‘DeFi’ or Decentralized Finance started out as a movement in late 2018 when a group of blockchain enthusiasts and visionaries realized the potential of the blockchain and distributed ledger technology to create new permission-less financial applications
In this study, we make an attempt to decipher the growth of DeFi, broadly tracking the growth of finance from analog to the digital age and how the wave of finance and decentralized computing merge together to give birth to this new phenomenon.
I. Foundation of financial markets and DeFi
One might have seen in documentaries or elsewhere what traditional finance markets looked like in the 1970-80s. There were eager speculators, investors & traders all climbing ladder asking bid-ask quotes, yelling and exchanging paper certificates. It was completely analog, extremely inefficient and highly inaccessible.
The 1980s marked the dawn of the digital age, manual analog bid-ask quotes were replaced by displays on the computer screen. Shouting and verbal exchanges got reduced to a minimum. Paper certificates were replaced by bits and bytes. Marketplaces like the NASDAQ became more efficient and accessible.
Financial markets, enabled by computers and the internet, allowed innovation to peak and this era saw a rise in the number of new financial tools being developed. From derivatives to insurance, margin trading, risk hedging and more.
In the first decade of this Millennium, fast forward 40 years, finance became digital & came to mobile and web applications. Although much more efficient and accessible relative to the venues highlighted above, they were still not globally accessible. The digital age has revolutionized the financial markets and allowed it to support increasingly abstract and complex trade mechanisms much more than an average person could fully partake in. The informational asymmetry between those in the industry and those constituting the general populace created a barrier of entry to the most.
Enter DeFi also called Decentralized Finance or Open Finance.
DeFi broke all barriers. It is decentralized as the name suggests. Accessible to everyone. Financially transparent and permissionless unlike the big giants who are working in walled gardens. Space encompasses a whole host of underlying financial primitives. It enables anyone to construct markets, products, and services. We will talk more about its characteristics in a separate section later. Meanwhile, let’s just stay excited about the revolution that has started.
II. Reflection of financial markets in open finance and beyond
A financial market is one where people trade securities and derivatives. Securities include stocks and bonds and precious metals. Financial products and services are investments and securities that are created to provide users with a long term or short term financial exposure and gains. These allow risk to be spread or mitigated and provides liquidity to circulate in an economy.
DeFi since its inception in 2015 and major catching up in 2017 has been able to cover a wide range of avenues widely provided by traditional finance. 2019 is regarded as the year of DeFi in the digital asset industry. We believe that it is just the tip of the iceberg.
Let’s dive deep into how DeFi has mirrored Traditional Finance and what avenues and solutions DeFi have to offer in its budding stage.
From Consumer (both Retail & Institutional) point of view financial markets are broadly segregated as:
- Lending/Borrowing
- Asset Management – Equities, Bonds, Real Estate, Gold, etc & their derivatives
- Insurance – Both General & Life Insurance
- Capital Markets & Transactions – Investment Banking, Payments (Domestic & Cross-Border), Broking & Distribution, etc
All the above-mentioned avenues have started emerging in the DeFi space.
III. Need for open finance & how it started
Finance has always had the power to make society more prosperous. Educating oneself about the dynamics and how the economics work makes them financially capable of managing their own funds and financially independent from the need of banks and institutions to keep control of their assets. Despite its power, finance has always been centralized. Walled within a few primitives and sectors of society. The authorities issuing money, controlling, regulating and managing the supply is centralized. Moreover, the control of our assets has also been given in the hands of centralized authorities and institutions. The control is at the center and so does the risk. These institutions invest money in the average population in equity markets, make profits and return a meager share or in many cases not even that. The middle class holds fewer shares (equities) in the market directly and there is disparity compared to what the rich hold. In a financially strong nation like the United States, the bottom 80% own just 7% of the company’s shares from the stock markets. The economic inequality has reached its peak.
With the inception of Bitcoin and other digital assets, the concept of decentralizing money first started to emerge. The manner in which money is issued with a fixed supply and how it is stored with investors and in a controlled way to the owner has made the common person aware of the power they hold and what they have been giving up so far. But the access to financial systems was still limited only with the few.
After Bitcoin in 2009, the diversity of digital assets started emerging. Payments were done via these new monetary systems. People started to hold them because of their powers. Soon, it started attracting new users. Some were fascinated with the technology and their use-cases across a spectrum of domains and few others got involved because of speculative reasons. But they always wanted to achieve more. That’s when Ethereum came into existence in 2013 with the ability to write smart contracts. Contracts that can be programmed, that can execute themselves, that can not be reversed and holds a plethora of use-cases beyond imagination.
As understood with any kind of technology boom, only when it is developed it starts showing its true colors. Day to day activities started to be programmed in smart contracts like sending a payment post completion of a particular task or accepting community proposals if it wins the majority. The world of smart contracts opened a new horizon of imagination.
Bitcoin’s Lightning Network and Ethereum’s DAO activity would have probably been the first use cases of finance in the digital asset world. Then came ICOs and the race to raise capital and releasing new tokens with different token economics each. The financial activities had already started taking place but not so much in the form of a movement.
DeFi first started to emerge as a concept in the last quarter of 2018 but until that it did not have a name. Although space was talking about the potential disruptions the blockchain technology would bring to financial systems, the movement did not have a vision. I have looked up activities that were happening before, which suggest the onset of financial inclusion with blockchain technology was shaping up. Below are some (References listed at the end of the article):
IV. How DeFi shaped up in 2019
This is how the movement started and 2019 became the year of DeFi in the industry. As more and more projects started envisioning the idea of DeFi and aligning themselves with the approach, a common set of principle values were identified:
We have compiled 4 in-depth studies in the coming pages. The data for this has been queried from various resources. The effort was put in because data speak. The community might be talking about various schemes in various protocols but let’s see what data has to say.
1. Evolution of DeFi Platforms and User Growth:
Since 2018, DeFi Platforms have seen significant growth in terms of users as well as interactions. This information is beautifully captured for multiple DeFi Platforms and below is the graph. In 2019, the number of new users has risen from 5000 to 65000 and still counting.
2. Ethereum locked in DeFi Platforms:
The data for ethereum locked has been studied for Maker, Compound, Uniswap, Augur and Moloch DAO. The graph below features only Uniswap and Maker as they are major contributors. Since 2018, Ethereum locked in these platforms has risen from 0 to almost 3 million. Roughly 3% of Ethereum’s total supply is being used in DeFi applications. On 7th Feb 2020, the total USD locked in DeFi Platforms touched 1b USD which is a big milestone for the DeFi community.
3. Loans Originated and Repaid:
Since 2018, a whopping $886m worth loans have been originated on the most popular platforms like Maker, Compound, and dYdX of which $826m have been repaid which also tells about the efficiency of loan dynamics like collateralization and stability fees.
4. DAI Movements:
The data for DAI movements have been studied and the following metrics have been taken into account:
- DAI Minted: DAI is minted when Ethereum is put as collateral on the Maker Platform and new DAI coins are generated. 488m DAI tokens have been minted since 2018
- DAI Burned: DAI is burned when CDP is closed. 438m DAI tokens have been burned since 2018 and a net 50m tokens have been minted
- DAI Monthly Supply: It is the average supply of DAI during a particular month in the market. Since 2018, it has risen from 5m to 95m tokens
- DAI Transfer Value: It is the sum of DAI transfers that have taken place, between platforms and addresses. This has touched an all-time high of $2b
V. How decentralized DeFi really is?
A centralized organization is one that is controlled by a central authority. The decisions of the governance, the transparency of the functioning protocol, access to the data and source-code or the technical aspects are all limited to walled gardens.
Traditional finance systems have a tendency to be centralized by nature. While DeFi projects do not advocate full decentralization at the moment they do promote decentralization and are designed to be decentralized. Below is a comparison for how traditional finance and DeFi differ when it comes to decentralizing the project:
| Aspects of financial model | Traditional Finance | DeFi |
|---|---|---|
| Design / Architecture | Central | Currently centralized for many, moving towards decentralization |
| Point of failure | Single | Distributed |
| Transactions | via Central authorities | Peer to peer |
| Governance of the Protocol | Central | Central in most projects |
| Decision making | Central | Central in most projects |
| Market level data | Central | Open to public |
| Company level data | Central | Closed for most |
| Technology | Confidential | Mostly open-source |
| Development / Administration | Central | Currently centralized for many, moving towards decentralization |
Kyle Kistner, the co-founder of bZx protocol published a study for the major lending protocols in space and identifies degrees of decentralization for them. For more in-depth understanding check out the original post.
We will just share the summary here for a quick understanding. The aspects of decentralization are broken into:
- Custody of assets: If the protocol keeps custody of the borrower funds (Custodial)
- Initiation of margin calls: If a loan is going below margin collateral who initiates the liquidation of the loan
- Provision of margin call liquidity: Who supplies liquidity for the protocol functioning
- Price feeds: The source of providing price feeds for digital assets
- Interest rates determination: Self-explanatory
- Protocol development: If it is controlled centrally or community-driven
The infographic explains degrees of decentralization for a variety of projects:
If we understand from the scenarios, many aspects of the DeFi Projects are still centralized which seems ironic to the concept of Decentralized Finance.
If we talk about decentralization for a moment in the blockchain space, currently only Bitcoin advocates ideal decentralization where transactions are peer-to-peer, governance and decision making is done by the community, any new proposal is welcomed by anyone, new proposals if accepted by majority are executed or forked from the original chain if not (Bitcoin Cash, Bitcoin Gold, Bitcoin SV), data is completely accessible to the public and technology is completely open-source. While some may argue Bitcoin mining is centralized to some levels, Bitcoin still sets the legacy for decentralization, is also the most mature protocol and is paving the way towards decentralization for others to follow.
Having said that, DeFi projects are still in a nascent stage and completely decentralizing these projects would not work in favor of these. Let’s understand how decentralization can become a drawback for projects in the nascent stage.
Hence, total decentralization for these early-stage projects might not be the most ideal solution so it might be worthwhile to be centralized towards development in the early stage, slowly decentralizing different aspects of the system as the protocol and the community matures.
VI. Risks and caution
While DeFi looks like a strong use-case of the Decentralized Ecosystem, it inherently comes with a few risks that users must be cautioned with:
- Smart Contract Vulnerability:
A Smart contract which is error-proof is very hard to code and leaves space for human errors. Extensive Testing, Formal Verification, Multiple Audits, Bug Bounties are much-identified measures to make the smart contract immune to vulnerabilities that can be exploited. - External Risk:
A lot of DeFi platforms and the smart code they are founded on, requires external inputs which are fed either manually or by oracles. Manipulation at this stage can prove to be maliciously influencing the functioning of these protocols. - Economic Incentive Failure Risk:
Many platforms rely on the economic incentives for honest behavior by the participants. If however, these incentives fail to encourage honest behavior when say the ‘cost of attack’ is less than the ‘profit from attack’, then these protocols will be at risk of corruption. - Procedural Security:
Developers try to make the platforms as safe as possible but users need to be wary of measures of protecting their own private keys, using hardware wallets, multi-factor authentication. - Changing Governance:
Keeping up with the updated protocols and terms of services is a little challenging for users. Many of these incorporate a DAO structure where the users get to vote for the governance of the protocol. For example, MakerDAO stability fees bounced between a percent and twenty in the year 2019. This makes keeping up with the protocol governance critical for users who are involved in DeFi Services. - Level of Centralization:
Many projects are still centralized at the core and their functioning depends a lot on the central aspects within the team. These keep users away from the decision making, development and governance of the protocol and hence possess a single point of failure for these protocols.
DeFi score methodology is a community-driven standard for assessing DeFi Risk which is developed by ConsenSys and should be actively considered before trying out a new protocol or a mere understanding of what all aspects need to be considered when opting to use one.
VII. SWOT analysis
STRENGTH
- Improved price Efficiency with the option to short asset results in great price discovery/efficiency
- Immutability with irreversible transactions
- No stop to Lending/borrowing once started
- Greater Capital Access with stablecoins
- Transparency with P2P and user-controlled Lending/Borrowing
- Lower Setup Cost
- Lower TAT with fast lending/borrowing
- Full custody of funds
- Accessible to all from restricted Jurisdictions
WEAKNESS
- Lack of Insurance Mechanism in case loan defaults
- Lack of Fiat Loans since only digital assets are provided
- Not helping the unbanked with over-collateralization
- Network Congestion due to scalability issues may lead to pending transactions and changing interest rates
- Gas Fees Competition may leave transactions with lower fees with less priority
- Not completely decentralized with a lack of transparency. Central control over interest rates
- Custodial Solutions do exist
OPPORTUNITY
- More stablecoins can emerge pegged to other global currencies
- More aggregators and platform bridges like InstaDapp, Zerion, etc
- Insurance Providers to cover risk and volatility
- Fiat Loans
- Smart Contract Auditors are needed to safeguard smart contracts against hacks
- Oracle Development to connect physical and digital work seamlessly
THREAT
- Oracle Data Manipulation can lead to false information to smart contracts resulting in unexpected behavior
- Smart Contract Flaws can lead to loss of massive funds
- Volatility Risk in the price of digital assets
- SEC Regulations can become a barrier
- Operating without License in most Jurisdictions
VII. Funding received by DeFi projects
The information gathered here shows the amount of funding received by these projects. The Funding received reflects the amount of capital these companies have had raised which will be utilized in product development, market expansion, research, etc.
IX. 2020 and beyond
DeFi has had a great start so far. The total value of USD locked in DeFi was 50m$ at the start of 2018, 300m$ at the start of 2019 and 2020 started with the entire ecosystem touching just over $1 billion and these numbers are bound to go much higher in the coming years. Considering the total market capitalization of $300 billion, DeFi still accounts for less than 0.5% of the whole ecosystem. First peer-to-peer transactions with Bitcoin, then smart contracts powering ICOs, DAOs, and stablecoins, and now lending/borrowing, staking, margin trading, derivatives, synthetic assets, etc. We are witnessing an evolution of the traditional finance system moving towards more transparency, decentralization, eradicating middle-men, making markets cost-efficient, and making the global economy far more accessible to many more people. Much like the internet which only a few had the privilege at an early stage, DeFi will cater to a larger population in the coming years.
Ethereum has established itself as the protocol for new financial systems. Most DeFi projects are built on top of Ethereum. While this presents a great opportunity for Ethereum, it also makes proposing major changes to the Ethereum protocol a lot more challenging and hard forks highly improbable as the value locked in DeFi goes up and DeFi projects become opposed to radical changes that might pose a risk to the DeFi ecosystem.
Market leaders like Binance and Coinbase are envisioning the future of the entire ecosystem and space is witnessing acquisitions, funding and rapid expansions. Stablecoins have served the purpose of volatility safe markets and more complex tools like synthetic assets are making their way from the ground up. DeFi holds the potential to replace various aspects of the existing financial system whereas integrating with others in the future.
With great power comes great responsibility. If these new open-source protocols have to serve as the new backbone of the global economy, they will have to go through rigorous iterations and security audits. We have projects like Certik, Quantstamp, Zeppelin. etc doing some great work in the smart contract audits space and projects like Nexus Mutual and Etherisc providing insurance on smart contract risks. All these solutions together will help reduce risk and make the whole DeFi ecosystem a more reliable place to start attracting large capital.
Use-cases around DeFi focused smart wallets, aggregators and platform bridges have emerged rapidly. Solutions like InstaDapp and Zerion have been well received since they provide interoperability for the customer and eradicates on-boarding barriers by providing multiple DeFi products and services under one roof. Wallets like Frontier, Argent and DEX Wallet solve the needs of making DeFi transactions directly from the wallet. For DeFi to emerge solutions like these are much needed since they simplify the DeFi experience for new users.
DeFi provides fundamental freedom to builders which are witnessing a powerful network effect. We’re still very early though and DeFi remains a sub-optimal choice on most dimensions for most of the use-cases which will change rapidly in the coming years as the technology becomes more mature and scalable, and user experience bottlenecks get resolved.
“DeFi is the next evolution in finance and will pave the way for an algorithm-based financial system. For any DeFi project to be successful, it will be imperative for the project to have a clear vision that resonates with all its participants. DeFi promises to bring endless opportunities to the world of finance by tilting the balance from few to all. For me, this is the most exciting characteristic.”
–Sumit Gupta, CoinDCX
Disclaimer: The views, information, and opinions expressed are solely those of the authors in the personal capacity and do not reflect the official position or views of Woodstock. The authors have taken the utmost effort to ensure the research is up-to-date and accurate. However, no warranties or representations, express or implied, are made as to the timeliness, completeness or accuracy of the information. Readers are advised to obtain independent professional advice before making any investment decisions or investing. Woodstock does not endorse the views expressed by the authors. Under no circumstances shall Woodstock, its affiliates, partners, directors, employees or advisors be liable for any loss suffered by a reader on account of the views, information, and opinions expressed herein.
Published by: Woodstock Research
Author: Ankur Dubey
Contributors: Himanshu Yadav , Deepa Vishwanathan
Thanks to Sumit Gupta and Ganesh Swami for reviewing the article.
References:
Wikipedia Financial Markets
DeFi Projects
Stocks are high, but investor numbers are low
Jason Turner: The Evolution of Financial Markets and the Corresponding Impact on Modern American Society
January 2014: Bitcoin is not just digital currency. It’s Napster for finance
July 2014: How Bitcoin Can and Will Disrupt the Financial System
June 2015: The Future of Financial Services
September 2015: Bitcoin Blockchain Technology In Financial Services: How The Disruption Will Play Out
November 2015: How will blockchain technology transform financial services?
December 2015: -Why & How Decentralized Prediction Markets Will Change Just About Everything
May 2016: How Blockchain Technology Will Disrupt Financial Services Firms
June 2016: Financial services technology 2020 and beyond: Embracing disruption
October 2016: Blockchain Powered Financial Inclusion
March 2017: The Blockchain Will Do to the Financial System What the Internet Did to Media
May 2018: Decentralized Lending Promises Easy And Global Access To Credit, But Is It Too Good To Be True?
July 2018: How is Blockchain Revolutionizing Banking and Financial Markets
August 2018: Announcing De.Fi
October 2018: Crypto Startup That Lets You ‘Short’ Ethereum Raises $10 Million
Data for Charts
How Decentralized DeFi is?
Centralization vs. Decentralization: The Best (and worst) of Both Worlds
Risks in DeFi
Binance Research
Funding Data
2019 year of DeFi and 2020 will be too
