On Interchain Finance: Part 1 — State of Decentalized Finance
Is DeFi Still Worth It?
Decentralized Finance, or DeFi, has been a massive topic in the blockchain space in 2019. Everyone is calling DeFi as blockchain’s next big thing, and expecting DeFi to completely disrupt traditional finance — just like back when Bitcoin first debuted as an alternative to centralized banks.
The reason for the massive hype around DeFi is simple: DeFi is the only application where public blockchains, such as Ethereum, could prove real utility for end users. It was different from almost everything else attempted on public blockchains, where most attempts either becoming an over-hyped scam or simply failing to gain enough mainstream industry attention. This time, DeFi seems real.
When we look at the amount of assets locked in DeFi applications, it is pretty clear why DeFi will not end up as a void hype machine. According to DeFi Pulse, the total value of assets locked on Ethereum DeFi services is nearing $900M USD as of time of writing. While this may not look like a large number compared to Fortune 500 companies, this is nearly 5% of Ethereum’s entire market cap — which, ranked against the Fortune 500 list, is around the 160–170th range. Considering Bitcoin’s market cap of $169,993M USD, which can be ranked around 9th on the Fortune 500 list, the potential of blockchain assets — and DeFi in general — is huge. No blockchain application have reached this number before, albeit still being relatively tiny.
The question is, though, whether it will be really worth the hype. Will DeFi finally be able to prove that public blockchains are also worth using for the ordinary end user?
A. The Current DeFi Stack
Current generation DeFi protocols can be largely classified into 5 categories: Lending, DEXes, Derivatives, Payments, and Assets. While some protocols and applications may not fit into these categories as clearly as others do, Lending appears to be the most popular category by market cap, with its dominance being more than 73%.
While there are a large pool of different DeFi protocols worth noting, we will briefly discuss major examples within two categories: Lending and DEXes.
(i) Lending
Maker is the most popular DeFi application in the entire market, with its market dominance being more than 57% by itself. Maker “lends” its users Dai, a stablecoin pegged to US Dollars, in exchange for Ether (and now other cryptoassets as well, with the introduction of Multi-Collateral Dai) as a collateral. This is also known as a Collateralized Debt Position, or a CDP. While the concept of lending and CDPs are used as a method to stabilize the market value of Dai, which is commonly used as a payment method, Maker is classified as a lending DeFi protocol due to its nature of relying on Ether collected from users opening a CDP as a mean of lending.
Compound is another popular lending protocol, which issues cTokens in exchange for its underlying assets lent to other users. A popular combination is to use both Maker and Compound through services like InstaDApp to yield full control over all underlying assets while still earning interests from the Compound protocol.
(ii) DEXes
We can’t talk about on-chain DEXes without mentioning Uniswap. Uniswap allows anyone to create a liquidity pool (i.e. a trading pair) by setting an initial exchange rate, and providing both Ether and a specified ERC-20 token of the same value based on the set exchange rate. All fees per trading goes to the liquidity pool, which is then divided based on the market proportion of liquidity providers within a given trading pair.
Uniswap’s simplicity allowed users to easily buy or sell cryptoassets without going through complicated AML/KYC processes. Similar on-chain liquidity protocols include Kyber and 0x, albeit using different models to create liquidity pools and process trading fees.
B. Current Limitations of DeFi
Even though there is a proven market for DeFi protocols as discussed above, DeFi still struggles from a number of limitations that severely hinder its adoption within the mainstream market.
(i) Utility
DeFi, in itself, have sufficiently proved that cryptoassets can indeed be attracting investments for traders within the traditional finance sector. However, it still lacks luring factors for everyone else — in other words, DeFi and public blockchain protocols in general do not have enough utility to be used as an everyday product.
Traditional finance usually link financial products to real-world utility. For example, while there are professional traders that specializes in stock trading, those stocks are typically shares or securities of companies that create products and services that serve a defining purpose for a relatively large market. Even though DeFi now has most of the frameworks that exist in traditional finance, and often exceeds them in terms of architectural efficiency, cryptoassets in general still do not have enough utility to be justified as something beyond trading assets. Without utility, there is a limit to the influx of new investment assets that provide extra liquidity and investment opportunities for traders. It’s a zero-sum game.
For instance, buying Amazon’s shares mean to provide development funding for the services they provide to some extent, even though you may not use their products and services at all; you are investing in the potential value Amazon will provide to end users. But what about crypto? Theoretically, people can build a fully decentralized website with Ethereum as its processing backend, and use IPFS/Filecoin to serve static content. The problem is that virtually nobody uses this configuration in production — because it simply isn’t competitive enough compared to existing cloud computing solutions, such as Amazon Web Services. They don’t have end user value. Because of this, valuation frameworks used with traditional finance cannot be applied to DeFi and public blockchains. It is obvious that cryptoassets representing these services are overvalued as a result of trading, especially compared to its market utility.
Each individual blockchain is a silo, where utility doesn’t contribute as much to its market value. The cryptoasset market in general is showing its limitations as a direct result of liquidity combined with market volatility and inefficiency — this must change.
(ii) Regulatory Issues
Blockchain-based systems are very difficult to control from a traditional regulatory point of view, as they do not follow typical standards expected from a “service” ran by a controlled “legal entity”. DApps and DeFi protocols do not have such entities, and this may result in potential regulatory issues that further block DeFi from entering the mainstream finance market.
One example is Uniswap, which banned countries that void US and international sanctions or do not comply with anti-money laundering regulations, such as Syria, Iran and North Korea, from accessing its frontend website. This was due to AML issues within certain legal jurisdictions that may block Uniswap from operating entirely. However, the Ethereum blockchain is always accessible from these countries as well; it’s only Uniswap’s website frontend, uniswap.exchange, that could enforce those bans. Simply forking Uniswap’s frontend repository, reverting that particular ban commit, and serving it on another website address will disable those AML measures entirely.
This shows just how incompatible DeFi is with existing finance regulatory frameworks, and the potential legal problems that lies ahead, while bringing DeFi products to mainstream finance. Without new legal frameworks, DeFi will always be an unregulated product that is barred from legally gaining new users.
(iii) Fundamental problems regarding DeFi and Proof-of-Stake rewards
Everett’s founder, Ryan Park, wrote a detailed series of posts explaining those problems in depth. TL;DR is that DeFi rewards and Proof-of-Stake rewards fundamentally compete with one another, and that this problem will cannibalize network security, especially on PoS-based networks.
Proof-of-Stake is the very framework that maintains the security of DeFi protocols on chains that use them. If DeFi canibalizes network security by providing more attractive rewards than staking, it will eventually harm both ecosystems.
This article is part of a 3-part series on Interchain Finance, which covers how Everett Protocol aims to lead this new emerging industry sector. Follow our Medium account for further updates.
