Over the past twelve months, decentralized finance (DeFi) has been one of the most widely discussed trends in the digital asset space. After passing the milestone of $1 billion in total locked-in assets in early February 2020, DeFi went on to reach a peak of $45 billion almost exactly a year later, according to the tracking website DeFi Pulse.
The aim of DeFi protocols is to automate a range of financial services using smart contracts. The vision is a truly peer-to-peer financial services ecosystem, where users can access services like borrowing or even margins and derivatives trading without a centralized intermediary. While this idea might sound like a radical departure from the status quo, it is finding traction in unlikely places. According to the Financial Times, for instance, the former UK Chancellor of the Exchequer George Osborne has provided venture capital to several DeFi startups in partnership with his brother.
DeFi’s growth has come about thanks to yields that are simply not available in traditional markets. Even more intriguing is DeFi’s potential to completely automate many of the activities and roles performed in regular finance. For instance, decentralized exchange Uniswap was one of the early pioneers of automated market making. Users contribute their idle cryptocurrencies to liquidity pools, earning a share of transaction fees when traders take advantage of the liquidity to exchange tokens. Lending protocol Compound operates decentralized credit pools whereby users can earn interest by loaning their assets to others. Derivatives trading platform Synthetix allows users to trade tokenized synthetic assets that track the value of both cryptocurrencies and real-world assets.
DeFi’s proponents argue that this is all just the tip of the iceberg, with Brian Brooks, former US acting Comptroller of the Currency, going as far as predicting a future involving “self-driving banks.” Due to the recent cryptocurrency bull run, institutional funds are currently flowing into digital assets. If Brooks is right, can we expect to see the same interest in DeFi over the coming years due to their ability of creating positive cash flows? It’s a fascinating prospect, but DeFi needs to overcome a number of barriers before professional investors are likely to get involved in numbers.
A Growing Market Shows Signs of Immaturity
Firstly, liquidity is still likely to be an issue for many institutions. Cryptocurrency markets in general remain characterized by fragmented liquidity, and DeFi is no different. Compound, the second-biggest lending platform, holds $5 billion worth of assets, a relatively modest sum compared to the resources of institutional players. Fragmentation increases the risk of slippage and falling victim to practices such as front-running, while the scale of even the largest decentralized exchanges may not be large enough to accommodate institutional orders. As a result, DeFi markets will need to continue on their current growth trajectory for a while longer before they can support the kind of demand that comes from hedge funds, for example.
Furthermore, despite the proliferation of lending platforms, DeFi still requires loans to be heavily overcollateralized to mitigate creditor risks. This requirement exists to overcome another constraint likely to be off-putting to institutions – counterparty anonymity. A DeFi lender does not know who is on the other end of a transaction, so the over-collateralization protects their position. Nevertheless, the heavy collateral requirements combined with an inability to comply with Know Your Customer (KYC) and anti-money laundering (AML) regulations are likely to rule out such platforms for institutional players in their current guise.
Currently, the vast majority of DeFi exists on the Ethereum platform. As the largest public smart contract network, the dominance of Ethereum is understandable, but it also comes with some drawbacks. Transactions costs are paid in Gas, the cost of which can be prone to bouts of volatility depending on network demand. This has led to a situation where gas prices have markedly increased in periods of high network use, pricing small traders out of the market and making higher frequency trading no longer worthwhile. Finally, speed is also an issue, with transaction throughput far lower than on traditional financial networks since all Dex transactions are immediately settled on-chain, which could preclude some forms of algorithmic trading. These concerns have fueled the emergence of decentralized exchanges built on Ethereum clones with lower fees and higher throughput which is usually achieved at the cost of minimal decentralization and security due to the involvement of significantly fewer validator nodes (thus increasing the risk of double spending due to collusion). This is one of the main reasons why market participants are anxiously anticipating Ethereum’s switch from a proof-of-work to a proof-of-stake consensus mechanism. In particular, they are keen to find out whether the resulting potential compromise in network security and integrity outweighs the expected efficiency gains.
Of course, the automation offered by DeFi also means placing greater trust in code. Ultimately, smart contracts are written by humans and can be prone to bugs and vulnerabilities. Unfortunately, such flaws have surfaced on a number of occasions in recent years.
A final challenge for traders is connectivity. Just like the rest of the digital asset space, no common communication protocol like FIX exists in the DeFi space, making algorithmic trading across multiple decentralized exchanges extremely difficult. More recently, however, secondary market players have begun developing FIX-compatible solutions to help bridge this gap, which we will start seeing later in 2021.
So is DeFi destined to remain the preserve of a niche group of retail users and crypto whales? For now, perhaps. However, there are some signs that in the medium term, DeFi may follow the crypto market in shaking off its “wild west” persona and becoming mainstream enough to spark institutional interest.
For instance, the Chicago DeFi Alliance, formed by Compound Finance, TD Ameritrade, and the Cumberland DRW, aims to provide compliance guidance to DeFi focused startups. It provides an eight-week program to help the founders of DeFi projects to better understand and respond to the needs of institutional and professional traders.
There are also some tentative signs of progress on the regulatory front. In mid-2020, popular lending protocol Aave became the first DeFi project to obtain an e-money authorization from the UK Financial Conduct Authority. It gives the company a license to onboard fiat users to DeFi. Elsewhere, regulated stablecoin issuer TrustToken recently launched a DeFi lending platform allowing users to obtain uncollateralized credit based on reputation scoring. It is already being used by Alameda Research, the quantitative crypto trading firm behind the crypto derivatives exchange FTX. As regulatory clarity is one of the critical prerequisites for institutional cryptocurrency offerings, it is safe to assume that further progress will be required to spur wider adoption of DeFi.
A Promising Future
There is still some way to go. However, as we saw with the institutional adoption of cryptocurrencies, it’s an iterative cycle. Gradual improvements in technology, regulation, and liquidity will result in first movers entering the market. Once that happens, there is an incentive for more crypto-native firms to enter the space and cater to them. Eventually, an ecosystem of secondary market players begins to emerge. While certainly not on the immediate horizon, given time and the cryptocurrency sector’s propensity for innovation, self-driving banks may not be as fanciful an idea as it seems.