The introduction of decentralised finance (DeFi) or open finance innovation has been a pivotal moment in the history of finance. It rose to prominence in the summer of 2020 with yield farming, the rise of tokens such as Compound and Sushiswap promising attractive yields to crypto traders.
According to DeFi Pulse, the total value locked in DeFi protocols is over $78 billion — a growth of 10x since May 2020. This represents the current value of all deposits locked in the form of cryptocurrencies for lending, staking, liquidity pool and so on.
According to Dune Analytics, there are over 4 million unique addresses (proxy for users) using DeFi applications — a growth of over 40x in the last 2 years.
Ethereum, the core blockchain powering DeFi applications and the second largest cryptocurrency by market cap ($345 billion), settled over $11.6 trillion in transaction volumes surpassing Visa (the second largest payment processing company) in 2021. This is an emerging alternative financial infrastructure challenging traditional finance.
Why DeFi is scaling so fast and why does it matter?
The 2008 financial crisis was an eye-opener on how fragile our current financial system is and heavily reliant on banks and financial institutions that act as intermediaries in providing any financial service.
Financial infrastructure has structurally not changed since the industrial revolution and it is similar to software in the pre-internet era. High entry barriers, opaque and inefficient processes and high transaction cost has resulted in limited innovation in core finance.
In India, over 190 million adults don’t have bank accounts; merchants have to pay 2-3% on every card or online transaction; small businesses find it difficult to avail credit from banks and international wire transfer is expensive. Trades in capital markets are executed electronically yet the settlement period is T+2 days.
While many fintech startups have emerged in the last decade, they are built on top of existing financial rails. The creation of financial products and services has always been a top-down process dominated by a few large financial institutions such as asset management firms, commercial banks and insurance companies.
DeFi is a bottom-up innovation that takes the component of centralised finance and replaces human trust with math-based trust, paperwork with smart contracts, legal enforcement with cryptographic enforcement, and third party audit with open source code and public ledger.
It is enabling developers to create new financial products such as decentralised banking, decentralised money markets and decentralised asset management firms.
DeFi aims to be 10x better, faster and cheaper compared with today’s financial services.
What the internet did to information, decentralised finance will do to centralised finance
Imagine the rate at which information is exchanged across the world today with social media. What if money is transferred and trades are executed and settled at the same rate?
Bitcoin challenged our assumptions about money. For the first time in history, we can send and receive money to anyone, anywhere in the world without a centralised intermediary. The launch of Ethereum in 2015 as a smart contract development platform was the “AWS (Amazon Web Services) moment in crypto”, enabling developers to build more complex financial applications like DeFi on top of it.
Comparison of decentralised finance stack with centralised finance stack
In centralised finance, there are assets like loans, gold, stocks and fiat. DeFi has new-age assets such as Stablecoins (1:1 pegged to US dollar), NFTs, protocol native tokens such as Ethereum, Compound and Aave in the form of cryptocurrencies.
Payments – In centralised finance, when a consumer makes an online payment to a merchant, various intermediaries are involved, such as issuing bank, acquiring bank, payment processors like Visa/Mastercard and payment gateway for validating and executing the transaction.
This increases the transaction cost. In the DeFi world, the same transaction will be executed and validated by blockchains such as Ethereum, which form the base layer of the DeFi stack and act as a single source of truth for all transactions within the network.
Transaction processing, clearing and settlement happen when a transaction is broadcasted on the network, eliminating the need for any intermediaries.
Addressing the challenge of cryptocurrency price volatility, Stablecoins are ERC 20 (Ethereum tokens) designed to stay at fixed value ($1) even when Ethereum price fluctuates. They are emerging as faster and cheaper alternatives in making domestic and cross-border payments globally.
The top 5 stablecoins (USDT, USDC, Binance USD, Terra USD and Dai) have a market cap of $170 billion.
Yield seeking (Lending, Borrowing) – In the DeFi world, anyone can avail crypto loans outside the traditional banking system without KYC and credit score, or borrow against crypto collateral. It is a peer-to-peer lending/borrowing market without the involvement of centralised banking and executed through smart contracts. Smart contract logic is immutable once coded on the blockchain.
Three of the top 5 DeFi lending/borrowing protocols are MakerDAO, Aave and Compound. Over $4 billion worth of loans has been issued on Compound.
Trading (Exchanges and Liquidity) – In centralised finance, being a market maker requires large capital and, thus, is concentrated in the hands of few large institutions. DeFi is building a level playing field for anyone with low capital to become a liquidity provider to a trading pool and earn yield with an automated market maker protocol like Uniswap.
As with any new promising technology, there are risks such as unsustainable high yields, leverage trading, smart contract bugs and price volatility of cryptocurrencies.
We are still in the nascent stage of DeFi, which is constantly evolving. There is innovation happening at every layer from core blockchain protocols, decentralised applications to front-end UI. Indian founders are addressing challenging problems in DeFi such as Layer 2 scaling solutions like Polygon and Biconomy and we at Gemba Capital are actively looking to invest in this space.
DeFi is a massive opportunity to disrupt any financial contracts from derivatives ($1 quadrillion), stock market ($90 trillion) to insurance ($6 trillion). And this is just the beginning.