Part 1. DeFi Introduction. Why Blockchain?
Decentralized Finance (DeFi) ecosystem is one of the fastest growing ecosystems within the blockchain space and rightfully so, as we are not just talking potentially taking a piece of the financial industry pie, but also expanding the pie altogether. This is made possible due to the novel services programmable money enables, something we never had before.
In this new dedicated DeFi series of our Journal articles, we will take a closer look at DeFi space, its components, DeFi stack, composability, incentive assumptions and of course the leading projects from various corners of this no doubt exciting space.
DeFi might well be the killer application of Ethereum. We have seen the narrative and usage of Ethereum shift from fundraising (hello 2017 ICO mania) towards it being a base layer for DeFi applications (see chart).
Ethereum’s character has changed: From a fundraising tool to a settlement layer for DeFi (see chart).
DeFi itself is a rather broad term and various people have their own understanding of DeFi. One of the recent debates with regards to DeFi definition was whether a Dapp with KYC can be considered a DeFi or not. Here in this series we take a broader stance on DeFi as the branch of blockchain-powered applications in one way or another playing into the financial industry, either competing with it, enabling or extending its functionalities.
One of the reasons for us to look at DeFi space broadly and not getting into a single community bubble is the fact that we as StakingRewards would like to provide data for all sorts of blockain-native ways to generate passive or semi-passive yield, hence the broader focus. Staking for example, as a means of generating yield, alternative to for example an interest rate belongs to this broad DeFi definition.
Blockchains are ecosystems and live off network effects. We have seen a lot of great projects struggle due to their inability to escape a failing protocol and being tied to an unhealthy ecosystem. This is why interoperability between DeFi is so important on both social and technological level. Developments around composability and increased modularity of the DeFi stack are further supporting this notion. There are some downsides to greater interoperability however, as when the frictions are phased out, we are likely to see increased competition, some incentive distortions and potential convergence to just a few DeFi applications. Some of these concerns will be raised in this series in more detail as we are still in the early stages, working out our assumptions and experimenting with new models, sometimes learning on our mistakes as it was with two recent bZx exploits.
Is there a place for traditional finance in DeFi?
Coming from a more traditional angle, is the asset tokenization, security or asset-backed tokens. Here we talk about real-world financial instruments and assets, which in itself is a space not to be underestimated. Here, DeFi applications enable the creation of an entirely new set of markets and financial instruments via a set of cryptoeconomic incentives.
In addition to enabling new markets and applications for consumers, DeFi is also changing the approach of established institutions by bringing decentralized solutions into play, which for the first time creates a competition in the financial industry.
When it comes to financial instruments and trading of these, most of the activity today is happening on centralized platforms which are not an improvement to what already exists in traditional markets. In addition to that, such centralized exchanges have a head-start as they have low latency, low fees and high liquidity. If DeFi applications want to compete with these directly, we need to address these issues and/or find market niches and products where some of the above-mentioned criteria are not as crucial for the market in question.
First projects trying to tackle these issues and challenge the status quo of centralized systems despite working, still are very fragmented, are siloed within their small niches due to lack of interoperability and standardization. These applications can also lack adoption due to sub-par UX. On the project side, often developers face regulatory uncertainty a lot of legal overhead. These issues combined did not manage to bring the promised liquidity to DeFi applications.
We have to build the DeFi stack piece by piece which is a complex task, but due to the number of teams working in the space this is a possible issue to tackle.
Blockchain for DeFi
Before we proceed with the Defi deep-dive, we need to get the traditional question out of the way – why even blockchain?
As we discussed in our Blockchain Infrastructure Thesis, if we collectively want to build a new or alternative financial system, we would need a solid financial infrastructure.
One of the pre-requisites of building any sort of meaningful application is the financial foundation (money) which is borderless, censorship-resistant, neutral, global and publicly verifiable. Without these, we will end up with centralized, siloed, censorable networks, which won’t be open APIs and would just replicate the systems of today. And even if for some reason we do want to pursue those use-cases where censorship-resistant money is not required, we still need a reliable, robust digital token of value to fuel our applications and smart contracts in the form of a stablecoin for instance (mostly relevant in enterprise setting).
Currently blockchain is the only base layer technology which provides us with a shot of that. There is a need to create 1-to-1 defensible peg between native blockchain tokens (BTC, ETH, ATOM, etc.) and synthetic assets in a trustless manner. Data transparency and auditability is an added value proposition for regulatory purposes, entitles however certain trade-offs like e.g. front-running (see our upcoming Liquidity, Front-running & Order Matching chapter).
Long tail of financial innovation, combined with cryptoeconomic liquidity incentivisation mechanism for e.g. underserved financial markets make DeFi protocols extremely interesting and not directly competing with some of traditional markets (FX and equities) and major centralized exchanges as well… at least in short- to mid-term (we will talk about it in an upcoming DeFi Ecosystem chapter).
One of the things to keep in mind however with the introduction of blockchain and tokens (see our upcoming DeFi deep-dive chapter) is that we as humans indirectly attach the value of the token to the value of the network, there are price-related risks which can impact the perception of the project and potentially drive community and investors away.
Coming up next
In the next issue of our DeFi series we will break down the DeFi stack, deep-dive into the ecosystem, Dapp landscape as well as various classes of actors. This will help us to get a comprehensive overview of the DeFi space before we can address issues and concerns, looking at DeFi solution design.
Gleb (Glib) Dudka is a strategic thinker and research analyst. He has bootstrapped the blockchain validator operations of T-Systems (Deutsche Telekom) as the first enterprise player in the staking space. At Staking Rewards he is leading Content and Research / Development.
Mirko Schmiedl is the Co-Founder, CEO and Product Lead at Staking Rewards. He is researching Proof of Stake Networks and yield-bearing assets since 2013. Prior to Staking Rewards he has led a Bitcoin Mining Operation in Southeast Asia.
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