It has only been about two weeks since I reflected on what it would take for the broader capital markets to take notice of DeFi in my blog post.
As if on cue, a few tokens were launched, products shipped and partnerships announced, and the DeFi ecosystem responded with a loud “HOLD MY BEER.”
Yield farming is on everyone’s lips as DeFi has now reached the point where the potential of programmable financial services is becoming visible to the outside world. That, and everyone is noticing a startup that has a liquid market cap of $2 billion six months after its Series A.
DeFi has now caught everyone’s attention.
Gas costs and scalability concerns
But something funny happened on the way to reinventing money and finance, because Ethereum isn’t scaling yet.
While most individual swap transactions occur in the $1 per Tx range, more complicated yield farming strategies that involve multiple protocols and multiple metatransactions can end up costing $20 to $50 to implement or settle. And that’s at current gas prices when user metrics are tiny. How high will gas prices be when the Robinhood brothers find out about Metamask?
Expensive transactions relative to the potential returns for retail stores mean that yield farming costs are prohibitive for most retailers, and the expensive transaction fees will shut out most day traders. We haven’t even touched on the still very strange user interface and the introduction of new concepts like permanent loss.
Ethereum’s scalability will be improved by a variety of approaches, from ETH2 to L2 to better gas and smart contract optimization approaches, but the incentives for yield farming and the inevitable frenzy won’t wait for scaling. This starts now.
So, on these important points, the ETH killers and skeptics were right. Isn’t this a catastrophe for Ethereum? Won’t this trigger a mass exodus of developers and users to the scalable blockchains?
A feature or a bug?
While we are not surprised to see the first fruits of composable financial services, there is legitimate collective concern that we do not yet fully understand what we have achieved.
Securing smart contracts alone is difficult. The risk of smart contracts related to composability is something we don’t fully understand yet, and in this case, failure can trigger a catastrophic or systemic event. It is impossible for the average retailer to assess this risk. Even crypto VCs have made this mistake in the past few months.
More pragmatically, the increased composability led to heated discussions about how $COMP incentives might affect $DAI binding. Of even greater concern is the permissionless ability to create cascading leveraged positions.
As Dan Elitzer put it in his Bankless post on aquaponic yield farming:
There will likely be hacking, exit scams, short-term asset price manipulation leading to liquidation cascades, and a whole host of other ways in which people (and likely some professional funds) lose a lot of money. Given the natural interconnectedness of many of these protocols and liquidity mining’s massive financial incentives to stack them as deep as possible, it’s possible that the whole thing will collapse. Even if that happens, it will be rebuilt. The promise of truly open, permissionless financial services is too big to die for.
A confusing user interface and exorbitant transaction costs, which at first might seem like a bug, end up becoming more of a feature that acts as a master of even greater speculation. If one were to imagine the most likely scenario for DeFi to experience a catastrophic event in the near future, it would be the combination of rampant speculation and cascading leverage before smart contracts are suitably battle tested.
DeFi is still learning and adapting
Predictably, new DeFi yield farmers chased the immediate high yield opportunities in BAT and USDT, with the Compound BAT pool hitting a whopping $311 million. It took the DeFi ecosystem just under two weeks to see how incentives had skewed, how changes were proposed, changes discussed and voted on, and then how those changes were implemented. The desired outcome occurred almost immediately, and the liquidity pool’s cBAT fell back to a more reasonable level of $29 million.
It’s fascinating how quickly this decentralized governance process happened and ended up providing the right incentives for DeFi’s long-term health. This result would have been a stunning accomplishment for an operationally efficient, centralized organization, but it’s a largely decentralized group of actors who happen to share the same long-term goals. Just as the composability of DeFi technology is beginning to show, so is the composability of the DeFi community.
Why it’s better to be lucky than good
DeFi is maturing at an *amazing* rate, but it’s not ready for mass adoption just yet. New stimulus is juicy enough to inject large amounts of new capital into the DeFi economy, but the remaining hurdles will prevent retail from getting the full load anytime soon. This should provide a sufficient hurdle for them to remain focused on the shiny object of bankrupt Stonks, allowing the DeFi ecosystem to continue to adapt and mature. And as DeFi stands today, that’s probably the best possible outcome. But for the ETH killers and skeptics, there won’t be much consolation beyond a few “I told you so.”
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