Decentralized Finance – Can DeFi weather the current crypto storm and deliver on its promise?

Martin Koderisch, Principal at Edgar, Dunn & Company, discusses smart contracts and use cases for Decentralized Finance (DeFi) while also detailing key challenges and the emergence of DeFi 2.0

The coronavirus pandemic led to a surge in money flow into cryptocurrencies and related decentralized finance (DeFi) projects. But so far, 2022 has been catastrophic for this space, with words like “complete meltdown,” “perfect storm,” “crash,” and “collapse” now being used to describe what’s going on. And yet it has happened before.

Bitcoin crashed 80% in 2018 to $3,000 in December 2018 and then rallied magnificently to an incredible high of $64,000 and a market cap of $1,270 billion in December 2021. Since then, the price has fallen to $20,000 and a market cap of 398 USD billion (as of early July 2022).

Given its volatile price action, one might think it will recover. Why should it be different this time?

On the downside, some commentators are taking a different view this time around – viewing the decline as part of a broader pullback from risky assets fueled by rising interest rates, inflation and economic uncertainty.

This pullback is leading to a massive amount of collateral damage, with the implosion of cryptocurrencies and DeFi platforms gaining momentum. The most recent high-profile case was platform Celsius, which paused inter-account withdrawals and transfers. From this point of view, you could now conclude that crypto is most certainly done and doomed.

In this short article, I will give a summary of DeFi, which has become the most active sector in the blockchain space and where cryptocurrency use cases, shall we say, have started to develop. DeFi still has a long way to go to maturity, but progress so far suggests that crypto is not dead and has a future – perhaps comparable to the dot-com bubble that predicted the future correctly but way too soon.

DeFi smart contracts and use cases

The aim of DeFi is to use blockchain technology to develop an alternative to the traditional financial system’s centralized approach, in which central authorities, institutions and intermediaries such as banks and brokers play the role of a trusted middleman to facilitate two-party transactions.

The first generation of blockchain-based cryptocurrencies demonstrated that two parties are able to conduct transactions without relying on a middleman acting as a validation agent. The advent of the Ethereum blockchain, considered the foundation of DeFi, further demonstrated that validation can be programmed directly into the code of the Ethereum blockchain.

These so-called smart contracts on the Ethereum blockchain have certain properties that offer potential benefits, allowing the smart contracts to act as an intermediary, replacing traditional middlemen and becoming the source of trust.

Features include:

• Programmability – Contracts are programmed to run automatically. The conditions are written into the smart contract code – known as algorithmic governance.

• Immutability – The terms cannot be altered or altered once the smart contract has started.

• Interoperability and composability – different components can be easily connected and work together.

• Transparency – Transactions are published on the public Ethereum blockchain and can be verified by other users.

• Permissionless – in theory, anyone can access the DeFi applications.

• Self-Custody – Users keep their assets safe and control their personal information.

There are many use cases in DeFi. Some are still quite ambitious – but others may be more concrete and include:

• Staking – the process of staging crypto assets to support a blockchain network and then acting as a validator to verify the transaction for which the user earns interest and other rewards – part of next-gen Ethereum 2.0 based on Proof of Stake and not based on a proof of the working model.

• Saving and peer-to-peer (P2P) lending – earning interest on crypto savings accounts – or crypto tied to a loan pool.

• Trading – The DeFi trading space is very broad and includes derivatives trading, margin trading and token swaps.

• Marketplaces – NFTs and DeFi protocols support a range of online marketplaces that allow users to exchange products and services globally and P2P – everything from freelance coding gigs to digital collectibles to real jewelry and clothing.

There are now countless DeFi use cases, platforms, exchanges and initiatives:

• New conceptual entities have emerged, including decentralized autonomous organizations (DAO). These cooperate according to transparent rules encoded on the Ethereum blockchain, eliminating the need for a centralized management entity.

• Stablecoins — a cryptocurrency pegged to fiat, gold, or other more stable cryptocurrencies — remittance payments, lending and lending platforms, and even institutional use cases like central bank digital currencies (CBDCs).

With billions of dollars worth of assets locked into Ethereum smart contracts, decentralized finance has become the most active sector in the blockchain space.

DeFi challenges and the emergence of DeFi 2.0

All blockchain projects face similar problems dubbed the “blockchain trilemma” coined by Vitalik Buterin, co-founder of the Ethereum blockchain. The trilemma posits that blockchain developers are forced to make tradeoffs between decentralization, scalability, and security — and are unable to deliver all three at the same time at the same level.

DeFi projects in particular face further dilemmas in terms of liquidity. Providing liquidity to a pool requires a user to allocate their funds to a specific liquidity pool. This so-called “lock-up” of funds is an inherently rigid structure, but is at odds with the natural behavior of investors to switch between pools of liquidity in order to achieve better returns. To retain the provider, pools offer rewards in the form of a native token.

However, short-term farm and dump behavior is common, resulting in an inevitable, capitulated sale of the native DeFi token, causing huge disruption and market inefficiencies. A DeFi 2.0 movement is attempting to address these issues by developing sustainable methods that ensure long-term liquidity. The most important thing here is to help users generate income.

Conclusion

At the conceptual level, the idea of ​​programmable smart contracts with blockchain-enabled immutability and transparency remains compelling. But efforts to put theory into practice have not been without problems. As in conventional capital markets, the behavior of market participants remains irrational for a long time.

But overall, the progress made so far suggests that DeFi and crypto have a future. It will continue to be a bumpy road and may take much longer than originally anticipated. There is a temptation to step out of the room and relegate crypto to the history books of bubbles and mania – but to do so would be wrong.

About Martin Koderisch

Martin Koderisch is a Principal at Edgar, Dunn & Company. He advises stakeholders across the payments ecosystem with a particular focus on recurring payments, helping e-commerce and subscription businesses transform their digital payments capabilities to drive recurring revenue growth. Before joining EDC in 2015, he had over 10 years of experience in the payments industry.

About Edgar, Dunn & Company

Edgar, Dunn & Company (EDC) is an independent global payments advisory firm. Widely regarded as a trusted advisor, the firm offers a comprehensive range of strategy advisory services, expertise and market insight. EDC’s expertise includes M&A due diligence, legal and regulatory support across the payment ecosystem, fintech, mobile payments, digitization of personal and corporate payments, and financial services.

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