assured by over-collateralization of loans, which addresses the concerns of potential default of repayment and excessive volatility of cryptocurrencies as collateral. While providing more assets as collateral than you borrow might seem counterintuitive at the first glance. But DeFi platforms are often used for speculation and trading. For example, an investor might want to borrow DAI (a stablecoin pegged to the US dollar) and lock ETH as collateral with the expectation that ETH appreciates over time and that he may realize trading gains with the borrowed DAI, allowing him to settle the loan with the realized gains and not lose access to any of his assets. [4]  

For the lenders, the incentives for providing loans are interest gains on the contributed assets to the platform which exceed yields on traditional lending. The absence of a central authority that provides liquidity for the platform to operate and issue loans distinguishes decentralized protocols from traditional finance; instead, they rely on and incentivize crypto investors to provide liquidity using their funds. [5] The interest rates differ significantly depending on the platform and tokens locked and average at 2%-7% for well-established tokens on platforms like Compound and Aave and rise up to 70% APY or even higher in other cases. [6] Given the negative interest rate environment in traditional finance, DeFi offers significantly better depositing conditions but also comes with a higher risk. Over $2.3 billion in cryptocurrency were stolen in 2021,  up from $77 million in 2020, which resulted from the inefficiencies of some DeFi protocols and vulnerability of smart contracts to hacking, loan platforms accounting for 60% of the total loss. [7], [3]  

Nevetherless, observers believe that these are the teething problems of these nascent use cases and that the resilience of these platforms will increase. Because the industry is still in its infancy, the initial adopters are on the steep learning curve in terms of coding and solving bugs and security vulnerabilities, which is projected to grow in tandem with the rate of adoption of services and user knowledge in the new industry. In recent months, there has also been an expansion of the DeFi ecosystem, with an increasing number of security protocols (such as HAPI) advocating for cyber security techniques to be widely employed on the blockchain. 

Decentralised exchanges (DEX)  

DEXes are peer-to-peer marketplaces where cryptocurrency traders make transaction directly amongst each other instead of handling it over an intermediary with a centralised order book. The trading mechanism is based on "liquidity pools," in which investors delegate their crypto in exchange for interest-like incentives, similar to lending protocols. The trade appears to users as a straight exchange of two assets, but behind the scenes, Automated Market Makers (AMM) maintains pools of different assets, handling the pricing and distribution of these assets in an automated way based on supply and demand. Along with the increase of assets in the pool,  liquidity rises as well and makes trading on DEX easier. Automated Market Makers are protocols, using smart contracts with an autonomous trading mechanism based on mathematical formulas, replacing order matching systems and traditional order books. Thanks to AMM protocols you do not need another trader to match your transaction. Instead, you are trading with a smart contract, making your transaction peer-to-contract with the liquidity pool, not peer-to-peer as it seems to be, where the bid or ask price is determined by the mathematical equation. [8

Uniswap was one of the first exchanges in the DeFi sector and now accounts for the majority of total DEX volume, which peaked at 162.8 billion in May 2021 and later that year in September 2021 in between even exceeded the 24h trading volume of Coinbase, a centralised crypto exchange. [9] New players are also entering the market, such as Curve, which provides a steady and low-risk yield due to its focus on stablecoins and has in this sense become the largest DEX by value in 2021, with $16.8 billion locked in. [3

 

  Share of DEX Volume.png (273 KB)  
  Graph 2: Share of DEX Volume Monthly [19  

Decentralised Asset Management (DAM or DeFi AM) 

Decentralised Asset Management allows the delegation of investment decisions to dedicated structured token products and infrastructure. It offers key advantages of DeFi and Web3, such as transparency, trustlessness, and flexible composability. [10] DeFi Asset Management ecosystems are driven and maintained by protocols, decentralised applications (dApps), decentralised autonomous organisations (DAOs), or individual fund managers. Those structured token products (such as indexes on certain tokens) are regulated by a set of rules, with the ability of continuous rebalancing, giving investors exposure to the best performing assets with assessing and minimizing the potentials risks. [11] Decentralised token indexes are new in the investment area, an example is the DeFi Pulse Index Token (DPI), a capitalization-weighted index that tracks the performance of decentralised financial assets across the market. [12]  

Another way to invest into the crypto-economy is through venture investment DAOs, which provide a simpler getaway to invest in these new ecosystems than traditional investment funds with their high entry thresholds. Investment-focused DAOs are communities of crypto-enthusiasts who invest their personal capital or parts of DAO’s treasury into early-stage crypto startups. For example, Global Coin Research (GCR), “a decentralised community of learners and investors in Web3“, has cumulatively invested in more than 30 deals, deploying over $31 million into blockchain applications, crypto, space travel, and biotech. [13]

Decentralised Asset Management enables access to crypto investments and financial token products to everyone, regardless of their investing proficiency level. Such offerings can be a real game-changer in the asset management space. It offers significant time-savings, especially for investors with limited knowledge of the DeFi space, who would have to spend days on extensive research on how to make the right investment decision, but also execute more complex transactions, which in such a volatile segment directly translates into the case “time is money”. We have to mention that the regulatory aspect of such applications will evolve over time, as with DeFi in general, and should certainly be monitored closely. 

Decentralised Insurance

The idea behind Decentralised Insurance is creating a risk pool where investors who serve as an insurer provide the capital to it, simultaneously sharing the risk among themselves in return for premiums (insurance fees). [14]

Decentralised Insurance aims to provide more transparency and reliability than traditional insurance solutions. Such systems imply an immediate self-execution when the predefined conditions included in a smart contract are met (event is confirmed to have taken place), without any communication between parties needed, nor exposure to human error, fraud, and malicious intent of the insurance company. Blockchain solutions allow transactions to be verified within minutes, which is substantially faster than traditional alternatives, and allows to reduce the role of parties involved in this process, lowering the price of such services and the barrier to entry for participants. [15] Another potential benefit may be the transmission of any type of digital evidence for underwriting, which might result in changes in pricing and the development of insurance products. [16] Decentralised Insurance allows to broaden the scope of the insurance products offered on chain – from flight delays and natural disasters such as a hurricane or the insurance of crop failure. For example, Etherisc provides blockchain-based insurance for such circumstances; their FlightDelay dApp autonomously controls the entire business process from policy application to underwriting and approval, including automatic detection of delayed flights, and subsequent payouts minutes after arrival. [17

While the DeFi sector generally took off to an astounding level throughout the past year, Decentralised Insurance is still at the very start. [3] As of February 2022, Total Value Locked (TVL) in insurance protocols stood at $1.06 billion, while in their all-time high in November 2021 reached $1.8 billion. [18] Considering the growing awareness of DeFi security challenges, this year might be marked by the further widening of insurance products and enlarged user base of main insurance protocols. 

What does all this mean for us? Decentralised finance has been growing exponentially over the last 2 years, increasing in number of innovative solutions and capital deployed, benefiting of short-comings in the traditional sector. The future of DeFi is actively being moulded, institutional investors slowly enter the space to capitalize on the efficiency improvements and profit opportunities in DeFi. As DeFi accelerates, discussions on regulatory implications intensify, but the same applies for DeFi’s role in the metaverse and integration of traditional finance into the new ecosystems. While a prediction is still difficult on which use case will make the breakthrough of mass-adoption and how DeFi will develop in general, it is safe to say that the DeFi infrastructure will continue to develop and increasingly challenge areas of the traditional financial world. These vast opportunities alone make DeFi assets central to diversifying an innovative (crypto) investment portfolio.