The recent events in the crypto markets have reaffirmed the value proposition of decentralized finance (DeFi) as one of the core building blocks of the future of digital assets. However, the DeFi space has also been impacted by the changes in the market because many of the top participants in DeFi have effectively disappeared. This combination of events creates a very strong friction for the future of DeFi. In some ways, the challenges with centralized financial (CeFi) institutions should favor the adoption of DeFi protocols. On the other hand, the fundamental market conditions that triggered the recent DeFi summer are not present anymore. While we can all agree that DeFi should be a key component of the next phase of the crypto market, the specifics are far from trivial and, most likely, will require significant changes in the industry.
Jesus Rodriguez is the CEO of IntoTheBlock. This article is part of Crypto 2023.
The DeFi adoption paradox
From a philosophical standpoint, DeFi is the one movement that encompasses the true ethos of decentralization, censorship resistance and financial inclusion. The recent DeFi rush was marked by both a tremendous level of innovation in protocols but also a disproportional wave of artificial incentives that fomented unsustainable yields and attracted participation from some of the biggest companies in the crypto space. The recent changes in composition in the crypto market have caused the total value locked (TVL) in some protocols to be at a multi-year low and activity in some DeFi ecosystems to be virtually nonexistent. Still, DeFi protocols have largely remained incredibly resilient while some of the biggest centralized institutions in crypto have completely collapsed.
The crypto market is relatively small, and CeFi and DeFi are intertwined in an almost paradoxical way. While the DeFi infrastructure was able to sustain the recent market shocks, the collapse of CeFi institutions has put a lot of pressure on DeFi protocols.
Simply put, DeFi blossomed in a market that doesn’t exist anymore. To fully realize its potential in the new reality of crypto, DeFi needs to evolve. But that evolution can translate into massive opportunities. For DeFi to find its place as the financial services foundation of the crypto space, there are five key areas where it needs to improve.
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The first generation of DeFi primitives that have dominated the market embody the principles of democratizing access to programmable financial services, but they do so at the expense of capital efficiency. Automated market makers (AMM) are an incredible innovation to foment transparency in financial markets, but they lack the efficiency of centralized order books. Overcollateralized lending has powered amazing innovations like flash loans – but it is the textbook definition of capital inefficiency.
Building a new wave of DeFi protocols with a robust capital efficiency foundation is paramount to streamlining the adoption of DeFi. Ideas such as hybrid decentralized exchanges (DEX) that combine order books and AMM mechanics or semi/undercollateralized lending protocols are likely to unlock some of the value in this area.
Crypto credit markets have been under stress for the last few months. Many of the market leaders in discretionary lending have gone out of business or remain unable to operate. As a result, building new mechanisms for credit in a transparent way has become one of the most attractive opportunities in the crypto market. The way to improve credit in DeFi is to build new forms of undercollateralized or semi-collateralized lending. While there have been some attempts in this space they can hardly be considered DeFi and have suffered from the native risks of lending to market makers. Alternatives that lend to parties with predictable on-chain activity such as staking providers, miners or DeFi protocols might be interesting to explore in this area.
New financial primitives
The majority of the activity in DeFi today is dominated by two main protocol primitives: market making and lending. While those components are certainly important, they are hardly sufficient to build an efficient financial market. DeFi is in desperate need of new financial primitives that achieve the level of traction experienced by AMMs and lending protocols.
Derivatives seem to be the obvious place for expanding the set of financial primitives in DeFi because they play a role in capital efficiency and risk management. The DeFi derivatives space has been steadily growing, and protocols such as Ribbon or GMX have certainly showcased the potential of the space. However, most DeFi derivative protocols still haven’t achieved meaningful adoption and more innovation is certainly needed in the space.
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Risk management and insurance
The events of the last few months have put risk management at the top of the list of requirements for institutions to participate in DeFi. Risk takes a very different form in DeFi than it does in traditional markets and, therefore, requires a new form of risk management technologies. The initial risk management efforts in DeFi have centered around technical smart contract exploits that, although important, only represent a portion of the risks investors face participating in DeFi.
Economic risk management represents one of the biggest opportunities to catalyze institutional adoption of DeFi. Solutions that manage economic risk conditions such as pool compositions, depegging scenarios, slippage, whales’ impact and many others are required to establish the level of rigor that large capital market institutions need to adopt DeFi at scale. One of the most interesting expressions of risk management will be insurance products. Economic insurance in DeFi remains a largely unaddressed problem and limits the options for creating sophisticated institutional structured products on DeFi rails.
TradFi bridges and real world utility
For the last two years, DeFi has remained a crypto-to-crypto market with very limited exposure to off-chain applications. While the crypto-centric dynamic has been key to accelerating innovation in the space, it limits the sustainability of DeFi as a financial market. For instance, sustainable yields in financial markets do not only come from market asymmetries but also from creating utility in businesses in the real world. DeFi needs to recreate a similar dynamic.
Building bridges to traditional finance (TradFi) applications can bring a new wave of utility to DeFi that translates into new avenues of financial activity. Protocols like MakerDAO have been experimenting with ideas in this area by extending loans to financial institutions.
When it comes to DeFi, very few topics are as polarizing as the discussions regarding regulation. Regardless of which side of the regulatory argument you sympathize with, it is hard to argue with the fact that the recent changes in the crypto market composition have catalyzed a more aggressive regulatory agenda that is going to touch DeFi at some point.
Regulation can certainly be harmful to the innovation taking place in DeFi but, when implemented thoughtfully, it represents an interesting opportunity for institutional adoption of the space. Many regulated financial institutions struggle with reconciling the financial benefits and opportunities of DeFi with the regulatory uncertainty surrounding the space. Protocols that implement forms of regulatory controls can certainly fill that vacuum. Most of the initial efforts to force know-your-customer (KYC) routines upon DeFi protocols have seen limited adoption, but there are interesting opportunities to leverage on-chain data for regulatory assessments of protocols. Brute force regulation could be very harmful to DeFi, but thoughtful regulatory controls might open the door to new waves of institutional adoption.
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