Decentralized finance (DeFi) is one of the crypto market's fastest growing and most innovative sectors. Since the beginning of 2021, the total value locked (TVL) in DeFi has grown from $26 billion to almost $100 billion in November 2021.
Moreover, the tokens of successful DeFi projects became one of the most profitable assets in the crypto market in 2021. Their holders have increased capital by tens or even hundreds of times. But all this does not yet lead to significant growth and even less so for mass users.
This article explains how DeFi is revolutionizing the financial industry and whether will DeFi replace banks.
DeFi prospects
The DeFi market goes far beyond cryptocurrencies and simple transfers. It provides access to decentralized exchanges (DEX) and liquidity pools, credit, loan and escrow protocols, insurance, derivatives trading, and various other financial services. In theory, the DeFi sector offers a complete alternative to the traditional financial market. It operates without intermediaries on the blockchain and uses smart contracts.
Crypto-enthusiasts believe that DeFi is not just about high returns and speculation. It's a sector that can supplant the traditional financial market, replacing banks and fintech companies for hundreds of millions or even a few billion people. First of all, I am talking about that part of the population that has no access to traditional financial market services.
Decentralization and smart contracts allow DeFi-protocols to conduct transactions faster and cheaper than classical financial service providers. At the same time, these transactions are conducted without minimum transfer amounts and paperwork, and with full transparency. To access DeFi-enabled services, you don't need to provide documents, KYC/AML checks, and contracts to anyone. All you need is a smartphone and a crypto wallet.
I expect these DeFi advantages will encourage many people to abandon traditional banks and brokers in favor of DeFi-protocols. But this will not happen soon.
The DeFi sector is far from mass adoption
The real picture of DeFi adoption is still far from its theoretical prospects. Although the sector is growing at a fantastic rate, the number of users, transactions, and liquidity volume are not impressive.
According to Dune Analytics, the total number of unique DeFi addresses is 4.8 million, which is not much compared to the total number of cryptocurrency owners, estimated at over 240 million people.
Monthly DEX trading volume in 2022 averaged about $90 billion per month, exceeding $130 billion in May. By comparison, the daily trading volume on the centralized cryptocurrency exchange Binance alone exceeded $30 billion.
The highest activity in DeFi is among those players with large transactions. According to Chainalysis, transactions over $10 million accounted for more than 60% of transactions in the DeFi sector in the second quarter of 2021. In the crypto market as a whole, the share of such transactions amounted to 50% during the same period. The main players in the DeFi sector are professional traders, speculators, and large/institutional investors.
Chainalysis also ranked the countries whose citizens use decentralized finance most often. Thus, the top 5 countries for implementing DeFi are the U.S., Vietnam, Thailand, China, and the UK. Ukraine is in 9th place. The countries in the rankings are ranked in 3 categories:
- On-chain DeFi value received
- On-chain number of DeFi deposits
- On-chain retail DeFi value received
This data from Chainalysis makes me think.
Analysis of web traffic to DeFi platforms also showed Western Europeans had the greatest interest in the DeFi sector. At the same time, traffic from North America began to increase sharply from September 2019 and from June 2020 from other regions, especially Central and South Asia.
Interestingly, although China has become one of the largest countries in terms of DeFi transactions, the country's share of web traffic on DeFi platforms in East Asia remains low compared to its share of traffic on centralized crypto services.
Thus, it is clear that the adoption of the DeFi sector is moving fastest in high-income countries with already developed cryptocurrency markets and the largest institutional and professional markets. They are the driving force behind the popularization of decentralized finance.
This is another difference between the DeFi sector and the crypto market. According to the same Chainalysis data, digital currencies are generally more prevalent among residents of developing countries.
They are used for international transfers, protection against inflation, and access to financial services. United States, China, Ukraine, and several Western European countries with high levels of cryptocurrency adoption are critical to the DeFi market’s growth.
DeFi growth prospects
Looking forward, DeFi is quite capable of growing by 10 or more times in terms of funds raised. There are several reasons for this:
- Massive adoption of cryptocurrencies
- Global pursuit of high returns by investors
- Global rise in inflation
Institutional investments are another driver of DeFi's future growth. Right now, institutional investors cannot directly own cryptocurrencies and have to use custodial services.
For example, Grayscale, the largest crypto fund, plans to create investment funds for DeFi projects such as Aave and Uniswap. And crypto asset manager Bitwise launched its DeFi index in 2021, tracking the tokens of the 10 most popular DeFi protocols. The Aave credit protocol has been working on launching liquidity pools for institutional investors since May 2021.
But it is also important to understand that the growth rate of the DeFi sector will gradually decrease. For example, the high yields that DeFi protocols now offer should decline significantly as the industry matures. And it will also reduce speculators' interest in DeFi.
When venture capitalists will enter DeFi
Currently, venture capitalist search and investment potential are focused on blockchain, particularly the DeFi market. They believe DeFi will change the financial landscape in the near future. The argument for this is that there are many weaknesses in the traditional economic structure that decentralized finance implements more effectively, addressing trust, service availability, cost, liquidity, and many others.
Like many giants from the IT market, companies in the DeFi market started with a team of 3-5 people, and sometimes even less. By now, the industry has dozens of "unicorns," and the number of its investors' assets, according to Bloomberg, exceeded $100 billion in October 2021.
One prime example of such "unicorns" is Uniswap - a decentralized exchange, built on the principle of an automatic market maker. Its market cap on 07.08.2022 is $6 billion. Another "unicorn" is AAVE, a decentralized lending and borrowing protocol with a market cap of $1.5 billion. Using AAVE, users can pledge one asset to the protocol and borrow another against its collateral.
Institutional investors coming into the DeFi are looking at projects that, combined with the laws of the jurisdiction in which they are located, can effectively address traditional finance challenges. The most promising solutions are being developed based on Ethereum, Binance Smart Chain, and Polkadot.
They are likely to become major blockchains in the further development of the decentralized finance market. Institutional investors are also looking at projects that increase interoperability, allowing protocols from different networks to communicate effectively with each other.
World-renowned venture capital funds are already involved in the DeFi market, and there is increasing interest from Wall Street and other financial centers. An obstacle to expanding institutional capital into the DeFi industry is the lack of legally regulated solutions and products that meet corporate-level security and risk management standards.
What prevents mass adoption of DeFi (decentralized finances)
While DeFi has the potential to create an alternative financial system, right now, the sector is mainly used for speculation and is not popular with the mass audience and residents of developing countries. This has several reasons:
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Lack of responsibility. Decentralization is a major advantage and a major disadvantage at the same time. The absence of an intermediary means that no one is responsible for anything and assumes no responsibility for the safety of users' funds. This is an understandable risk when investing but a deterrent factor for other financial transactions, especially since most DeFi-project teams remain anonymous.
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Security concerns. Hackers regularly withdraw funds from DeFi-protocols by finding vulnerabilities in the code of projects. Errors of developers - the result of the haste with which new projects are launched. Investors' money constantly flows from one project to another - each new one takes off faster than the previous ones. Therefore, long work on security is simply unprofitable.
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Difficult to use. Figuring out how DeFi-protocols or liquidity pools work is much more complicated than just buying cryptocurrencies on an exchange and keeping them in your crypto wallet. The complicated interface of many DeFi-platforms also does not help in any way. It is rarely localized into national languages, is confusing, and contains no tips. You have to figure everything out on your own or search for information on the Internet. All of this is designed for experienced users who already know what they are doing. Therefore only technically savvy users go to the DeFi sector.
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Limited liquidity. DeFi-protocols do not have enough liquidity for a much larger audience right now. To reach the mass user will need to increase liquidity by hundreds of times. And the existing liquidity models are not ideal. For example, MakerDAO has a complicated pledge mechanism, while the gradual decline in liquidity with changes in the price of the asset occurs in Uniswap.
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Amount of collateral. DeFi-protocols have no credit ratings and scoring service, so projects need to be pledged from 150% of the loan amount. This option is unsuitable for those who don't have the funds.
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No direct exchange for fiat. Stablecoins do not replace the simple exchange of digital assets for fiat money that the mass user needs.
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Scalability. Although there are now over 40 blockchain networks in DeFi, most of the protocols run on the slow and inefficient Ethereum blockchain. With its use, a mass DeFi market really just isn't possible.
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Regulatory barriers. While regulators are still more preoccupied with ICO projects and large centralized exchanges, they are also starting to pay attention to the fast-growing DeFi sector. For example, SEC Chairman Gary Gensler believes DeFi protocols pose many challenges for investors and regulators. He has hinted that the decentralized finances sector may be high on his list of priorities. It should not be forgotten that the tokens of DeFi projects have shown impressive growth over the past two years - the regulator may well classify them as securities.
I have written A Brief Guide to the Challenges, Benefits, and Threats of the DeFi Industry article, where you can find much more about issues that prevent the DeFi sector from mass adoption.
Is it possible to solve DeFi's problems and accelerate its mass adoption
All the above problems are solvable and should fade away as the DeFi sector develops and matures. For example, security issues will decrease noticeably if developers conduct stricter audits.
The quality of interfaces, support functionality, and usability are also improving little by little.
Ethereum has begun transitioning to Ethereum 2.0, which should solve scaling problems and make it possible for tens or hundreds of millions of people to participate in the DeFi sector. And Ethereum is gradually losing share in the DeFi industry, giving way to other, faster, and more efficient blockchains.
The participants' desire for at least minimal regulation will give considerable impetus to the popularization of the DeFi sector. DeFi protocols will need to reduce the risks of fraud and money laundering, or regulators may take them seriously.
Conclusion: will DeFi be adopted en masse
Decentralized Finance (DeFi) market, a tool that helps improve a company's economic performance and helps save financial costs, is gaining interest among investors. The DeFi industry today is a multibillion-dollar business, with many "unicorn" companies represented.
But DeFi will definitely not replace the traditional financial system: we won't see mortgages or benefit payments in this sector. But neither will DeFi share the fate of the ICO sector, which imploded a year after the boom. Decentralized finance will be with us for a long time, if not forever.
DeFi technology and principles will likely move into traditional fintech companies. We will see P2P products based on smart contracts, with regulations and a central governing body. This will make the financial system fairer, more transparent, and more accessible.
DeFi will remain a niche for professionals in the coming years. Still, if the industry gets regulation and attracts more institutions, we may also see a gradual popularization of decentralized finance among mass users. For DeFi to become more mainstream, the sector needs to solve security issues, introduce minimal regulation, and websites need to improve the interface and user experience, as well as increase scalability, and attract liquidity. Then the benefits of decentralization will become more apparent to the broadest audience.
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