Understanding DeFi: is it really better than banks?

year of DeFi

Many have heralded 2020 as the — and the same was said about 2019. What's so attractive about decentralized finance — and does it have a bright future?

+250% in one year: DeFi in numbers

Two trends ruled the minds of the crypto community in 2019: IEOs and decentralized finance. The first trend produced mostly disappointment, with IEO tokens losing most of their value after getting listed (as it happened with Blockcloud, which lost 98%). By contrast, the second trend was developing rapidly, as DeFi apps kept growing their user bases and assets locked in smart contracts. 

Numbers speak for themselves:

According to DeFi Pulse, there was a total of $274m locked in DeFi contracts. In just a year, this figure grew to $907m – an increase of 3.5 times. For comparison: in the same period IEO tokens lost an average of 80% of their value.

Types of DeFi projects

DeFi is like an umbrella: it covers all apps and protocols that permit users to manage their assets without involving traditional financial institutions. 

Asset storage, transfers, lending, trading, and investment are all part of DeFi.

1. Lending and deposits

Competitors: banks and lending organizations (including fiat P2P services), trading brokers that issue loans to margin traders. 

This is the largest and most competitive segment of DeFi. Crypto holders can earn a profit by not just trading their assets, but lending them to other users. A collateral in crypto serves as a guarantee. 

Most lending platforms use the Ethereum blockchain. The average interest rate for lenders is between 3% and 8%, while borrowers have to pay from 8% to 13%, depending on the chosen coin. 

MakerDAO is the undisputed leader in this area, with over $500m locked in its contract.

2. Decentralized exchange protocols

Competitors: centralized exchanges and brokers: 

Decentralized exchanges' share in the total crypto trading volumes is still tiny. One of the reasons why users are unwilling to trade on these platforms is low liquidity.

DeFi strives to solve this problem by creating new decentralized trading protocols. On platforms like Bancor and Uniswap, liquidity is provided by the users themselves, who join into pools. In exchange for their liquidity, pool members get a share in the trading fees. For instance, Uniswap has already paid out $1 m in rewards to its liquidity providers. 

A different approach is used by Kyber. The system aggregates liquidity across different sources using atomic swaps. Since launch, the total amount of transactions on Kyber has already exceeded $500 million.

3) New-generation stablecoins

Competitors: traditional cryptocurrencies/stablecoins, fiat currencies

The new DeFi infrastructure requires new assets that could help solve the volatility problem. For example, in order not to issue crypto loans in the highly volatile Bitcoins, MakerDao created the stablecoin DAI, pegged to the US dollar.

Yet another type of new DeFi assets comprises tokens pegged to BTC and other crypto. They allow the users of Ethereum-based decentralized exchanges to trade assets created for other blockchains. WBTC (Wrapped BTC) is a good example. 

By the way, a token doesn't have to be pegged to just one cryptocurrency. For example, the project Set Protocol allows to create synthetic tokens linked to several coins and indicators. It's sort of a portfolio enclosed in just one token.

How decentralized is DeFi?

The industry of decentralized finance is still in an early stage, and lots of business models are being tested. There are fully decentralized and automated systems, hybrid projects, and even companies with a strong element of centralization. For example, MakerDAO functions without any central authority, while BlockFi is a structured company with a license and a verification system. Nevertheless, both projects do the same thing – issue crypto loans.

The battle of solutions

We can find competing approaches in almost every segment of DeFi. Who should issue loans – the system or users? Which source of liquidity is preferable – user pools or aggregators? Finally, is it better to use existing stablecoins like USDC – or create new ones, such as DAI?

It's impossible to predict which approach will win out in each case. So far there aren't that many players in the market, and new projects have a good chance to carve out a niche for themselves. All of the proposed solutions are technologically sound. So the success of each project will depend on its ability to 'package' its product in a way that will attract both users and investors. 

For example, famous venture fund Andreessen Horowitz recently invested $25 million in  Compound Finance. This can give Compound a serious competitive advantage – until another crypto lending project succeeds in attracting a large investor. 

As for the success of decentralized finance as a whole as an alternative to traditional finance, it will depend on a number of factors – both positive and negative.

DeFi growth drivers

1. Source of income for asset owners. Crypto loans are the easiest DeFi use case to understand. Instead of holding your crypto in a wallet waiting for the price to rise, you can make it work. For example, on the Compound and Dharma platforms you can earn over 10% by lending your crypto.
2. Growing demand for crypto loans. Apart from marginal traders, the main clients of crypto lending projects are large investors, mining companies, and crypto businesses in general. For example, Genesis issued a $545m worth of loans in Q4 2019, which is 21% more than in the preceding quarter.
3. Fast and easy access. Many DeFi apps have automated the issue of loans. No need to gather documents and wait for a decision: it's enough to supply a collateral. This works well for those borrowers who would find it hard to get a regular loan – such as crypto projects and miners.
4. Security. DeFi solutions are better protected from hackers than centralized exchanges and custodial wallets. If the liquidity problem is solved, DeFi projects can attract a lot of clients from platforms like Binance and Upbit, which lost a total of $89 million to hackers in 2019.

DeFi stop factors

1) Difficulties in promotion. DeFi projects use technological solutions that average users find hard to understand. At the moment, most of their users are tech-savvy traders, miners, etc. 

A good example is Compound.Finance. The main page of the website gives no indication that the app allows users to borrow and lend crypto.

If you manage to guess that you have to go to the App page, you'll find a list of coins that can be deposited and borrowed. There are no explanations, no tips, and no interest rate/collateral table for various coins.
 

Only 3 wallets are supported: MetaMask, Coinbase and Ledger. Some assets can be used 'as is', while others have to be 'wrapped' first – though there is no explanation of what it means.
 

Overall, the app is aimed at experienced crypto users who know how to work with smart contracts. For example, the account balance is often displayed as being 0. In this case, the developers suggest that you check it manually on Etherscan.

In order for DeFi to achieve mass adoption, projects will have to expand their user base fast. And that means that their products must be packaged for a wide audience of potential lenders and creditors. Apps must be intuitive and not require lengthy guides like Compound Finance for Dummies. Otherwise liquidity levels on DeFi platforms will remain very low.

2) Regulatory barriers. Even though state regulators are now more interested in large crypto exchanges, sooner or later they will turn to DeFi. The same privacy and independence that are so important to blockchain enthusiasts can become a serious problem. Projects will have to find ways to prevent fraud, money laundering, financing of terrorism, and so on. In other words, DeFi will have to become regulated. 

3) Migration to Ethereum 2.0. If the popularity of an Ethereum-based app grows suddenly, it can lead to network delays and a spike in transaction fees. This happened in August 2019, when the number of Tether transactions went up rapidly. The planned switch to Ethereum 2.0, expected to increase network capacity to 2000 tps, is still years away. Meanwhile, DeFi projects are looking for ways to process transactions instantly off-chain or on sidechains.

Is mass adoption in the cards for DeFi?

DeFi may be growing at an impressive speed, but the real volumes are still small – both in terms of liquidity and the number of transactions. 

The largest DeFi app, MakerDAO, processed a total of $217m worth of transactions in the past month for 30 thousand active users. Compare this to the 4 million loans for a total worth of $17 billion issued monthly by Lending Club – the largest P2P lending platform in the US. 

Representing these numbers in scale on a diagram shows that turnovers in DeFi are still tiny compared with traditional finance:

If the DeFi revolution is ever to happen, companies in this market will need to solve two challenges. The first is to enlist support of institutional players. The second is to make DeFi apps attractive and intuitive for average users. 

In both cases, success will depend on how well DeFi projects manage to package their products. If they fail, investors won't understand their potential, while users won't bring in the much-needed liquidity.