DeFi 2021: What can we expect?

Markets Dec 30, 2020

What a difference a year makes.

Over the last 12 months, decentralized finance (DeFi) has exploded from a mere experiment into a multi-billion dollar industry with a slew of applications for saving, investing, derivatives, options and insurance. Total value locked (TVL), the key metric measuring how much capital is locked in DeFi, soared over 20x to reach north of $14 billion by the end of 2020, and there’s a sense that this is only just beginning.

So without further ado, let’s jump straight into some of the trends that are likely to drive DeFi over the coming year.

1. DeFi is Dead, Long Live DeFi!

During 2020, two trends played out in the blockchain space simultaneously. On the one hand, decentralized finance (DeFi) grew from an experiment into a behemoth with over $14 billion worth of value locked. As DeFi projects like Uniswap, Maker, Aave, Yearn, and Compound were becoming billion-dollar protocols, there was also a boom in high-profile security incidents that exposed many of DeFi’s vulnerabilities. DeFi farmers in 2020 felt a sense of manifest destiny as they sought out fertile land and the associated riches in an ever expanding territorial push across Ethereum.

It was not uncommon for FOMO-gripped investors to rush into unaudited, experimental applications with the expectation of earning insane returns, only to lose their funds in unfortunate hacks. Many high profile smart contract breaches and exploits have yielded handsomely for hackers and arbitrageurs at the expense of everyone else. The name ‘degenerate finance’ began to stick to these applications operating in the wild west of DeFi, where the lure of extremely high returns often trumps caution and common sense.

Aware that a ‘degen’ approach to finance is unsustainable at best if not outright destructive, DeFi industry leaders like Kevin Owocki, CEO of Gitcoin, are shifting in the direction of best practices that could boost the long-term durability of the space. This move from ‘degenerate finance’ to ‘regenerate finance,’ encourages fiscal responsibility, high standards of smart contract security, and an ecosystem built for the long run. Growth in accelerated security-focused development, DeFi insurance, and risk management will help expedite this move towards “regen” finance.

In a way, this shift mirrors the natural evolution that occurred in the blockchain space from the ICO-craze of 2017 to the more mature ecosystem of today. As DeFi enters its much-anticipated sophomore year, serious projects and investors could place a premium on sustainability while less-than-savory projects get pushed to the fringes.

2. Layer-Two Adoption Unlocks More Throughput, and Ultimately, More Volume

The worst-kept secret in DeFi, and blockchain in general, is that under the current network conditions, DeFi will struggle severely to handle the load of a mainstream wave of users. Ethereum mainnet, where most of DeFi currently lives, can be compared to a single lane highway prone to severe traffic jams. The more jammed up the Ethereum mainnet becomes, the more expensive it becomes to participate in staking, saving, lending and borrowing on-chain. It is not uncommon for users to face costs of over $100 for interacting with DeFi.

For this reason, much attention has been focused on layer-two networks that could raise DeFi’s glass ceiling by freeing it from the limitations of Ethereum. Instead of running all the processing associated with DeFi applications on a single blockchain, layer-two allows developers to offload the heavy lifting to a network of side chains while keeping a bulk of liquidity on Ethereum. If Ethereum is a congested highway packed with bumper-to-bumper traffic, layer-twos can be viewed as an alternative ‘lane’ on which to drive that nevertheless connects to the main highway.

Alternatively, many Ethereum supporters have been looking ahead towards Ethereum 2.0. Phase 0 launched in late 2020 with a flourish, but we will have to wait several years before the full migration is complete. Although promising, there are a lot of unknowns. Will applications and users migrate to Eth2? Can Eth2 handle the complexity of DeFi applications? These risks have driven a set of developers off Ethereum entirely to new blockchains in search of scalability and certainty.

3. The Flourishing of Non-Ethereum DeFi

In retrospect, one can see how the entire history of the Ethereum blockchain has built up to the ‘Year of DeFi’ we’ve just witnessed.

From the formative days of smart contracts, to stablecoins, DAO’s, and early decentralized exchanges, the range of applications at our fingertips today has become a set of building blocks supporting the modern DeFi economy. Each novel application leveraged the innovations that came before it, strengthening projects across the board. While Ethereum has benefited from a strong first mover advantage, newer ecosystems and protocols are taking a fast follower approach while pitching their scalability, costs, speed of transactions.

In 2019 and 2020, we saw multiple new protocols emerge with a dedicated focus on the blockchain’s largest use case. Binance, for example, is leveraging its huge user base to drive traction of the DeFi products on Binance Chain. At the same time, second-generation blockchains such as Cosmos, Polkadot, Tron, Solana, Algorand — to name only a few — are birthing their own decentralized lending, trading and liquidity platforms. FTX launched their DeFi offering, Serum, on Solana. Algorand has pulled in a slew of stablecoins onto their protocol including USDT and USDC. Even Compound, the Ethereum DeFi stalwart, is preparing to launch their own protocol.

Without a near term path to scalability on Ethereum 2.0, all of these protocols are racing to overtake Ethereum in terms of developer and user mind-share. They may be several years behind Ethereum in terms of users, applications, and financial “building blocks,” but they can benefit from the knowledge of the successes and failures of Ethereum. 2021 will see a growth of adoption and DeFi applications across these newer protocols, but whether they will succeed in overtaking Ethereum is another question entirely.

4. Accelerating Bitcoin Flow Into DeFi

At the same time as non-Ethereum DeFi ecosystems evolve, institutional involvement in Bitcoin is intensifying alongside a reawakening in retail interest in the space. Bitcoin’s meteoric rise undoubtedly fueled the DeFi fire in 2020, and is poised to do the same in the upcoming year. All the while the enthusiasm (and profits) generated by DeFi has fed back into Bitcoin.

In 2020 we saw the first true cross-protocol success story with Wrapped Bitcoin (WBTC). Without practical applications for their BTC, bitcoin holders have rushed to ‘wrap’ their assets and create DeFi-compatible mirror assets out of their precious BTC in order to participate in the DeFi boom. The outright leader in the “tokenized Bitcoin” movement is wBTC, which has a full 112,385 BTC locked, and is joined by other solutions like renBTC (14,000 BTC locked) and tBTC (1,700 BTC locked). Wrapped Bitcoin had an incredible 2020, fast outpacing Bitcoin’s layer-two Lightning Network in value. At less than 2% of the total Bitcoin supply, tokenized Bitcoin (in all its centralized and decentralized iterations) still has some way to climb and it won’t be surprising if it ends 2021 at closer to 5% of BTC’s total market cap. In 2021, it’s unlikely that Ethereum-based Bitcoin will be the only game in town as new protocols build out their DeFi offerings. No matter what anyone says, Bitcoin is still the biggest game in town and we’ll see it move across to these newer protocols in 2021.

5. Regulation Will Intensify, At Least In The US

Following on the heels of the CFTC’s enforcement actions against BitMex, SEC chairman Jay Clayton — on his last day on the job and right before Christmas jubilations — brought down the hammer on Ripple, suing the company and two of its executives for illegal security offerings. These two high profile cases demonstrate that U.S. regulatory bodies haven’t forgotten about crypto and they almost certainly are keeping an eye on DeFi.  

While there have been no DeFi specific enforcement actions since 2018’s settlement with the founder of EtherDelta, it would be far too presumptuous to assume that DeFi protocols and their founders are immune to U.S. regulators. SEC Commissioner Hester Peirce,  also known as “Crypto Mom,” was quoted in a recent CoinTelegraph article,

“DeFi has posed a challenge for the SEC in a similar way that the ICO boom did in 2017. What is different here is that the pace of DeFi has actually been much faster. I also think that the legal issues are more difficult to sort out on the DeFi side.”

The wild west of crypto may have been fun while it lasted, at least for some, but as the industry channels more volume it will inevitably attract more regulatory attention. DeFi, with its wealth of platforms and meteoric rise in value, is an obvious target for regulators. While some DeFi applications may be safer from enforcement on account of their decentralization, the space as a whole is on guard waiting on the SEC’s or CFTC’s next move.

Next Up: Mainstream Adoption

Although there is still a lot of uncertainty for DeFi heading into 2021, it is clear that DeFi is here to stay. There may be new protocols, new regulations, new tokens, but DeFi as a concept has established a foothold strong enough to withstand future headwinds. For now, DeFi has been limited primarily to a core group of blockchain fanatics, but the next milestone will be mainstream adoption in 2021 and beyond as DeFi blends more and more with the traditional fintech world.

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