Decentralized finance or DeFi has taken off in a big way in the past 12 months. The platforms driving this market have seen exponential growth, with a 25-fold increase in locked assets over the past year.
So, what’s driving this stratospheric expansion, how sustainable is it and are institutional players likely to get involved?
You can think of the difference between centralized finance and DeFi as being analogous to the difference between a bookmaker and a betting exchange. While a normal bookmaker calculates odds, takes bets and pays out winnings, a betting exchange is a marketplace that connects consumers who wish to make opposing bets and takes a commission on the winnings.
Similarly, DeFi lending platforms connect borrowers and lenders and automatically calculate interest rates based on supply and demand. Furthermore, as this connectivity is entirely automated by smart contracts, fees tend to be very low.
DeFi first began to gather momentum in late 2018 through the work of a number of loosely-related blockchain projects. As the name suggests, the core goal is to offer financial services without intermediaries. 2020 has seen a huge expansion in crypto lending and borrowing, which, in turn, has led to increased awareness of the underlying platforms.
The reasons for the growth of the DeFi market
The growth of the DeFi market is driven in part by the need for cryptocurrency investors to access liquidity. In this respect, the digital asset market shares commonalities with commodities markets, where liquidity is also key. These dynamics produce the potential for asset holders to earn attractive yields, particularly in the current era of ultra-low rates.
For instance, credit networks such as Compound, Maker and dYdX offer crypto holders the chance to earn interest on assets that previously lay dormant in cold wallets. Borrowers are typically required to put up collateral that exceeds the size of the loan, while lenders earn regular interest payouts, but at a variable rate. This gives rise to the concept of yield farming, where asset owners put their holdings “to work” in various different liquidity pools in an effort to increase their annual percentage yield (APY).
This can prove lucrative, with some platforms offering double-digit annual percentage yield (APY) on US-dollar based stablecoins. Thus, it is hardly surprising that an estimated $44.2 billion is now locked in DeFi platforms according to the tracking websites.
Lending is however just one part of DeFi, with numerous other DeFi platforms already experimenting with other services such as trading and prediction markets (like Augur). Platforms like Uniswap, and its fork Sushiswap, achieved staggering growth in 2020, amassing a combined total of over $4bn in liquidity according to DeFi Pulse. In essence, these players serve as automated market makers, using an innovative and transparent protocol to connect traders and liquidity providers through smart contracts, all without the need for a central intermediary.
While these platforms have been buoyed by a flood of enthusiasm from retail investors, however, some issues still need to be resolved before they are a viable option for institutional players. For one thing, DeFi still carries significant technology risk. Capital flows within DeFi protocols are governed by immutable smart contracts. While this ensures they should be tamper-proof, they are still programmed by humans and bugs and vulnerabilities remain relatively common as a result.
In March this year, for example, the positions of 1,200 lenders on the Maker platform were suddenly liquidated for almost nothing due to a chain reaction caused by a rapid fall in the price of Ethereum. In November, a hacker managed to steal $8 million from Nexus Mutual CEO Hugh Karp by compromising his browser-based Metamask wallet. Such attacks provide a strong argument for enterprise custody solutions. One of Algotrader’s partners, Fireblocks, has met this need by providing a DeFi software development kit focused on the institutional market.
Regulatory concerns pose an additional barrier. Recall that DeFi platforms aim to remove intermediaries and as such, they typically consist of smart contracts running on Ethereum. As a result, there is not always an obvious institution or individual to regulate. The direction of travel seems to be that if a smart contract can be controlled by an administrator who yields special privileges, they are subject to the regulation. If no such privileges exist however (as is the case with Uniswap), nobody can be held accountable, even if it is well known who developed the smart contract.
As a result, some banks and financial service providers are exploring ways that DeFi protocols could be used to complement, rather than replace, their existing offerings. Indeed, AlgoTrader is working on integrating decentralized exchanges directly into our product so traders have the freedom to trade on both centralized and decentralized exchanges. This functionality will go live later in 2021.
In the more immediate term, some established players are seeking to provide a centralized alternative to crypto lending services. Swiss players like Bitcoin Suisse, SEBA and Sygnum, for example, recognize borrowing and lending are highly interesting crypto asset use cases, allowing them to augment their custody solutions with an additional service. In addition, centralized players tend to be able to offer lenders higher returns on ETH and BTC loans than DeFi platforms, which suggests that they can remain competitive while earning a margin.
The recent success of DeFi illustrates some of the underlying dynamics of the cryptocurrency market. In particular, it shows a large and growing demand for crypto-based financial services, particularly lending. While decentralized platforms have stolen the limelight in the retail space due to their stellar growth in recent months, regulated financial institutions are also beginning to respond to these trends. Hybrid solutions from regulated players and additional regulatory clarity will be required before institutional players are likely to start coming on board in numbers. Nevertheless, DeFi has emerged as a clear candidate to play a central role in the digital asset economy of tomorrow.
Andy Flury, Founder & Chief Executive Officer of AlgoTrader AG
Andy Flury is a serial Entrepreneur and Quantitative Trading Expert. Andy is a former Swiss Air Force pilot. He led projects at the Swiss intelligence Agency and various major banks. In 2010 Andy became partner and Head of Algorithmic Trading at Linard Capital AG, a Switzerland based quantitative hedge fund. In 2014 Andy started AlgoTrader, a comprehensive algorithmic trading platform that enables buy side and sell side trading firms to rapidly develop, simulate, backtest and deploy automated quantitative trading strategies on a single platform. Initially designed for global equities, futures, forex and options, since 2017 AlgoTrader fully supports automated trading of Cryptocurrencies. In early 2020 the company launched their new product WIRESWARM, and advanced order- and execution management system (OEMS) for trading and execution of digital assets. It enables banks and brokers to connect seamlessly with the world’s most liquid and regulated digital asset and cryptocurrency trading venues. Andy Flury holds a Masters in Industrial Management and Manufacturing Engineering from ETH Zurich and an Executive MBA from the University of St. Gallen.