Decentralized finance (DeFi) has a problem. Our goal was to create a financial alternative based on the shortcomings of opaque companies that often put their interests above those of their customers. The goal was a decentralized, self-managed economy that was transparent and largely independent of external influences.
Instead, crypto markets today depend on Federal Reserve Chairman Jerome Powell's every word, rely almost entirely on centralized stablecoins and incorporate real bonds as collateral.
While I am fully committed to a pragmatic approach – making short-term sacrifices that give us a better chance of achieving an end goal – it is time to accept that DeFi in its current form is not that decentralized. Blockchain financing might be a better term.
But returns from crypto-native staking can help us return to DeFi.
Many previous attempts at decentralized stablecoins have fallen by the wayside. In short, this is because they either found it difficult to scale and compete with their centralized counterparts or scaled too quickly due to fundamentally flawed designs.
Decentralized stablecoins are the holy grail, but we have seen a lack of innovation in this space since the collapse of Terra. New approaches are immediately rejected if they suggest anything other than an over-collateralized approach. DeFi was battered and shaken after Terra, and since then there has been an emphasis on security at the expense of innovation.
Centralized stablecoins are powering DeFi today and have a market share of more than 95% of on-chain volume compared to their more decentralized counterparts. The entry of established Web2 providers such as PayPal into the stablecoin space will only strengthen this trend. Centralized stablecoins are designed to get into as many hands as possible and have therefore quickly spread throughout DeFi. On the other hand, over-collateralized stablecoins, limited by their design, have lagged behind and failed to achieve the same level of adoption.
While it is positive to see the adoption of stablecoins, regardless of who issues them, it is important for DeFi to offer a competitive decentralized stablecoin that can stand on its own two feet and bring the “De” back into DeFi.
Second, the rise in US bond yields has pushed the real risk-free rate to 5%, leaving crypto-security assets that generate little to no passive income facing a competitive mountain to climb. If you run a crypto protocol that doesn't prioritize decentralization, it makes a lot of sense to transfer your collateral into a risk-free asset with a 5% return. However, this isn't just a problem with real-world asset inclusion protocols (RWAs) in search of higher yield – some of DeFi's biggest blue chips have moved a large portion of their assets into RWAs. According to rwa.xyz, tokenized treasuries have increased from $100 million at the start of 2023 to over $600 million today.
The speed and pace of US Treasury and RWA adoption should cause us to question the industry's commitment to decentralization. To be clear: It's okay if we have other goals, such as moving funds on the blockchain à la PayPal USD or settling Visa transactions via USDC on Solana. But let's be honest about the current state of DeFi: it is blockchain finance that runs on US treasuries and centralized stablecoins. This could modernize finance and bring more users onto the crypto track, but we need to start developing solutions that serve as decentralized forces for the space to provide viable options for holding money outside of the banking system.
Enter crypto staking returns, or more specifically, “post-Shapella” staking returns. Since the Ethereum network's Shapella upgrade, users have been able to stake and de-collateralize their Ether (ETH) at will, significantly reducing the risk of staked ETH from a liquidity perspective. This is reflected in Staked Ether (stETH)'s discount to ETH, which has barely fallen below 30 basis points since Ethereum's last major upgrade. Before the Shapella upgrade, stETH was a poor security due to its illiquidity and discount volatility. Now that stETH has been de-risked, we have seen it overtake ETH as the primary collateral asset across the DeFi space.
This means that DeFi now has a high-yield collateral asset that is both native to cryptocurrencies and decentralized. StETH's yield is 4% to 5%, giving protocols another option without the censorship risk profile of bonds. This will only contribute to the decentralization of DeFi as protocols and stablecoins can now be built on stETH instead of RWAs and continue to develop independently of the traditional banking system.
An interesting addition is that we are most likely at the peak of an interest rate cycle for bond yields and interest rates, meaning that in a few years we could see staked ETH returns exceed bond returns. In this scenario, the decision to keep RWAs for crypto protocols would be difficult to justify. At this point, we could see DeFi become truly self-sufficient and built on crypto-native, high-yield collateral.
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