Previously we’ve explored the transformative effects of the blockchain, social tokens and NFTs. Today’s post will explore Decentralized Finance (DeFi), with the challenges and opportunities we see as investors.
What is DeFi?
DeFi is the bank-less digitization of Wall Street. There are no intermediaries or excessive fees, just code. Transaction processing (settlement, payment, and transfer of ownership) are all near instantaneous. It’s accessible to anyone anywhere, so long as there’s an internet connection.
DeFi is built on blockchain technology and smart contracts, which we covered here. Simply put, smart contracts are programs stored on the blockchain and run automatically when pre-determined conditions are met. Numerous innovative companies are applying smart contracts to categories like lending and borrowing (Aave, Maker, Compound), insurance (Nexus Mutual, Opyn, InsurAce), trading or exchanges (Uniswap) and investments (UMA, Synthetix, and Market protocol.)
According to DeFi Llama, at the end of 2021 the total value locked in the DeFi ecosystem reached $247.5 billion. (Total value locked, or TVL, refers to the amount of capital in “use” or secured.) While that number is tiny compared to the equities, commodities, and derivative markets, the industry’s growth rate is impressive – an extraordinary 13x lift since January 2021. The open and efficient nature of DeFi, in addition to high returns to retail investors, have spurred this growth. In time, we feel crypto alternatives will apply significant competitive pressure on incumbent financial- service providers.
What’s next in DeFi?
A general-purpose blockchain, Ethereum is the dominant network of DeFi. As a first mover, Ethereum has fostered a strong community of users, developers, nodes, tools, and applications. However, Ethereum charges gas, or fees, to prioritize transactions. The greater demand for usage, the higher the cost of gas. Ethereum has sustained such a prolonged period of high demand that ‘gas’ costs have become preventative for many retail users. This runs counter to DeFi’s goals to lower costs and increase financial accessibility. Ethereum 2.0 should improve throughput and speed – but other smart contract platforms are making inroads. A key trend in DeFi is the rising popularity of other blockchain ecosystems beyond Ethereum.
In early 2021, according to Coindesk, “97% of DeFi’s aggregate TVL belonged to Ethereum; today, Ethereum possesses only 63% of that TVL.” One fast-growing “ETH Killer” is Solana, with nearly $9.9 billion TVL. They’ve capitalized on high transaction speeds and low fees, although they also face criticism for network centralization and technical outages.
Other blockchains like Terra are successfully focusing on a primary use case, like algorithmic stablecoins. Currently Terra has $18.46 billion in TVL with huge growth last year. Other Layer 1 (L1) blockchains that support DeFi include Avalanche, PolkaDot, Binance Smart Chain, Polygon, and Harmony. Their TVL growth and developer popularity signal a diversifying DeFi landscape.
A major hurdle in DeFi is scalability. A ‘one blockchain fits all use cases’ approach sounds good but clearly has limitations. Short- to mid-term, a sustainable DeFi ecosystem will likely consist of interoperable blockchains, each finding footholds among different market segments. We’d predict a multi-chain world enabled by bridges and cross-chain protocols will characterize the DeFi ecosystem over the next three to five years. Long-term, we’d expect most protocols will again hit the upper limits of scalability and fail to keep up with consumer adoption. In the decades ahead, the DeFi market will consolidate down to a few ‘best of breed’ players with the most sophisticated and robust infrastructure.
Another hurdle is regulatory. The SEC has concerns about lack of equal informational access around DeFi. Technical and sophisticated investors maintain a significant advantage over the average user in their ability to extract and interpret complex data, but the same could be said about traditional finance. While the SEC holds authority over some segments of DeFi, in other areas it’s ambiguous. A clear regulatory framework will take time to emerge, but a forward-thinking directive will accelerate consumer and institutional adoption.
Other hurdles to institutional adoption include tools to assess counterparty risk, enterprise-grade data and analytics, and a standardized application layer for trade execution. An enterprise-grade trading platform must rationalize the fragmented nature of DeFi. Early institutional adoption will follow mass consumer adoption, and be pushed by client demand, but only once the stage is set.
What does DeFi mean for finance’s future?
Interest in DeFi has risen with crypto’s boom and will likely persist. While cryptocurrencies and stablecoins are considered risky, DeFi offers token holders attractive returns compared to the sub-1% offered by major banks and geographies with negative interest rates.
In the near term, we expect more neo-banks and fintech companies to expand their product offerings to include cryptocurrency and standardized DeFi products – a trend known as Centralized Finance, or CeFi. CeFi players like BlockFi, Celsius and Nexo act as an intermediary for consumers and reduce DeFi’s complexity. In our opinion, whoever increases DeFi consumer usability and access will onboard the next 100M to 1 billion users.
We also expect DeFi to bridge the digital and physical worlds. DeFi will make alternative asset classes much more liquid and interchangeable. For example, tokenization has enabled fractionalization in real estate and other illiquid asset classes.
DeFi won’t replace our financial infrastructure entirely, the two will co-exist, but traditional institutions will eventually have to navigate this complex landscape. That will mean expanding their offerings, acquiring crypto market leaders, and/or re-engineering traditional financial products to remain competitive.
Like the rest of Web3, DeFi is a nascent category demonstrating tremendous growth. Within the next decade we believe DeFi will be a very competitive force in the finance industry, helping consumers improve choice, avoid inefficient “middlemen”, and align financial incentives.
The information contained herein is based solely on the opinions of Roger Lee and Courtney Chow and nothing should be construed as investment advice. This material is provided for informational purposes, and it is not, and may not be relied on in any manner as, legal, tax or investment advice or as an offer to sell or a solicitation of an offer to buy an interest in any fund or investment vehicle managed by Battery Ventures or any other Battery entity.
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