Thus far, 2020 hasn’t been the best of years for many. But for decentralised finance, or DeFi, 2020 has been a period of stratospheric growth, with the total value locked in rising from under $1bn, to just under $8bn today.
Although still very much in its infancy, the popular ecosystem is rapidly transforming the face of modern finance by taking components of a wide range of functions within traditional finance, and moulding them into trustless and transparent protocols via smart contracts and tokens.
Savings accounts, lending platforms and decentralised exchanges are some of the many decentralised applications (dApps) that offer a glimpse of the opportunities DeFi could unlock:
With advantages such as the instant settlement of funds, the ability to use digital assets as collateral and no credit checks, DeFi lending platforms embody a great deal of appeal compared to existing credit systems.
Data from industry site, DeFi Pulse, reports that since March, DeFi lending on platforms including Compound and Aave, has surged more than seven-fold to $3.7bn, as investors seek returns at a time when interest rates are at historic lows.
However, DeFi lending is not for the faint-hearted. Borrowers typically tend to be traders who take out loans in say, Ethereum, then trade the coins on various exchanges against other cryptocurrencies. They then aim to pay back the loan and pocket their profits, comparable to short-sellers in stock markets.
The hype around DeFi appears to have benefited decentralised exchanges, with trading volumes on DEXs setting new all-time highs.
Smart contracts enable direct trades between the participants’ wallets, meaning users can trade digital assets without needing an exchange to hold their funds. This alleviates the risk that comes with depositing crypto into exchanges, which can lead to losing funds in the event of a hack.
The dominant platform is Ethereum-based DEX Uniswap, which accounts for 57% of all DeFi users. Since the latter half of August, there has been a spike in volume on Uniswap, a figure which recently surged to close to over $900 million – surging even way past Coinbase in terms of sheer volume.
In the sphere of traditional financial markets, data is governed by a small group of stakeholders that control pricing, access and the type of data being provided.
In addition to eliminating corruption, DeFi aims to enable the democratisation of data. One company, a Swiss non-profit association, DIA, is striving on becoming the open-source Bloomberg for both crypto and traditional finance.
Using DeFi, DIA’s platform provides financial institutions with an immutable and verified single source of financial market data for any market and asset type. This will ultimately help diminish the problems seen currently with financial markets data providers around the world.
Insurance, in all its forms, is critical to our daily life. And much like everything else online, DeFi accounts can be vulnerable to hackers. Take Yam Finance, which quickly amassed $750 million in value before crashing spectacularly days just after its launch when a bug in its code made it impossible for the app to function properly.
Fred Ehrsam, the co-founder of Paradigm recently commented that DeFi insurance could become the next billion-dollar market.
Currently, there are now a handful of DeFi insurance providers such as Nexus Mutual and CDx, providing security for everything from transactions on exchanges to lending, and helping to create an ecosystem that is based on transparency and accessibility.
Their ambition is to quash expensive traditional insurance agencies that run as monopolies, and ensure insurance is less costly and flexible to both institutional and individual users.
Though Nexus Mutual and co still have a long way to go before disrupting traditional incumbents, DeFi insurance platforms help reimagine the current design space.
Due to DeFi being a frontier area of finance, users need to tread with caution and be mindful of which dApps they are making use of. The entry threshold for developers is still very low and there are certain to be a few rogue dapps floating around.
However, the building blocks for this market are still being built. At this nascent stage, DeFi is still only scratching the surface in terms of decentralising the key pillars of traditional finance. As the industry matures and new protocols and platforms continue to emerge, sophistication will too grow as the market size increases, mirroring the depth and scale of traditional financial products.
Innovation, however, while welcomed by most, is not without its hazards. Regulators are faced with the conundrum of governing smart contracts – beholden to no person and domiciled in no country.
Given that the pace of development in this space and DeFi’s potential to disrupt many industries at scale is incomparable to anything financial regulators have had to face, there is significant incentive for regulatory bodies to work more closely than ever with industry in ensuring a safe path is forged.
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