Decentralized finance, or DeFi, is a young industry.
It’s tough to find any mention of it before mid-2020, but the trend since then is unmistakable:
But this isn’t just an increase in curiosity. It translates to an inflow of money too. DeFi is a $100 billion sector, as of April 2021, and is continuing to attract new investors.
Good news for the industry, and for the nascent group of projects and platforms seeking to build out further. But how will they attract further investment?
Currently, DeFi is mainly appealing to a specific group of investors. They’re early adopters, unfazed by a space where much of the technology is relatively untested. They don’t demand consumer-grade UIs, easy access or simple controls. They’re risk-tolerant. And they can get along without a professional financial press.
Where traditional investment professionals read the Financial Times, DeFi investors rely on Reddit, Hackernoon, blogs specific to the space, Medium, and their own ecosystem of Telegram chats and Discord servers. In other words, they’re native to a financialized vision of the blockchain economy.
But for all their financial savvy and ambition, they’re typically retail-level investors, and that imposes limits on growth for the space. The High Net-Worth Individuals (HNWIs), professional funds, and institutional investors have not yet arrived in the space in force. But they’re probably coming, as we’ll see.
We can look to the history of investment in Bitcoin to see how retail investment alone doesn’t allow assets and businesses to reach their full potential.
Bitcoin’s investment history
About 46 million people in the USA now own some Bitcoin, according to a recent survey. But the majority of these hold small sums, just a few thousand dollars’ worth. Most BTC is held in large wallets belonging to exchanges (where the majority of BTC holders actually keep their crypto), HNWIs and institutional investors. And the percentage of Bitcoin’s $713 billion market cap held by institutional investors and funds is growing.
As it grows, it drives both an increase in price, and an insistence on regulation and professionalization. Thus, retail investors profit from the process too.
We can expect to see this same process played out for DeFi. First, it needs to attract savvy retail investors, a process which is already well under way. Then it needs to attract larger investors. Unlike BTC, which grows through price appreciation alone, DeFi platforms actually generate new wealth by trading.
How does DeFi work?
Much of DeFi takes place on the Ethereum chain, at least for now. Smart contracts are used to perform trades of other tokens and replicate the functionality of the institutions that make up the traditional financial system on the blockchain.
Users buy ETH, then invest it in a range of smart contracts that make investments in other projects; when those projects are successful, investors in the smart contract get back their ETH — plus more, or plus some other tokens. (This may sound a bit like ICOs, but there are important differences.)
There are two main ways DeFi investors can make money through the patchwork of smart contracts, stablecoins, and lending applications hosted both on Ethereum and elsewhere:
Users stake their existing digital assets in complex, multistage buy-and-sell deals that generate profits for new digital asset businesses, platforms, and investors alike. Gil Shpirman, CEO of Don-Key Finance, says DeFi is “trying to imitate traditional financial service providers with a decentralized twist”. Spiderman isn’t an outsider criticizing the space: In April, Don-Key added $2.2 million in funding from Black Edge Capital, Genesis Block Ventures and other digital asset-focused investors to its own DeFi social yield farming platform.
Platforms tempt DeFi investors with the offer of free tokens, meaning the barrier to entry is low. The platform gets its tokens out into circulation, and users get something to trade with, though its value is not guaranteed.
Underneath the immediate advantages of DeFi as a financial opportunity lies a network of real businesses, all using DeFi to deliver funding for growth. This is the other part of the puzzle.
How do investors learn about DeFi now?
Currently, investors are learning about DeFi through specialized digital asset-focused online communities and through instructional videos on Youtube.
“There is a lot of opportunity for retail investors in the DeFi space, especially for creating passive income”, Audrey Nesbitt, Global Head of Marketing at Metaverse, told Forbes.
“Token holders can deposit their funds into a liquidity pool to earn a passive income. There are some more established DeFi lending and borrowing protocols like Aave. Token holders of Aave get reduced fees, improved loan-to-value ratios, and staking rewards. The more utilities there are, the greater the token is worth in my opinion”.
What are the barriers to DeFi investment?
DeFi currently has similar problems to the rest of the digital asset space. In particular, most DeFi investment is via Layer 2 protocols running on the Ethereum blockchain. These Dapps, Decentralized Applications, are “sprinting into treacle” as they come up against a core element of the Ethereum model: gas fees.
Because of the way gas fees are structured, they disproportionately privilege discrete blocs of large transactions — exactly the type of transaction that DeFi relies on.
That’s one barrier: an underlying, technical obstacle to full-scale DeFi adoption. It’s possible to make too much of it in the context of the long-term prospects of DeFi. After all, Ethereum is planning to do away with gas fees altogether when it moves to the PoS-powered Eth2. But until then, it definitely stands in the way of more widespread adoption.
It’s also a special case of a wider issue. Blockchain-based tools will always encounter scalability issues because of the consensus algorithms that make blockchains safe and secure. When every node must participate in every transaction, times will slow and scaling will involve massively-greater computational load on the system than in conventional web applications.
This obstacle helps stop institutional and HNWI investors from getting involved in DeFi, because it’s clear that basic, underlying technical problems have yet to be solved.
Interfaces and access
DeFi also isn’t able to attract all the smaller and retail investors that it could. Interfaces are confusing, specialized knowledge is required, and a certain degree of confidence is a must if you’re to navigate the space’s customer-facing assets as they currently stand. That’s analogous to the wider digital assets space in 2017 and 2018, when the flow of investors into the space was slowed by difficulties accessing it.
Lack of on and off ramps, shortage of professionals able to communicate with both digital assets and traditional finance communities, and a lack of interfaces that hit the same standard as we’ve all been taught to expect by consumer-level web apps all helped. So did concern about regulation.
Regulation for DeFi is in a similar position to digital asset regulation in 2018-2019; it’s under discussion, everyone knows it’s coming, but few are certain of the form it will take. As with digital assets more generally, DeFi eliminates intermediaries and as such calls for a new approach to financial regulation.
It’s no longer possible to regulate crucial intermediaries such as banks, using them as “choke points” through which all financial traffic must pass. Around the world, other approaches are being trialled, including Europe’s MiCA (Markets in Crypto-Assets) regulations, are expected to be implemented sometime before the end of 2022. While we can’t be sure what form eventual regulation will take, we can guess at its general parameters, and we know it’s coming.
Where next for the space?
Regulators will move slowly, and there’s the background of uncertainty around digital assets regulation more generally, especially in key jurisdictions like China and India. So the space will move first, generating business solutions to problems like opaque interfaces and infrastructure issues.
One solution already up and running is Reef Finance, a Substrate-powered, Ethereum Virtual Machine-compatible DeFi-specific platform that allows wrapping, bridging and staking. Another is Cryption Network, calling itself DeFi 2.0 and offering a simple and accessible way to begin generating yield with DeFi.
We can also expect to see existing exchanges modify their stances, making it easier to connect to Layer 2 solutions and reducing fees and friction on transactions. They have a twofold job: to improve the service they offer extant clients, and to grow their user base by lowering barriers to entry.
Since the early days of digital assets, most on-ramping has been via centralized gateways and centralized exchanges. To the ongoing bafflement of decentralization and encryption enthusiasts, some of the largest and most active Bitcoin wallets in the world are owned and operated by centralized exchanges which are custodying millions of dollars’ worth of Bitcoin for their customers, all of it commingled in the same wallet (this drives conventional finance folks wild too).
But DeFi seems to be going the same way, with choke points not inside the system, but where it interfaces with the traditional financial world in the form of fiat on-ramping. Such “CeDeFi” (Centralized Decentralized Finance) operations are making it easier for the current crop of potential investors to step into DeFi and make money; they’ll even help you avoid common mistakes with your investments.
The real driving force for DeFi will be the ability to attract major investment, likely from wealthier individuals, professional investors, and institutions. It’s clear that major projects in the space expect to achieve this soon; why else would Karura, the Kusama-based DeFi sister project to Acala, have won the network’s first parachain auction, spending over half a million of its native KAR token (currently valued at $38 valued at $38 per token) to secure the slot?