DeFi splits in two
Will regulated assets resurrect a moribund DeFi market?
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DeFi began as a meme during the 2019 bear market and quickly rose to prominence. And with the explosive DeFi Summer in 2020, it soon became the leading crypto narrative outside of Bitcoin. At first, DeFi was hailed as the future of finance, the ultimate 'killer app' for crypto. However, as the bull market surged in 2021, it was NFTs (with their playful JPEGs) that captured mainstream attention.
Since then, DeFi has struggled to regain momentum, awaiting a breakthrough product that has yet to materialize. Few standout DeFi products have launched post-2020, and the OG DeFi tokens have failed to keep up with L1 tokens (only Aave has held its own). No consumer-facing application has achieved widespread adoption, and institutional DeFi has also failed to take off.
Despite the stagnation, DeFi activity continues its slow ascent, and is still the most widely used application type on blockchains. Moreover, unlike centralized players, the largest DeFi protocols have never failed. So why have investors and builders soured on DeFi?
Are we in the early stages of the decline of DeFi?
Our short answer is no. DeFi isn't disappearing— but it seems to be diverging. One side is more focused on attracting regulated U.S.-based investors, while the other embraces a borderless, permissionless ethos for global users. This bifurcation is making product development more focused and mission-driven for both segments.
Below, we explore the factors behind DeFi’s rise and then slowdown, and discuss whether stablecoins, RWAs, and other centralized assets will kickstart a DeFi Renaissance.
The core innovations of DeFi
DeFi distinguishes itself from TradFi with four key properties:
Non-custodial
Composability and permissionless
Transparent collateral and trustless execution
Onchain liquidity pools.
Though it may just be heresy in Ethereum-land, Bitcoin was the first official DeFi product, because it offered the first way to save without relying on an intermediary. Ethereum took this a step further by enabling non-custodial financial services built using smart contracts. Even now, this remains the defining feature of DeFi. This doesn’t mean that everyone must “be their own bank”, but it does mean that in DeFi, custody of assets is decoupled from financial activity.
“Money legos” were one of the first mini-memes in DeFi that demonstrated how different DeFi protocols could be packaged together permissionless-ly to form a new product. As DeFi has gone multichain, composability has become harder, although progress has been made at the infrastructure layer over the past year.
DeFi has shined most during periods of market turbulence, where anyone can inspect the onchain collateral of DeFi lending platforms, in sharp contrast to the black box of centralized lenders. This was most evident when Celsisus paid-off their onchain debts first; you can’t sweet talk a smart contract to hold off for a few more hours. Likewise, something like FTX repurposing (ahem, stealing) customer funds literally couldn’t happen in DeFi. This is because balance sheets in DeFi are transparent and its rules are enforced by open-source code.
The last major innovative property of DeFi are pooled onchain assets that enable liquidity for small markets. The first wave of DeFi lenders and decentralized exchanges struggled to gain users because of the cold-start problem. In lending, Compound pioneered liquidity pools so users didn’t need to match with a specific lender. Rather, they can now simply deposit into a liquidity pool where deposit and lending rates are determined algorithmically. For DEXs, Bancor and later Uniswap introduced automated market makers that utilized onchain liquidity pools to facilitate trading. Blue chip assets may be more efficiently traded on orderbooks, but onchain liquidity pools allow the long-tail of assets to easily bootstrap liquidity with low amounts of capital committed, and without needing to hire a market maker. Liquidity pools are key infrastructure for oracles and onchain liquidity is crucial to decisions around listing tokens on lending platforms. Liquidity pools also unlock another key innovation in DeFi: flash loans.
What went wrong?
With such innovations, why hasn’t DeFi already overtaken TradFi?
In part, it’s still too early. Much like how driverless cars are now slowly coming to market more than ten years after the hype began, building confidence and mainstreaming financial markets takes time. DeFi is not social media, where breakaway growth comes right after the proof of concept. Getting people to invest requires a higher level of trust that will take decades to build.
Next comes the elephant in the room. The regulatory environment in the U.S. – which has been broadly hostile towards crypto over the past three and half years – has dented DeFi in three notable ways:
Lack of quality assets: A financial system is only as good as its assets, and there aren’t enough blue chip assets to bring in more investors. DeFi can never reach real-world impact if it's constrained by the total market cap of crypto assets.
Banned front-ends for U.S. users: Many DeFi applications - like (Sky, formerly MakerDAO*) have geoblocked U.S. users due to fears of regulatory appraisal. Importantly, this prevents new U.S. companies from building mainstream-friendly products that use DeFi in the backend.
Disengaged DeFi governance: There’s no sadder story than Compound, which ushered in onchain money markets and kick-started DeFi summer with the launch of COMP. Its core team has moved on, and while they do not state it directly, fear of SEC action has kept their hands tied. This means that DeFi protocols suffered from a vacuum of governance with no serious engagement from investors and stakeholders.
This has hindered the growth of successful DeFi projects and prevented adjacent centralized players (CeFi, TradFi and traditional consumer tech companies) from offering products that would appeal to the crypto naive.
There are two other main impediments to DeFi’s growth:
1. The pernicious effects of MEV, with MEV-fear having stopped more crypto natives from moving onchain en masse.
2. The difficulty in building healthy credit markets.
DeFi lending is almost entirely dependent on leverage for underlying demand. It’s simply not a big enough market, and the attempts to expand to new areas like uncollateralized lending have largely failed.
So to recap, DeFi has failed to attract new crypto users largely because of regulatory constraints and a lack of quality assets. And it has failed to grow organically because of MEV and the inability to substantially grow credit markets.
DeFi growth: Two divergent paths
While it seems the regulatory winds will change after the U.S. election regardless of the outcome — and this will help with overall enthusiasm around onchain products — this won't help DeFi attract more high-quality assets. Even if there is a warmer regulatory reception to the idea of decentralization, there is no appetite for allowing tokenized versions of stocks or other real world assets to be freely traded by U.S. persons (unless that activity is under the regime of U.S. security laws). The same is true for any product offering a yield.
With U.S. regulation inevitable, there seems to be two future versions of DeFi emerging. One for U.S. investors that is regulated, and one for the rest of the world, which is less so.
The foundations of this regulated future are now emerging, with the issuance of tokenized regulated funds that limit purchases to qualified individuals and institutions. Here, the tokens come with a centrally-controlled “allowed list”, preventing transfers to unqualified individuals. We are already seeing product releases that would fit this model from TradFi and DeFi teams. Earlier this year, BlackRock launched BUIDL, a tokenized treasury product, and Superstate – founded by Robert Leshner, former CEO & founder of Compound – tokenized two regulated funds to be traded onchain. RWA.xyz tracks all of these tokens.
The onchain activity for these tokens is currently very limited. There are only a few addresses holding tokens. There are no lending pools, yield aggregators, or any onchain trading at all, but the benefit of tokenization is the ability to create a market structure that is digitally and globally native. Once there are enough assets onchain, then DeFi protocols are likely to launch, limiting users to regulated entities.
But is this really DeFi? Well, if we look back at the four innovations that DeFi unlocks above, we might give this version of DeFi a B grade. It’s not permissionless, but it can still offer transparency and trustless execution while enhancing efficiency with pooled assets. Perhaps the centralization of asset issuance will simply become the price of admission for U.S. institutional investors.
We can also see this drift towards regulation at the infrastructure level. ZKsync is actively marketing itself as an L2 for “institutional-grade tokenization” that would help maintain “regulatory compliance”. The launch of Unichain gives Uniswap more regulatory flexibility by controlling the validator set through UNI staking. Uniswap, in particular, seems well-positioned for a more regulated DeFi world with a wallet, an L2, a DEX aggregator, and a DEX.
The tokenization craze…again?
All of this sounds a lot like the tokenize-everything wave that swept the crypto space in 2017 (remember tokenized parking spaces and security tokens?). Much of this was silly, but the wave really fell short because there was never any reason to use a blockchain to facilitate regulated activity. Now with DeFi, we can see the attraction of financial infrastructure unique to blockchains. Onchain protocols can be valuable even if they're highly regulated.
There could also be some new unlocks from a more regulated DeFi. A regulated future reopens the possibility of capital formation returning as a key value add. If tokens had clearer guidance on how to be traded, then we could see the return of initial coin offerings (ICOs), which paired with AMMs and lending protocols could really lower the cost of liquidity and financing to small organizations. DeFi can compete for non-crypto businesses if there is a regulated, cheaper path to liquidity through onchain markets.
Two DeFi worlds, one DeFi Renaissance
At this point, it seems inevitable that there will be two versions of DeFi. So how will they interact?
Will they be at odds?
Ever the optimists, we say no. In fact, these two worlds will be largely complementary. We are already seeing this with stablecoins. The biggest holder of the BUIDL tokenized treasury product from BlackRock is Ondo Finance, which uses it to back another stablecoin (USDY) and pass along the yield from BUIDL’s holding of U.S. treasuries. Even Sky (formerly MakerDAO) has moved away from onchain backing of the USDS stablecoin (an upgraded version of Dai). Its RWA Tokenization Grand Prix invites teams to compete to introduce more RWA into USDS’s collateral base. M^0, meanwhile, is a new project that allows minting and redeeming of its M stablecoin by qualified financial institutions with appropriate backing.
Oddly enough, the most appealing DeFi product for non-U.S. individuals is stablecoins tied to the U.S. dollar. Already, it’s easy for U.S. residents to save in dollars, and it’s the asset of choice for the wealthy in developing countries. Yet there is huge untapped demand for dollar savings accounts across the world that stablecoins could tap into by offering cheaper access to dollar yield. This follows in the tradition of the Eurodollar, which are U.S. dollar-denominated deposits at foreign banks that are not subject to U.S. banking regulations. Eurodollars typically offer higher yields than dollars held in U.S. banks, but are also riskier because they don’t have the same reserve requirements or FDIC insurance.
With Stripe’s acquisition of Bridge, stablecoins are on the precipice for a breakout moment that will fuel growth in both regulated and non-regulated DeFi. This will bring in two new DeFi users: businesses that get stablecoin-pilled from Stripe, and retail savers outside the U.S. who don’t want to speculate but rather save using the world’s most stable asset. These users will spur new DeFi products not built around leverage nor speculation.
We expect the regulated version of DeFi to grow faster because it taps into the oceans of capital at regulated institutions, but the non-regulated DeFi world will still thrive, as has been clear from the success of Binance and Tether. Not only will this world serve a different market segment, like the Eurodollar market it will come with higher yields and more risk. The greater risk appetite in this world will also drive product innovation that will push innovation in regulated DeFi forward. This happened with Ethena, a synthetic dollar that derives yield from the basis trade, which surged to a $3 billion market cap in five months despite being off limits to U.S. investors. A month later, Superstate launched a regulated version of this with the Crypto Carry Fund. Non-regulated DeFi will be able to move quicker, but regulated DeFi will have access to an ocean of capital.
So how will it play out? Predictions are fun, so we’ll make a couple. In five years, the TVL of regulated DeFi products will be 50% of all financial activity on blockchains. And in ten years, the market will stabilize with regulated DeFi at 70%, as more and more real world assets are tokenized and the ocean of capital from regulated U.S. investors pours in.
The question is, will we still call it DeFi? TBD, but we believe two things will be true. 1. Financial activity will be the primary value driver for blockchains 2. Blockchain-based finance will eventually surpass traditional finance in scale.
Call it whatever you want.
Odds & Ends
African crypto startup Yellow Card raises $33 million in new funding Link
Overview of recent stablecoin bills Link
Uniswap launches its own DeFi-focused L2 Link
Recent trends in DEX volume across multiple chains Link
Flashbots releases Rollup boost that utilizes TEEs Link
Maker waffles on rebrand to Sky Link
Kraken plans to launch its own L2, Ink, based on Optimism Superchain Link
SAFE announces multichain gasless deployment for same address Link
Thoughts & Prognostications
Possible futures of the Ethereum protocol, part 3: The Scourge [Vitalik]
A new era of DeFi with Application Specific Sequencing (ASS) [Yuki Yuminaga/Sorella Labs]
Money routers- the Economic case for bridges [Joel John/Decentralised.co]
2022 Seed Stage Retrospective [Lattice]
How reliable is your node? [Kerman Kohli]
Polymarket and the power of collective intelligence [Matías Andrade Cabieses & Tanay Ved/CoinMetrics]
Uniswap v4 and Onchain Investment Banking [Peteris Erins/Auditless Research]
That’s it! Feedback appreciated. Just hit reply. Fall is here! I’ll be in Bangkok for Devcon and the week before. If you want to meet up, get in touch!
Dose of DeFi is written by Chris Powers, with help from Denis Suslov and Financial Content Lab. *I spend most of my time contributing to Powerhouse, an ecosystem actor for MakerDAO/Sky. Some of my compensation comes from MKR, so I’m financially incentivized for its success. All content is for informational purposes and is not intended as investment advice.