Decentralised finance – or DeFi – is gathering pace. After the ‘DeFi Summer’ of 2020, we’ve seen further growth in adoption this year. But is DeFi really moving towards the mainstream – and if it is, what are the second-order effects?
Will yields remain as attractive as they are today? Is more centralisation inevitable? What will regulators say? In our latest Mosaic Patterns Clubhouse, Toby, Chandar, and Benedict spoke to Stani Kulechov (CEO, Aave), Evgeny Yurtaev (CEO, Zerion), Lucas Vogelsang (CEO, Centrifuge) and Sam Harrison (Managing Partner, Blockchain.com Ventures) to find out what’s next.
What is DeFi, and why should we care?
For those who aren’t familiar with the term, ‘DeFi’ refers to financial services and products built on a public blockchain, with minimal central governance. DeFi makes financial services open and programmable. As Evgeny explains, DeFi puts financial infrastructure in the hands of the community: “anyone can create financial products and instruments and share them on the internet, as they would a webpage.” That means the potential is huge. “Things on the internet scale well. If a smart contract works for ten people, it could work for billions.”
And they are beginning to work. Lucas says that a key benefit of DeFi is the speed and efficiency with which services can be delivered. Traditional financial software is inherently siloed: one system is used to initiate a transaction, and another used to execute and settle. In DeFi, settlement happens alongside execution on a single trustless system of record.
Trustlessness is key. Traditional financial infrastructure requires a trusted verifier, and so has strict regulatory barriers to entry. The beauty of DeFi is that anyone can build better financial products on top of the protocols that already exist. “We can build not just new financial products, but better ones”, says Stani. “Whatever you create is public – anyone can take and add to the algorithm and improve it.” It’s little surprise, then, that DeFi is seeing rapid product innovation: anyone can build a next-generation protocol and attract liquidity.
How can DeFi find more users?
But there’s still a lot of work to be done to make DeFi more open and accessible. For Lucas, a key challenge is in bringing in new asset classes that have not enjoyed liquid markets in traditional finance. Enabling interoperability between real-world and crypto assets will be critical for DeFi to flourish: “liquidity needs to flow from one asset to the next to create optionality for users”, he explains. Though crypto is booming, it’s still very small compared with asset classes in the “real world”. DeFi offers a way to take the advantages of crypto and bring them to a much larger user base.
As the market grows, the sheer number of new protocols and assets is becoming difficult to navigate. Evgeny thinks that to see real growth in the DeFi user base over the next year, more tools will be needed to help them find and invest in the best opportunities. It’s difficult to predict which markets and assets they’ll be interested in: where the first batch of users were originally attracted by the higher yields of DeFi assets, now they’re starting to take an active interest in discovering new classes. To accelerate that adoption, DeFi needs to lower the barriers to entry. “In the near term, we’ll have a user experience on par with or even better than existing fintech applications”, he says.
Stani believes that building a better UX starts further upstream. “We need to get people interested in finance in the first place. There are amazing yields if we can make it easy to understand and use.”
Are DeFi yields going to drop?
One potential issue is that if DeFi moves towards the mainstream and sees more institutional participation, the high yields that make it so attractive might be compressed. As Sam points out, “if it all becomes cheap and easy and battle-tested, the yield rates will drop and that might disincentivise core users. The opportunity to build lots of new products that don’t exist yet is cool, but it’s not the hook that’s currently bringing people in”.
Stani doesn’t think it’s a problem. The constant cycle of innovation means that even if one protocol becomes ‘safer’ and sees yields drop, there’ll always be a new one to replace it – and for those, liquidity will stay at a premium. Evgeny agrees. “The rates definitely have a way to come down, but even if institutional money comes in and rates drop, new, riskier products will continue to produce high yields.”
Will traditional finance pose a blocker to DeFi?
It’s this speed of innovation that poses such a risk to traditional finance infrastructure. Put simply, traditional finance can’t keep up. “The tech stack of DeFi is much more powerful, so it will be difficult for traditional finance tools to match the settlement layers and composability”, explains Evgeny.
That being the case, will traditional financial institutions and regulators try to constrain DeFi’s growth? Stani doesn’t think it would be the best use of their time. Traditional finance works in a totally different way, where risk and trust are filtered through intermediaries. DeFi eliminates the need for that. “With smart contracts, you have community ownership of the protocol. You can limit undesired functions and behaviour to add security if you want,” he says. It’s hard to fight against the innovation that the open source model enables. While in traditional finance, innovation has been largely on the frontend, DeFi improves and removes the inefficiency from the banking backend.
Stani predicts that DeFi will follow a similar trajectory to Linux. Big corporates didn’t compete against it, but paid their own employees to contribute to the code, because it had become mission-critical software. “It makes more sense to contribute, provide liquidity and get governance power than to create a less efficient, closed system”, he says. “If you can’t beat them, join them.”
How much will users engage with the principles of DeFi?
But does everyone feel the same way? How fervent is the community’s passion for decentralisation? “The level of interest and adoption and transactions happening on Binance Smart Chain (BSC) have taken me by surprise”, says Sam. “It seems that a lot of people don’t care about decentralisation as much as we thought.”
Lucas agrees. He thinks that what is attractive about BSC to users is the ability to invest and interact in a riskier, more innovative and higher-yield ecosystem. “They can claim decentralisation, but are able to do so without the cost of true decentralisation” – and the volume of user activity shows that it might be this, rather than true self-custody, that users care about.
Currently, there’s a lot of infrastructure popping up to allow people with different levels of experience to participate. As Sam sees it, “some will want to get the benefits without knowing how it works, while others engage with the protocols directly and experiment as purists”.
Either way, finding an easier route into DeFi for a new, latent user base will be critical over the next 12 months. If you’re building a solution, please feel free to get in touch.