Will DeFi Emerge From Crypto Winter Stronger?

Galaxy Digital researcher Chelsea Virga writes about the innovations happening in decentralized finance.

AccessTimeIconMar 2, 2023 at 9:01 p.m. UTC
Updated Mar 3, 2023 at 9:35 p.m. UTC
AccessTimeIconMar 2, 2023 at 9:01 p.m. UTCUpdated Mar 3, 2023 at 9:35 p.m. UTC
AccessTimeIconMar 2, 2023 at 9:01 p.m. UTCUpdated Mar 3, 2023 at 9:35 p.m. UTC

We’ve all heard about hibernation, when animals in the wilderness conserve energy during periods of unfavorable weather conditions and food shortages. Bears, for example, reduce their metabolic state in the winter to conserve energy, only to later emerge in the spring leaner and stronger. The last few months in crypto has shown that decentralized finance (DeFi) is no stranger to a chilling winter – or bears, for that matter.

The total value locked across decentralized finance has fallen to about $50 billion, around one-third of its former high watermark in May 2022. While the question on DeFi’s potential to progress into a disintermediated and immutable financial system remains, there have been some meaningful progressions.

Chelsea Virga is vice president of Galaxy Digital’s strategic opportunities team.

In the aftermath of FTX’s collapse, billions of dollars flowed into decentralized exchanges (DEX) from centralized entities, doubling trading volumes in November alone. Even amid crypto’s market tumult, decentralized exchanges and lending platforms have functioned smoothly compared to some of their centralized peers. DeFi’s core features – such as smart contracts that have settlement instructions embedded in code and safety features including over-collateralized lending standards – explain how Maker, Aave and Compound successfully retrieved $400 million from a financially compromised borrower, Celsius Network. Meanwhile, that centralized borrower that has since declared bankruptcy and still has over $1 billion in outstanding liabilities to repay.

To unlock its potential, DeFi needs a narrative overhaul. For too long many protocols attracted users by dangling unsustainable yields – such as during the heated days of “DeFi Summer,” which was fueled in part by an accommodative macro backdrop. Since then interest rates have climbed, inflation has soared and the “risk-free” rate of return on six-month Treasury bills breached 5%, pulling interest (no pun intended) away from the blockchain.

A changing macroeconomic environment has had a ripple effect. A few months ago, after Coinbase increased its USDC rewards to 2.36%, DeFi giant MakerDAO voted to increase its DAI savings rate tenfold to 1% to remain competitive. Ondo Finance, an on-chain project focused on tokenizing U.S. Treasurys and corporate bonds launched a couple months back with the intention to offer “share class” tokens useful on other DeFi platforms as on-chain collateral.

DeFi’s future success lies in the creation of a financial offering that can improve upon centralized finance (CeFi) products. We’ve already snuck a peak at inventive concepts like distributed ledger technology (DLT) clearing and settlement, liquid staking, on-chain underwriting and zero-knowledge (ZK) privacy technology. These are all ideas that can drive efficiency in DeFi’s offering and underwriting systems.

Much of this activity is as dependent on regulators as smart contract engineers. Germany’s financial watchdog, BaFin, has acted proactively in regulating blockchain by issuing legislation on aspects like initial coin offerings, security token offerings and decentralized apps (dapps). Its approach may provide financial stability while still fostering innovation.

This is an area in which the U.S. is still gaining clarity. Securities and Exchange Commission Commissioner Hester Peirce has stated she believes regulation requires a nuanced approach where investor protection is prioritized without stifling technological progress. Peirce remarked in January that “regulation should foster an environment where good things flourish and bad things perish, not the other way around.” A unified framework needs to be implemented before many institutions will consider making the leap. In the meantime, DeFi continues to build.

Asset offerings and liquidity

Historically, CeFi has been the predominant liquidity provider for financial instruments in crypto, such as cash-settled perpetual forwards and other derivatives, primarily because they are more cost-effective for leverage seekers from a collateral perspective. However, this is changing rapidly due to distrust of centralized exchanges. On the back of the FTX exchange’s collapse, permissionless spot and swap exchange GMX more than doubled its protocol revenue in November to $16.7 million. Decentralized exchange dYdX gained 16,000 users between September 2022 and year’s end.

Another trend in DeFi has been liquid staking, which allows for users to earn yield from staking while still participating in DeFi activities. The Ethereum-based staking platform Lido’s utility token has seen an impressive increase in price since the start of this year, and there are over $9.4 billion of assets staked on its platform. Platforms like Lido take in assets, use those as staked collateral and provide alternative tokens users can utilize on their platform – a process that has a CeFi parallel in “repo transactions.”

Enabling a larger complex of assets on-chain will be key to enticing more activity and entrants to the DeFi market. Value generation will come from tokenizing real-world assets like money markets, real estate mortgages, trade finance and infrastructure loans, among others. With distributed ledger technology, DeFi has the potential to provide cheaper financing options through fractionalization and reducing the cost of entry for investors. Blockchain can drive a wider range of assets available to investors, ultimately building portfolio diversification.

There is a domino effect at play here. Last year MakerDAO, the largest DeFi protocol with $8.6 billion in total value locked, pushed further into traditional asset financing, with five traditional finance asset vaults and a $30 million DAI loan using bond token collateral out to a subsidiary of French finance juggernaut Société Générale. Then, a few months ago, private-equity giant KKR tokenized exposure to its $4 billion health-care fund on Avalanche. Subsequently, in November, Apollo announced plans to offer an upcoming fund on a public blockchain through Figure. Just last month Hong Kong’s government issued its first tokenized green bond worth around $100 million through Goldman Sachs’ tokenization protocol GS DAP.

These innovations show how traditional finance and decentralized finance continue to intertwine, or at least how many existing financial products can be reproduced on public blockchains.

Pricing models and risk management

DeFi’s fire was originally ignited by automated market maker (AMM) technology, such as Uniswap, where algorithms would facilitate token trading through a mathematical formula to determine asset prices. Nowadays DEXs like dYdX are increasingly implementing central limit order books (CLOB) similar to traditional exchanges where a database matches buy and sell orders for a particular asset. In some cases, market makers can be added through a request for quote (RFQ) integration to further supplement liquidity. Pairing AMMs with professional market makers bolsters liquidity and pricing execution.

An important consideration for all decentralized financial operations is how to optimize loan underwriting and ensure the collateral requirements are safe. DeFi lenders often require overcollateralization for lending. In other words, they require traders to pledge assets worth more than their loans.

Composable DeFi platforms provide innovative ways of collateralization. For instance, cross-margining, the process of cumulatively calculating a trader’s margin through calculating their unrealized profit and loss statements (more commonly shortened to “PnL”), is a valuable progression we’ve seen over the last cycle.

Lending protocols Aave and Compound allow for users to lever up based on loan to value ratios (LTV) and curate a single health factor that considers all their positions. DEXs like dYdX similarly allow for users to offset their trading losses with wins, and some are even offering partial liquidation protections (so if it comes to it, only the worst-performing part of a portfolio gets liquidated). While traditional prime brokerage offerings to funds remain more robust, these developments are a step in the right direction.

Flash loan smart contracts have been another interesting mechanism to reduce borrower defaults. For example, suppose a user is looking to fund a profitable arbitrage trade by borrowing capital unsecured. Smart contracts can consolidate the entire transaction from borrowing to repayment in an instant transaction, and will not fully execute if repayment will not occur.

Blockchain’s transparency can also be a benefit to risk management. Its immutable ledger gives users the ability to verify the ownership and movement of assets. Multiple projects are working along these lines, trying to use on-chain data to provide indications of creditworthiness and validation of real-time financial positions. That info can be used in tandem with off-chain financials to develop credit scores.

Zk-SNARKs (zero-knowledge succinct non-interactive argument of knowledge) will be an additional DeFi catalyst. In a nutshell, ZK technology will help parties examine whether or not a specific statement is true, without revealing any additional information beyond the statement itself. This can enable organizations to securely transact with others while still preserving some confidential financial information.

User interface and cross-chain accessibility

To reach mainstream adoption, user interfaces will need to improve. Wallets and decentralized applications (dapp) should be intuitive enough for all users – especially those new to crypto. Developers need to take a similar approach to the development of personal computers in the early 1990s, which focused on accessibility.

One user-friendly concept gaining traction among people interested in DeFi security is “account abstraction,” or a tailored approach to wallet recovery. This is an alternative to simply telling traders to take custody of their keys – “not your keys, not your coins.” Trading platforms like Argent.xyz allow select users or devices to act as guardians to help recover a wallet on a new phone. These social recovery features can make transacting on-chain safer.

Centralized exchanges in the past cycle were able to draw users from a widening array of layer 1 blockchain ecosystems. By contrast, DeFi projects are often limited by the chain they’re deployed on. For ether (ETH) to end up on it needs to pass via a bridge; a cumbersome experience will limit mainstream growth.

See also: DeFi Is the Way Forward, but It Needs to Evolve | Opinion (December 2022)

This is already changing. DeFi projects such as Osmosis, born in the interoperable Cosmos ecosystem, are using underlying cross-chain infrastructure providers, such as Axelar, to bring in users from any chain. Axelar enables Osmosis to create one-time deposit addresses for users similar to a centralized exchange. Osmosis is based on Cosmos, but it can accept tokens from Ethereum Virtual Machine (EVM) chains and beyond. (Axelar is a portfolio company of Galaxy.)

While Ethereum has been the dominant player for DeFi, the network’s congestion and significant gas fees remain a potential hurdle. At this point in blockchain’s evolution, DeFi is increasingly filled with alternative layer 1 and layer 2 high throughput systems, which scale transaction counts at a fraction of the price.

With the expansion of its product offering, improvements in pricing and accessibility, upgrades to user experience and enhancements in cross-chain capabilities, DeFi can emerge from crypto winter as a stronger animal. These major shifts will require a collaborative effort made up of innovation from developers, clarity from regulators and continuous feedback from users.

Vincent Van Gogh likened convention to “a paved road: It’s comfortable to walk,but no flowers grow on it.” DeFi has an opportunity to revolutionize traditional financial markets in the next upturn for cryptocurrency broadly – but only if we use the current crypto winter to rebuild the infrastructure that will let new things flourish.

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Chelsea Virga

Chelsea Virga is vice president of Galaxy Digital’s strategic opportunities team.