On the back of blockchain networks, tokenizing assets is boosting the rise of decentralized financial services. So-called Decentralized Finance (DeFi) applications are providing alternative means to deliver digital financial services. It’s the idea of rebuilding the global, traditional infrastructure of the financial industry and moving it onto decentralized networks to bring the centralized system towards a trustless and transparent world that runs with no, or more efficient and low-cost, intermediaries.

DeFi services offer traditional financial instruments without relying on banks or traditional fiat currencies. Instead, these products use cryptocurrencies or digital tokens. The big idea behind DeFi is to create a new decentralized financial system, where payments, trading, and the transaction of value happen over new “rails” driven by tokens and peer-to-peer exchanges. In this emerging sector, blockchain is providing users offers they could not get from traditional services.

DeFi is creating a stir of experimentation and innovation in the FinTech space, including offers of decentralized mainstream financial products. These include simple services but also more complex products:

  • Dollar-pegged stablecoins (e.g. MakerDAO)
  • Decentralized exchange platforms (e.g. Uniswap, Kyber network, or 0x)
  • Peer-to-peer lending protocols (e.g. Compound or Aave)
  • Synthetic assets (e.g. Synthetix or UMA)
  • Decentralized leverage trading (e.g. dYdX)
  • Insurance (e.g. Nexus Mutual)
  • Predictions market (e.g. Augur)
  • Interest on crypto (e.g. Celsius Network)

Source: Linkedin post from Ivan de Lastours, Blockchain Lead at BPIFrance

The DeFi ecosystem is flourishing and unlocking a parallel financial system that is setting new standards of access, resilience, and transparency. It represents an entirely new financial infrastructure stack. Its unique competitive advantage lies in its combinatorial innovation capacity to enable the development of new products and services in organic and unexpected ways. These new financial technologies can become the building blocks for future innovations, promoting new combinations and new products. If successful, these decentralized business models have the potential to reshape the FinTech industry and create a new landscape for entrepreneurship and innovation.

The evolving state of DeFi

Primarily built on the Ethereum network, DeFi now represents one of the main application types for cryptocurrencies that brings non-custodial financial services to the mass market by leveraging the blockchain’s interoperability and smart contract capabilities.

However, before the hype of DeFi this year, there was not much buzz about it. Throughout 2019, the decentralized finance market was relatively stagnant until the concept of yield farming and governance tokens became more popular. In the DeFi space, the concept of Yield Farming has been introduced as a developing mechanism to distribute rewards to early-adopters of new decentralized initiatives. It is basically a token compensation mechanism to encourage users to adopt a new product, giving them a share in governance or future revenues.

Yield farming is currently one of the most popular mechanisms to bootstrap a user community around new DeFi solutions. It allows early-adopters to receive interest for interacting with the product. This yield-farming phenomenon is highly interesting as it enables a new and improved vehicle of community creation. The result is instant community cohesion and vitality in a way that was impossible to achieve before.

This prospect of giving people a fresh new token above and beyond normal returns on deposits sparked a wave of interest in DeFi applications in 2020. And after some first successful launches of DeFi projects, the DeFi market saw a significant spike in the emergence of governance tokens. Consequently, many users hoping to earn lucrative yields started to buy and sell governance tokens from decentralized exchanges, with an abundance of new money flowing in.

Source: DeFi Pulse, 2020

The decentralized finance space seemingly grew exponentially over the third quarter of 2020. The total value locked (TVL) in the decentralized finance space surged 380% from the end of Q2 2020 ($2 billion) to reach $10 billion by the end of the third quarter. Similarly, transaction volumes skyrocketed to surpass $100 billion.

While DeFi was not able to reach crypto ICO hype levels of 2017, it has been the standout narrative for the cryptocurrency industry this summer. Despite numerous hacks and security concerns, the opportunity to earn hundreds and sometimes thousands of percent in interest per year through yield farming has driven investors to DeFi.

Even though yield farming has declined over recent weeks as retail investors have seemingly sidelined their capital and as the price of leading DeFi coins has decreased, the continued innovation in the space should elevate DeFi coins over time. The majority of projects are still in the beginning stages of their development towards mainstream success.

Challenges ahead

As mentioned before, DeFi applications are mainly based on the Ethereum blockchain. 96% of the transaction volume is based on the network. This "success" has created a new congestion issue: over the recent months, Ethereum (ETH) gas prices have soared considerably as myriad projects jumped on the DeFi bandwagon. We’ve seen gas prices hitting record highs, with the largest decentralized exchange, Uniswap, causing major network congestion when its governance token UNI was distributed to its user base.

With the surge in activity on the blockchain, Ethereum co-founder Vitalik Buterin and other industry experts have questioned whether the Ethereum blockchain infrastructure was scalable enough to sustain the DeFi boom in the long run. Despite Ethereum 2.0 being in progress to deliver an even more decentralized, secure, and scalable blockchain solution than the current mainnet, DeFi developers have already been scrambling to look for other solutions to host their dApps.

Other platforms offer a viable PoS alternative for DeFi projects, such as Cardano which is the first blockchain platform to evolve out of a scientific philosophy and takes a research-first driven approach; or The Polkadot (DOT) blockchain which is optimized around interoperability, enabling users to move any type of data across any type of blockchain.

Last word

Despite its early maturity stage, DeFi is already demonstrating promising network effects creating efficient self-organized markets. We might be at the beginning of a major revolution for the financial services world. But for it to happen, the industry requires more regulatory clarity to generate adoption and usage from traditional financial institutions. To reach mass adoption, DeFi requires further development, and needs to merge with centralized finance!

Have a look at our following post regarding DeFi to CeFi bridge to reach the traditional finance 👈

Sources:

96% of Decentralized Finance’s Transactions Are Based on Ethereum - Cryptoglobe; Oct 12, 2020 [1]

New Ethereum yield farm backed by Binance, top crypto VCs just launched - Cryptoslate; Oct 10, 2020 [2]

Will DeFi Migrate to New Blockchain Platforms with the Surge in Ethereum Gas Prices? - Blockchain.News; Oct 8, 2020 [3]

Q3 Decentralized Finance Ecosystem Report - DappRadar; Oct 7, 2020 [4]