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The entire cryptocurrency space continues to evolve rapidly, surpassing the $3 trillion market cap for the first time in 2021. Furthermore, global blockchain spending has increased 7-fold in the past four years to an estimated $6.6 billion by 2021, and is expected to more than triple by 2024. That’s impressive considering the crypto industry’s seeds were sown with the launch of Bitcoin just over a decade ago.
Today, we have come a long way with the blockchain industry moving beyond just peer-to-peer transactions as various industries such as NFTs, GameFi, metaverse, and decentralized finance (DeFi) have emerged. But none have caught the attention of the traditional financial industry like DeFi.
DeFi = decentralized finance
DeFi is an eclectic mix of blockchain technology, digital assets and financial services that aim to decompose financial resources. The market experienced explosive growth in 2020, which many even refer to as the ‘Year of DeFi’. That said, it is still early in its maturation.
According to defillamaTotal value locked-down (TVL) in DeFi has risen from $625 million in April 2020 to now, and stayed above a whopping $211 billion, but fell from a peak of over $255 billion in December 2021. Currently, it is dominated by including DEX Curve, which accounts for 9.6% of this TVL, strike platform Lido, money market Anchor and loan protocol Aave.
DeFi is revolutionizing the financial world, starting with exchanges, derivatives, asset management, credit, insurance and stablecoins. Unlike traditional finance, which rely on intermediaries to manage and process financial services, DeFi operates in a decentralized environment. Decentralized applications (dApps) are built on public, permissionless blockchains, and services are generally coded into open-source software protocols and smart contracts.
As a result, investors are putting more money into those startups targeting DeFi and Web3, according to a report by deal-tracking company Pitchbook. Young Web3 and DeFi startups secured a total of $1.26 billion in investments in the third quarter of 2021, which are seen as “biggest growth opportunities.”
In the DeFi sector, dApps provide financial services without the need for centralized intermediaries or institutions. Here, open protocols make it possible to programmatically combine services in flexible ways. That’s the opposite of what traditional markets stand for. In traditional financial markets, intermediaries act as agents of trust, liquidity, settlement and security, making the current system increasingly complex. In fact, the 2008 global financial crisis exposed the flaws, inefficiencies, structural inequalities and hidden risks of these intermediary financial systems.
In addition, the legacy financial infrastructure is still fraught with shortcomings in the form of slow settlement cycles, inefficient pricing, liquidity challenges and the lack of certainty about the underlying assets. The cure is the rise of decentralized finance, which aims to address these challenges by leveraging blockchain technology to enable alternatives to traditional service providers and market structures.
In addition to using distributed ledgers as a settlement layer for transactions, DeFi takes advantage of several other technologies, such as smart contracts, which are programs that run when predefined conditions are met. Here, digital assets represent a value that can be easily transferred. In DeFi, governance systems give the token holders of a protocol the right to vote on its future.
Wallets, meanwhile, are used to manage assets stored on a blockchain. While custodial wallets are much easier to handle and use with other applications, non-custodial wallets provide exclusive control over funds through their private keys.
The good and the bad
The opportunity that DeFi offers is quite simple and there is a lot of talk about it. It eliminates hefty fees charged by banks, brokers and other financial institutions. DeFi enables faster and more efficient transactions, reduces counterparty risk, increases functional interoperability to transparency, improves accountability, enhances stakeholder control, and grants permissionless and rapid innovation.
Plus, the open-source protocol means anyone can build on the platform, while providing opportunities for extra juicy returns on investments that vastly exceed gains in legacy markets.
DeFi has enormous potential in terms of efficiency, innovation and financial inclusion, but at the same time it has its risks. Some of them are scalability, throughput, transaction costs, limited interoperability between blockchains, overcollateralization, and regulatory challenges.
The early growth phase means that DeFi is currently promoting short-term returns and attracting unscrupulous actors. For example, carpet pulls, scam projects, bad actors, and hacking are also quite common in DeFi. Numbers speak for themselves.
DeFi users even lost $10.5 billion to theft in 2021, according to a report by Elliptic† Some of the biggest DeFi hacks are Poly Network, which lost $611 million. Then there was the cyberattack on the bridge to Axie Infinity’s Ronin protocol, in which hackers stole $522 million. The most recent DeFi hack occurred on April 17. Beanstalk, a stablecoin protocol, lost $182 million in a flash loan attack. Then comes the infamous $326 million Wormhole hack.
These are just some of the cyber attacks that caught the attention of the media and became the talk of the town on social media platforms. The actual numbers are much higher. Such cases show that the DeFi sector is far from an easy and safe way for the masses to deploy their capital.
The latest developments
Despite the risks of using DeFi, the industry is growing and innovating, and several new trends are emerging.
Liquidity mining is one of DeFi’s hottest trends, with the protocol allowing users to provide liquidity and be richly rewarded in native tokens. Yield farming is another popular method that combines staking, lending, and borrowing to optimize income.
The rise of nonfungible tokens (NFTs) has also paved the way for the introduction of new products to the market that combine NFTs with DeFi, such as GameFi, or earn games such as Decentraland and The Sandbox. The arrival of 5G is also expected to benefit DeFi as it will significantly bring fast connectivity.
Then there are decentralized autonomous organizations (DAOs), whose growth can be attributed to the rise of DeFi innovations, which are gaining a lot of traction as they reach mainstream consciousness. DAOs are used for everything from arts and sports to crowdfunding and finance.
Some of the most exciting DAOs are BeetsDAO, a collective focused on buying music-based NFTs; ConstitutionDAO, a group effort to purchase a copy of the United States Constitution; FriendsWithBenefitsDAO, a members-only crypto social club; and RaidGuild, a web3 marketing and design agency for hire.
However, the discussion about DeFi is incomplete without Ethereum, on which most of these applications are built for its capabilities and developer adoption. Ethereum is currently undergoing a shift to ETH 2.0 to improve scalability. But with other layer 1 blockchains such as Terra, Avalanche, Solana, BSC and Polygon, and layer 2 solutions such as Arbitrum and Optimism taking effect in 2022, cross-chain technology has emerged to facilitate the smooth movement of information between different enabling networks.
For example, the DEX Mangata Finance is built on the Polkadot network and bridged with Ethereum to provide low fixed costs and MEV-free trading.
Overall, DeFi has huge potential for users as it is available 24/7 to anyone worldwide. These decentralized protocols provide new and diversified investment opportunities. Not to mention the double-digit interest rates that many DeFi protocols offer, which are much higher than the less than 1% rates of regulated banks.
This, of course, has giants like Morgan Stanley clamoring for the DeFi industry to stay “fairly small.” But DeFi, while still new, is growing rapidly, attracting investment and users and working to bank the billions without a bank account.
Peter Kris is the CEO of Mangata Finance†
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