The Current State of DeFi

As of today, more than $200bn are locked in Decentralized Finance (DeFi). It has become a major field of in crypto. On the intersection to traditional finance, innovative smart contract-based applications open up entirely new markets for both traditional as well as novel finance business models. DeFi in the current state is a digital ecosystem that rebuilds long-standing financial services and processes them on a trustless infrastructure.

In this article, we will give an account of the current state of DeFi and its growth potential. We will also outline some of its applications.

DeFi has grown to >4.5mn users

Decentralized Finance is not only a transformative technology but also a movement. Teams of tech developers, visionaries and entrepreneurs have come together to improve the existing financial ecosystem and take it to the next level. DeFi has experienced incredible growth in the last few years. But how can we measure its adoption? A common approach is to look at the number of unique addresses that have interacted with DeFi protocols. According to Blockchain research company Dune Analytics, there were less than 10,000 unique addresses that interacted with Ethereum-based DeFi protocols in 2018. In 2019, the number of participants has increased by 100,000. To date, the number of users has grown to an astonishing count of >4.5mn. 

There are currently three main applications of DeFi:

Lending Markets

Borrowing and lending protocols have blown up in this space. Borrowers can access fast and easy loans, and lenders are able to generate interest on their assets. On the one hand, the protocols incentivize market participants to lend their tokens for very attractive rates. This way they get to access an extra source of yield to their assets holdings. On the other hand, borrowers are incentivized to borrow. This allows them, e.g., to profit from arbitrage opportunities between exchanges or other leveraged trading. To mitigate lenders’ risk of borrower default, borrowers have to lock-up collateral into a smart contract in order to access the borrowed funds.

Furthermore, lending protocols like Aave or Compound pioneered the concept of flash loans. In this innovative approach the issuance and repayment of the loan itself happens within one single block on the Blockchain. This mechanism waives the need for a collateral. This is only possible as the blocktime represents the fundamental, atomic time measurement within the ecosystem. Flash loans enabled parties, in principle, to get risk-free loans in strong contrast to the overcollateralized loans.

Maker was the first lending protocol to start functioning in the DeFi space. It allowed lenders to earn additional income through lending funds to other users. The Compound protocol appeared later, offering a wider range of tokens to lend and borrow. Then the Aave protocol (formerly ETHLend) started to compete directly with Compound, offering even more tokens and bigger margin possibilities. Currently, Aave has locked >$19bn in liquidity and is about to launch its version 3 soon. This in particular enables bridging possibilities (“cross-chain swaps”) between different Blockchain ecosystems. As an example one can deposit on Ethereum, borrow on Polygon and repay on Avalanche.

Decentralized Exchanges

Decentralized exchanges (DEX) have boomed over the last years. While lending markets might in total have greater liquidity volumes, decentralized exchanges have in general the biggest user share in DeFi. In decentralized exchanges, participants can choose either to swap their token or to provide liquidity to the exchange. This way they are able to earn a share of the trading fees and get rewards for the provision of liquidity. The ability to act as a liquidity provider (LP) creates a positive feedback loop: when the number of participants increases, the generated fees also increase, attracting more liquidity and therefore more participants.

The concept that Uniswap as one of the first DEX pioneered was that of an “Automated Market Maker” (AMM) functionality where the prices of a token pair is coupled through the so-called constant product formula x*y=k where x (resp. y) represent the price for token #1 (resp. #2) and the parameter k is the constant of the individual pool. The AMM stands in contrast to the orderbook model that traditional stock exchanges use and is also perfectly suited to decentralized networks as, e.g., there is no need for a (trusted) market maker to facilitate trades.

The DeFi protocol Curve Finance attracted huge inflows in 2021. Curve is based on an adapted version of the constant product formula. The protocol got famous as it provides a very efficient (i.e., cheap) mechanism to exchange pairs of stablecoins. It also features a cleverly designed governance structure and distribution mechanism of the rewards. These two factors lead to the “Curve Wars” which we will analyze in a later article.

Yield Aggregators

Yield aggregators act like “funds” that automatically look for the best yield opportunities in the space, managing participants’ capital with different strategies. Yearn Finance is the leader in this segment, with a total value of $3bn locked in the protocol to date. It is important to mention that yield aggregators not only serve individual investors that are looking for yield, but also serve other DeFi projects, and interact with their smart contracts autonomously. This is a significant improvement compared to the traditional finance ecosystem and is based on the compatibility of DeFi protocols as such.

Current state of DeFi: TVL of Yearn Finance over the last two years.
TVL of Yearn Finance, Source: DefiLlama

Participants receive rewards for providing liquidity to decentralized exchanges, borrowing/lending markets and yield aggregators. This attracts more participants and increases liquidity, which explains – together with the lack of attractive alternatives to invest in – why DeFi has grown so fast in the last few years.

Conclusion

DeFi has become one of the most dynamic sectors in the crypto realm in a very short time. In the current state of DeFi there are still lots of financial processes that are waiting for exploration and development. The actual size of DeFi is difficult to assess. It can be approximated with newly-created metrics such as total value locked (TVL), liquidity and unique users. All of them show an exponential growth over the last years. Despite DeFi being in its infancy, with the amount of room for improvement and current speed of developments, DeFi is without a doubt the future of finance.