October 2020

DeFi in 2020

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Over the last year the DeFi ecosystem has seen significant growth, with the total value locked in DeFi contracts on Ethereum growing from USD500m in September 2019 to over USD10bn today.

In the next decade, DeFi will reshape financial services in the way that the Internet reshaped media companies over the last decade.

In August 2019 we wrote about the emergence of decentralized finance, also known as DeFi. This is a growing ecosystem of projects that are decentralizing traditional financial products such as lending, insurance, trust-less trading, stablecoins and low-cost digital payments. Over the last year this ecosystem has seen significant growth, with the total value locked in DeFi contracts on Ethereum growing from USD500m in September 2019 to over USD10bn today. We foresee this growth continuing and believe that DeFi will start reaching a larger and more traditional audience. This month we are going to revisit the state of DeFi and how it has evolved throughout 2020.

DeFi is creating a peer-to-peer financial system. Rather than relying on middlemen to operate markets and secure user accounts, Ethereum has become the settlement layer for decentralized transactions. The size of the DeFi market is reflected through the total value locked (TVL) in DeFi contracts, which today stands at USD10.4bn and has seen substantial growth in the last 3 months.

38% of TVL is locked in contracts related to decentralized exchanges (Dexes). The leading Dex with the most locked collateral is Uniswap. This is a product that facilitates peer-to-peer trading without having an order book. Uniswap pools liquidity for trading pairs and makes markets that are dependent on a deterministic algorithm. For example, there is a Uniswap pool with both WETH (wrapped Ether) and USDT in it. A trader can deposit USDT into the pool and withdraw WETH, or vice versa. The price of the WETH is dependent on the ratio of USDT to WETH in the pool. This particular pool currently has around USD500m of collateral in it.

While Uniswap is the leading Dex, there are a number of competing products that are vying to attract liquidity away from it. Curve is another leading Dex that works by creating liquidity pools, similar to Uniswap. Its main goal is to let users exchange stablecoins (like USDT and DAI) with extremely low fees and low slippage. The main difference between Curve and Uniswap is Curve’s focus on stablecoins and the fact that Curve pools can have more than 2 assets in them.

One of the defining narratives of DeFi in 2020 has been that of cut-throat competition. The story of SushiSwap illustrates how quickly competition can emerge in a world of open source code. The creator of SushiSwap copied the entire codebase of Uniswap and set up a competing exchange. The one major difference was that SushiSwap incorporated a token that paid a cut of trading fees to token holders. SUSHI tokens could be earned by providing liquidity to SushiSwap pools. As a result of this mechanism, in a matter of days, over USD1bn moved from Uniswap pools into SushiSwap pools as traders looked to earn the SUSHI token. This forced Uniswap to then release its own token(something that had been in the works) in order to attract traders back to its platform.

This mechanism of earning tokens from providing liquidity to smart contracts is known as “yield farming” and is another key trend of DeFi in 2020. Yield farming, which is also referred to as “liquidity mining”, is a way for holders of digital assets to earn rewards by locking up their assets. Yield farming was popularized with the launch of the COMP token, the governance token linked to a project called Compound Finance. The team wanted to distribute a token to its users, and it decided that a fair way to do this was to algorithmically distribute to users that provided liquidity to the protocol. The result of this distribution mechanism was a flood of new collateral being allocated to Compound as investors sought to earn the COMP token. This paved the way for numerous DeFi projects to offer their own tokens through similar mechanisms.

“Yield farmers” will typically move their funds between protocols in search of the highest yield. As more and more projects started offering yield farming opportunities earlier this year, it became challenging for investors to monitor where the best yield was. This led to the creation of one of the most extraordinary projects of the year – Yearn Finance. Yearn is an aggregator of DeFi projects, allowing users to deposit their funds into the highest yielding liquidity pools available on Ethereum. What is striking about Yearn is that it is a community driven project, with no VC backing or indeed any investors. While there is a governance token associated with Yearn (the YFI token), the founder of the project did not allocate himself any of this token. As a result, there was a completely fair distribution of YFI tokens to users of the platform and the users have become vehement supporters and contributors to the project.

Looking at the state of DeFi in 2020, it is clear that the vast majority of projects and attention is focused on the Ethereum ecosystem. One reason for this is the ability for projects to interact with each other on the platform since to date, Ethereum has the largest community and number of decentralized applications of all smart contract platforms. Stablecoin contracts can be tied to lending protocols, which can themselves leverage liquidity on trading platforms. In this way, Ethereum has been described as facilitating “money legos”. However, Ethereum has technical limitations which make it unsuitable for some DeFi use cases. Other smart contract platforms are looking to use this to their advantage and attract projects away from Ethereum.

From a technical perspective, Solana is perfectly positioned to host decentralized exchanges due to its extremely high transaction throughput. Serum, a DEX that we wrote about last month, is being built on Solana and is looking to utilize Solana’s speed and low cost. Terra, another non-Ethereum blockchain, is a great example of DeFi in action in the real world. Few of Terra’s 2 million users know that they are using a blockchain-based application with DeFi integrations. What they experience are lower transaction fees, faster settlement times, instant credit lines and high savings rates.

We are excited by the innovations happening in DeFi but are also cautious of its level of hype. Our approach to gaining exposure to DeFi is through holding larger positions in the platforms that DeFi will operate on, such as Ethereum, Solana and Terra, and smaller positions in specific DeFi products, like Serum. We look forward to watching the space evolve and are convinced that over time DeFi will disrupt existing financial services due to greater efficiencies, cheaper products and more inclusive coverage. In the next decade, DeFi will reshape financial services in the way that the Internet reshaped media companies over the last decade.