The Defi revolution!
Current state of Decentralized finance and why it is a better alternative to the traditional system.
Cryptocurrencies have enabled monetization of ideas, paving the way for technological revolutions that were beyond imagination a few years back.
In doing so, cryptocurrencies have transformed the financial ecosystem and the flow of money around the world, moving away from the traditional centralized structures and ushering the foundations of a decentralized global economy.
Defi or Decentralized Finance has emerged as a booming industry, with products and services such as decentralized lending and borrowing, decentralized exchanges and a lot of other solutions which hold immense value to the masses. In Defi, financial services are accessible without a central authority. Transactions are peer to peer, and these peers mutually decide the terms of the transaction. Defi transparently integrates finance and technology. Currently, booming services in Defi markets are :
Lending and Borrowing protocols
Stable Coins
Decentralized exchanges
Derivatives
Prediction Markets
Tokenization of assets
In this letter, our research focuses on how decentralized finance can change the way we perceive the financial world and why there is an immediate need for it.
Defi platforms operate on three core principles:
Interoperability and open source: This means that information is exchanged between different protocols, Dapps, etc. The platforms are developed and maintained by people across the world, and its code is open-source. These protocols are composable and can be plugged into each other like lego pieces and create something completely new.
Accessibility and Financial Inclusion: A major problem with the current financial ecosystem is that banks are not available to everyone because the current system is operation intensive and unagile by which 1.7 bn of the adult population of the world do not have a bank account it is also the regional economic disparity is among the many reasons why banks have been unable to reach remote areas, especially in underdeveloped countries. All that you need to access a Defi platform is an active internet connection. There are 4.39 bn internet users worldwide and 5.11 bn mobile users worldwide. Because of this accessing services of a Defi is easier than accessing any traditional financial services.
Financial Transparency: This means that the market level information like details of transactions(such as amount, time, addresses, etc.), mechanism of the platform to decide rates are available to every user of the network while maintaining individual privacy. Where fintech develops trust-based software and have a high level of bureaucracy, Defi has trust-minimized software will low bureaucracy.
One of the biggest projects in Defi market currently is Maker Dao, a decentralized autonomous organization built on the Ethereum blockchain with a Defi market dominance of 54.61%. Maker Dao has dominated the Defi market with the total value of around $303mn is locked in Maker Dao alone to create Dai.
Dai is a cryptocurrency stable coin by Maker Dao, it is synthetically pegged to USD but due to forces of supply and demand its actual value changes, and it is not always $1 but deviates around it. Dai is created by collateralizing Ether by around 250% which led to a surge of Ether being locked to create Dai, which has stabilized the price of Ether making it less volatile compared to last year.
Notice in the chart above how the market cap curve of Ether behaves before Dec 2018, and how it has behaved this year after a significant surge in demand of Dai. This year, at the time of writing, the weekly standard deviation of Ether has reduced to 0.12737 from 0.18127 last year. As prices of Ether and BTC are correlated as well, however this reduction in the volatility of Ether is not a response to the behavior of Bitcoin whose weekly standard deviation has been around 0.11991 since 2017.
Dai currently yields an annual interest rate of around 10% on Compound Finance which is another emerging Defi service provider. It algorithmically sets rates for lending and borrowing based on the forces of supply and demand, which allows users to exchange time-value of Ethereum assets. At the time of writing around $113.7 Mn has been locked at Compound Finance. Compound finance is backed by investors like Bain Capital Ventures, Andreessen Horowitz, Polychain Capital, with participation from Transmedia Capital, Compound Ventures, Abstract Ventures, Danhua Capital, and Coinbase.
Other interesting projects in Defi community are:
Protocol bridge by Instadapp: Protocol bridge by Instadapp provides users a convenient way to move their locked-up assets within different protocols like from Maker Dao to Compound Finance a phenomenon called superfluidity. This service facilitates users to optimize their debt positions by which they can take advantage of the best rates in Defi lending and borrowing. By transferring debt positions, users can benefit from low borrowing or lending rates of the new platform their assets have been moved to. All processes involved are without the involvement of a third-party custodian wallet service provider. Assets are stored on contract addresses.
Synths by Synthetix network: Synths are on-chain synthetic assets that track the value of real-world assets such as currencies, commodities, crypto-assets, stocks, indices, etc. SNX(Synthetix) tokens are locked to mint synths. Hence without any third-party intrusion, real-world assets can be tracked and used to make transactions, trading or follow indices. This widens the scope where people can use cryptocurrency.
With Defi, micro-level finance can be operated with much more freedom. It allows an individual to hold more leverage in setting terms, and the rates at which they want to operate and make transactions. However, over-collateralization of assets as much as by 250% to get loans on Defi platforms is an inefficient way of using capital.
The concept of superfluidity is considered risky as over-collateralization ensures that in the event borrower defaults on payments and is unable to pay back the loan, the collateral will be liquidated as a payment. But if that collateral is loaned out on some other platform then that collateral provides no security to the primary loan.
Currently less than a hundred thousand people participating in Defi ecosystem because of its bad UX and no direct fiat on-ramp in major jurisdictions. For example, as crypto-assets are highly volatile, even their over-collateralization to provide loans does not make the whole process completely safe, if the price of the asset falls quickly and heavily so that the margin calls fail to cover the amount borrowed.
As the market cap of this market grows, jurisdictions will eventually step in to introduce requirements such as KYC, and taxes which may impact the liquidity of projects and their investments that these protocols require to be built and upgrade.
In conclusion, this market is still in its early phase. As our study shows, it has huge potential and has the capability to bring changes in the way we see finance. For which, it will require research on a broader basis than it is happening now.
For now, it is very important to understand that we are in the early phase of this market which has very huge potential and will bring landmark changes to the way humans have ever exchanged value.
The results in the Newsletter are only for informative purposes and is not investment advice. It is advisable to do your research before investing in any asset class or portfolios mentioned in this letter.