Crypto Weekly #6: Is DeFi All Show And No Substance?

Is DeFi the killer app for blockchain or is it just hype based on the imperfection of the market? The more interesting question, though, is: how long will this growth continue? 

Between September 2017 and the time of this writing, the total value locked up in DeFi contracts has exploded from $2.1 million to $6.9 billion (£1.6 million to £5.3 billion). Since the beginning of August alone it has risen by $2.9 billion.

The Total Value Locked (TVL) of DeFi recently exceeded the $9 billion mark. Many exchanges have added DeFi tokens to their listings, with the performance of some DeFi cryptos now largely exceeding that of Bitcoin (BTC). For example, the price of the token Yearn Finance (YFI) crossed the $38,000 mark.

Major asset management funds are starting to take DeFi seriously as well; the most prominent of which is Grayscale, the world’s largest crypto investment fund. In the first half of 2020, it was managing over $5.2 billion of crypto assets, including $4.4 billion of Bitcoin.

Some observers believe that this impressive growth in the sector is akin to that of a financial bubble similar to that of the crypto market in 2017 and 2018.

The on-chain data aggregator, Dune Analytics, is not of that opinion, however. Its position is based on the number of active addresses in the sector.

This number is currently estimated at 400,000 units, a tiny figure compared to, for example, the millions of Bitcoin holders who all represent potential DeFi users.

To get a better understanding of this subject, I’ve asked some experts and founders about real blockchain projects in this field and what they think. They are:

1. Nemr Hallak, from volentix.io - Decentralized exchange. Volentix can swap assets from any chain.

2. Matthew Niemerg from alephzero.org - A novel DAG protocol that aims to solve known blockchain issues.

3. Ivan, CEO and cofounder of CryptoTask - The biggest decentralized freelance marketplace.

4. Brian Kerr, cofounder of Kava - A decentralized bank for digital assets. 

5. Kris Marszalek, CEO, at Crypto.com - A leading payments and cryptocurrency platform.

6. Zachary Friedman, Co-Founder and COO GDA Capital - A financial institution that provides vertically integrated merchant banking and capital markets services to institutional investors and disruptive technology companies.

Nemr Hallak, from volentix.io

DeFi has definitely had a hyped-up start. Approximately $6.5 billion and counting locked up for various enticing  “returns”. It’s small compared to funds that have traditional models, but it’s like the Internet. No one really knew what happened, we just became dependent on it all of a sudden. While the growth is inevitable, it may be turbulent. As these new ways of doing things mature, hacks and other deterrents will be phased out, scalability issues will be a thing of the past, and everything will grow. How long this will take is anyone’s guess but things have been changing rapidly and I would like to think it is within this decade. “Real finance” will maintain a dominant role for the foreseeable future, but financial innovation on the Blockchain will keep growing and growing. One day, a world of DeFi services will play a role in the background of everyone’s portfolios seamlessly and 6.5 billion can just as well be 6.5 trillion or more. It can also come crashing down to zero for many possible reasons or for no reason at all! In general, I am optimistic about DeFi and the upside is very promising.

Matthew Niemerg from alephzero.org

In order to understand what's currently happening in the DeFi space, we need to take a step back and analyze it to bring overall clarity.  There are several mechanisms at play, with some common, overlapping themes when it comes to yield farming. The first situation is when users deposit assets not in use in liquidity pools (Metastable, Curve, Uniswap Pools, or Balancer Pools) and receive a proportional share of the trading fees (with the risk of impermanent loss). Another aspect is depositing unused digital assets into protocols like Compound and Aave and receiving a portion of the interest generated from these money market lending protocols. The third situation is when users lock assets into protocols such as YFI, YFL, YFV, YAM, ZZZ, and so on. The goal of each of these projects is to have liquidity either in the automated market maker liquidity pools or the money market lending protocols.  The way to achieve this is by incentivizing liquidity providers by compensating them with a coin, often with some form of governance rights embedded in the smart contract in how the community can manage the protocol, i.e. add new features, support new coins, etc.

The current demand of governance coins is driven largely by speculators who think that the cost of locking assets (and being exposed to the price volatility) in a given protocol is lower than the value received in a new governance coin.

One key difference between these sets of governance coins is the yield rate of each, with liquidity pools and money market lending protocols having a more sustainable return, whereas the high APY of the YAMs of the world can only last so long since the smart contracts are paying liquidity providers at larger-than-normal market rates (supposedly to commensurate with their risk).

The total locked value in automated market maker protocols and money market lending protocols will go up in the future as people will look for options to put their digital assets to use.

In general, the APY for LPs will most likely drop as more people add liquidity in the long run, assuming no significant increase in trading against these automated market makers.  The interest rates on money market lending protocols are probably not going to decrease terribly much, as more the protocols gain more adoption.

As for the YAMs and YFIs out there... just remember: "The market can stay irrational longer than you can stay solvent!"

Ivan, CEO and cofounder of CryptoTask

DeFi is one of the revolutionary features of blockchain, which essentially no one saw coming until this year. Money is made up and printed from nothing, and the "be your own bank" concept sounds more and more appealing. DeFis are certainly now going through their own kind of bubble, however, when that deflates, some really high-quality projects will remain and shake the conventional financial institutions to their foundations. Right now, about $6.5 billion is locked in DeFi projects, which is still a small number compared to the whole crypto market cap of $360B, so I believe there is still a lot of room for growth; however, that will come down at some point, when interest rates become close to the "real" markets, which will drive away some of the speculators. But that’s when the sustainable growth begins.

Brian Kerr, cofounder of Kava

Decentralized finance is simply more efficient. It removes middle men, fees, and connects profits directly back to users. With the additional liquidity of mining incentives, the traditional sector simply cannot compete with the returns. Rather than trying to launch their own savings product, centralized exchanges like Binance.com are integrating protocols like Kava's DeFi lending platform and passing the 25% APY on Binance Coin back to their users. This type of integration makes DeFi protocols like Kava much more accessible while further growing the AUM of the protocol. I expect to see many more integrations with centralized applications soon as yields continue to outperform traditional finance for the foreseeable future.

Kris Marszalek, CEO, Crypto.com

While this current growth is unlikely to continue at such a rapid rate and will level out as it matures, I do think it will continue growing at a steady rate for an extended time. The features behind DeFi products (trustless, censorship resistant, permissionless, open sourced) are fundamental to the foundation and promises of blockchains, and have been north stars guiding this industry for years, as evidenced by the fast-growing catalog of dApps and serious investor excitement. 

Like traditional finance, DeFi interest rates fluctuate with demand. When demand is high, so are the interest rates and vice versa. Demand to borrow crypto assets in dApps is extremely high right now, and DeFi projects are aggressively competing for users in a red-hot market, which has led to double-digit interest rates and high yields. Rates will come back down a bit, but likely not to the level of traditional banks whose high overhead and hefty capital expenditures lead to leaner profit margins and lower risk. Our research into DeFi returns shows it is a valuable, yet volatile way to earn passive income and investors should beware of investments that don’t offer sufficient returns for their level of risk.

Zachary Friedman, Co-Founder and COO GDA Capital

With $6.76 billion currently locked in, the DeFi ecosystem is in full swing. It’s 10x TVL growth since April 1st has shown no signs of slowing down, but it begs the question of how long can we see a boom like this continue. 

There are now over 70 coins primarily focused on or offering DeFi services, with over 40 protocols or projects making them. The space is thus becoming far more competitive, which alludes to a landscape of innovation and sustainable projects.

TVL in Defi should continue to increase both in the short and long term. First, the crypto boom, but this time being spearheaded by altcoins will provide a lot more capital flooding into the crypto space with some inevitably landing in DeFi. Secondly, DeFi sector growth led by the increasing number of projects will start to eat up a bigger piece of an already growing pie and churn out positive publicity. Finally, with mainstream adoption seemingly on the horizon, the sustainability and potential of DeFi is ever growing.

Rates:

The DeFi market currently has rates you can receive from lending that are about 100x what a savings account will pay you. This is mainly due to lower costs and Fed rates.

The DeFi market removes one crucial intermediary - the bank. With fewer parties taking a cut, and much more transparency, as well as a collateralized lending system ensuring high levels of security, all the benefits of lending can fall onto the lender and thus remove the majority of costs.

Secondly, regarding fed rates. For as long as those rates are at zero, that’s how much lenders can expect to make in the traditional financial system - fortunately, crypto isn’t guided by those same principles. The Fed is said to potentially keep these low rates until 2022, and if that’s the case, then seeing 100x returns in DeFi for at least two years more may not be too misguided.