After a slow start, with a number of DeFi protocols having been around for a few years, the segment has recently drawn plenty of attention.
Projects are on the rise and some of the main players within the CeFi space are making sure that they aren’t left behind.
As with any new space, however, the pitfalls are many and the gold rush could be short and sweet.
At the time of writing, simply comparing the market cap of non-stable coins and stable coins shows how far behind DeFi is from CeFi.
Based on numbers at the time of writing, the total market cap of non-stable coins stood at US$310bn. By contrast, the total market cap of stable coins stood at just US$16bn
Some of the main players within the DeFi space predict a 20 fold increase in the market cap of stablecoins. It is, therefore, unsurprising that there is an explosion in the number of protocols hitting DeFi.
To view the current protocols launched within DeFi, DeFi Pulse provides a platform for protocols to list.
The list is broken down by function to make it easier for investors to find the protocol of their liking. These categorizations include:
Lending; Trading; Payments; Wallets; Interfaces; Infrastructure; Assets; and Scaling.
Additionally, there are the following categories to assist DeFi communities or new entrants:
Analytics; Education; Podcasts; Newsletters; and Communities.
While the projects are readily accessible, with DeFi Pulse making it easier for DeFi investors, key risks exist.
As a result of the very nature of DeFi, which is Permissionless and Trustless, not all of the protocols are audited.
Without governance and the anonymous nature, the protocol developers are anonymous. This has led to a vast number of scams and Ponzi schemes. Akin to any industry, bad news and dishonest participants tend to slow progress and, in particular, adoption.
Due to the sheer number of projects coming to the market, we, therefore, expect a period of consolidation. Many of the main players within the DeFi space expect that the vast majority of the existing projects will eventually fail.
What to look out for
When considering the view that a large number of scams and Ponzi schemes exist, there are ways to at least mitigate some of the risks.
These would include:
- Avoid protocols that are unaudited or unverified: While DeFi is a Trustless and Permissionless world, the more serious projects provide investors with the necessary comfort.
- Look for projects with longer vesting and incentive periods: Projects with vesting periods of as little as 2-weeks are unlikely to be there in a few months, let alone a few years. The anonymous founders will take their money and run… The same view is taken on incentives given to protocol communities. Within the DeFi space, it is the communities that are of greater importance. Short-term incentive schemes will not keep a community together for the longer-term. This should be considered negative.
- Look for innovative protocols: The key to the success of DeFi is to deliver protocols over and above those available within the CeFi and banking space. Finding protocols that bring innovative financial services to the DeFi space will find support. This is assuming that they address the issues raised above.
- Reputable Communities: As previously mentioned, communities are key to the success of a project. Not only must they be appropriately incentivized but they must also be reputable.
- Governance and Transparency: Alongside the communities, some sort of governance is also needed. That should come from a degree of transparency in the early years before becoming fully Permissionless and Trustless.
As with anything nascent, there are plenty of risks associated with DeFi. An advantage for the DeFi space, however, is certainly the lessons learned from the ICO boom.
For the DeFi space key risks and threats to its evolution include:
- Bad news: As with any investment opportunity, bad news does not help. The ever-present threat of scams and hacks leave DeFi exposed to unscrupulous participants. News of thefts and hacks would give DeFi a bad name and put its advancement back by years.
- Blockchain constraints: Ethereum’s blockchain is already at capacity. This means that the market requires a degree of fragmentation. Currently, Tron’s blockchain is the next viable alternative. Ensuring that there is not a complete fragmentation is important, however. A degree of specialization would be an acceptable solution. Here different blockchains would support different sectors…
- Vesting and incentive periods: As previously discussed these would need to tie in developers and communities for the long haul. A cut and run mentality would slow the evolution and adoption of DeFi.
- Financial Risk: Investors are currently exposed to the risk of significant loss. The developers and communities can mitigate some of the risks by:
- Carrying out greater testing and verification to eliminate debilitating bugs.
- Provide insurance to protect investor capital.
- Educate: Vastly increase the education currently available on DeFi.
- Platform Access: Simplify access to DeFi. The more user-friendly the greater the degree of user comfort. This is another avenue to build trust in the Trustless world of DeFi.
When considering the risks associated with DeFi, these are not wholly different from those seen in the CeFi space.
The key to the success of DeFi is to deliver communities with solutions that are also available in the CeFi and banking space. At a minimum, DeFi must deliver viable alternatives that deliver greater earning power.
Additionally, DeFi will need to be far more innovative and offer protocols that address the shortcomings of both CeFi and banks. In essence, this would be the development and mass adoption of automated asset managers.
Communities don’t need people but smart contracts that are able to locate the best earnings power across DeFi.
Coupled with smoother user experience, zero gas fees, and addressing the issue of unaudited smart contracts, the future does look bright.
DeFi will need to experience some consolidation, however. As was the case in the .Com and ICO booms, a large number of the DeFi projects will not last.
To prevent a DeFi implosion, however, developers and communities must address existing blockchain constraints. There will also need to be a greater degree of auditing, addressing vesting and incentive periods, and the availability of insurance to protect investors.
Fishing out the scammers and Ponzi schemes with limited reputational damage to DeFi will also be a must.
Having said that, there are certainly some positives that yield optimism. These include:
- Speed of innovation: While currently lagging CeFi, market leaders expect DeFi to grow exponentially relative to CeFi.
- The benefit of hindsight: DeFi can take the lessons learned from CeFi and the ICO boom and avoid the same mistakes.
- Early Awareness: There is early awareness of some of the key DeFi risks. This gives communities the opportunity to mitigate the risks quickly to support growth.
- Education: As the news wires report huge earnings potential, the education side is also improving. There is yet the widespread awareness needed, however, to compete with the banking sector. DeFi remains a niche space today and will likely remain so for the near-term.
When considering the risks and the positives, addressing these while continuing to offer a greater earnings multiple would support a positive future for DeFi.
There is a sizeable audience that DeFi can capture with relative ease. Target audiences would include:
- The non-banked: At the time of writing, the World Bank estimated 1.7bn people with access to basic banking. In the DeFi world, all a user would need is a mobile phone or a computer. There are no KYC or AML requirements…
- CeFi Users: For CeFi users, a migration to DeFi seems a natural one. Once DeFi has gone through its teething problems it is hard to envisage CeFi keeping up.
- Disgruntled banking customers: This is possibly the largest target audience of them all. For DeFi, the inflection point is expected to be when users don’t know that they are on DeFi. At this point, the banking community and CeFi may well find themselves in the history books.
We don’t expect a bust. The more innovative and transparent projects will likely enjoy longevity.
There is undoubtedly going to be some pain ahead, however, something that is hard to avoid in the early days.
As with blockchain and cryptos, the concepts are right and so it rests in the hands of innovators to deliver.
One curveball to consider, as always, is whether governments and central banks will allow the untimely demise of the global banking system.
If we learned anything from back in 2017 and 2018, anonymity within the world of finance is a no-no for governments.
How this plays out may eventually decide the fate of DeFi