DeFi: Past, Present, and Future

The DeFi space is clearly at an interesting point in time.

On one hand, DeFi tokens have lost up to 95% of their value in the current inter-market cooldown, NFTs and the metaverse have taken center stage, and DeFi 2.0 has lost its initial momentum. There have also been a lot of exploits, regulatory uncertainty, an unprecedented cult of personality, and some questionable hires.

On the other hand, the existing mature DeFi protocols have been supporting a large amount of daily activities. DeFi has just started on L2 (second layer network) . Multi-chain DeFi and DeFi on other chains are also experiencing a rapid growth phase.

So, is the worst over? Are we on the brink of a DeFi renaissance? You’ll find the answers to this question and more in this article.

past

Since the beginning of 2021, the market has not been friendly to DeFi.

Despite the amazing innovation and growing TVL (total value locked) on DeFi protocols, the prices of DeFi tokens do not reflect this.

Even when DeFi tokens have appreciated in value along with the overall market, they have still underperformed ETH in most cases.

People’s attention is focused on other things: NFTs , Meme coins , the Metaverse , alternative L1 chains , and so on.

DeFi 2.0 brought a little hope, but ultimately led to excessive market exuberance and painful price corrections.

Ethereum L2 scaling has not arrived as quickly as most people expected, which has created a huge opportunity for other L1 chains. Due to the ease of deployment to other EVM-compatible L1 chains, forked versions of many well-known DeFi protocols (such as Uniswap and Aave) have been deployed on these L1 chains .

Olympus is perhaps the most forked of all DeFi protocols, driving a seemingly never-ending Ponzi game across all possible EVM-compatible chains.

An unprecedented cult of personality doesn’t help. Perhaps, in a world where code written anonymously can process billions of dollars’ worth of transactions, we should focus less on individuals and more on what really matters: code and community.

History has proven time and again that admiration for a person can dissipate just as quickly as it rose.

There’s also a lot of discussion about morality in DeFi. Should a criminal convicted of fraud be allowed to anonymously build a protocol without anyone else knowing?

This question may not be as easy to answer as we think. For some people, especially those coming from the traditional financial industry, this is unacceptable. For others, being a good contributor to the ecosystem is what matters, and they believe that people should be allowed to "turn over a new leaf."

One thing is clear, anyone working on a DeFi protocol should not be able to access people’s money on their own — no matter who it is.

The DeFi space is not very good in terms of attacks and vulnerabilities . DeFi protocols such as Poly Network, Compound, Cream Finance, Badger, etc. have all been attacked.

Rug pulls haven’t slowed down either, with hundreds of forked versions of DeFi protocols being created with the sole purpose of stealing user funds.

The Wormhole (cross-chain protocol) vulnerability alone caused a loss of $326 million, which was fortunately covered by Jump Crypto (investment company), one of the largest players in the Solana ecosystem.

Since the beginning of 2021, the total amount lost due to hacking attacks and vulnerability exploits is approximately $2 billion .

There were also a few very thrilling moments.

A vulnerability discovered by DeFi researcher and white hacker Sam Sun on the Sushiswap protocol could lead to a huge loss of up to $350 million. Hats off to Sam Sun for disclosing the vulnerability in a professional and timely manner.

Unclear regulation around DeFi and cryptocurrencies is another widely discussed topic that creates a lot of uncertainty for users, investors, and founders.

This includes countries banning and lifting cryptocurrency bans, draconian laws attempting to incorporate DeFi into existing financial rules being voted on, and more.

While regulatory uncertainty has not completely disappeared, the other things mentioned above can be considered relics of the past and there is certainly something to learn from them.

Now, let’s discuss the current state of DeFi.

Now

According to DeFi Llama, the total value locked in DeFi is about $215 billion . This is down slightly from $255 billion at the end of 2021, but still high.

In terms of decentralized exchanges (DEX), monthly trading volume is around $50-60 billion . This is down from over $100 billion at the end of 2021.

Despite some new entrants in the DeFi AMMs (automated market makers) space, Uniswap ’s market share remains high, accounting for about 75% of total trading volume.

In terms of DeFi lending, at the time of writing, Aave Protocol liquidity across 7 different blockchain networks hovers around $20 billion. This is down from $31 billion at the end of 2021, and the number of networks has also decreased.

Although on the surface it may seem like DeFi has been stagnant for some time. In reality, this couldn’t be further from the truth.

Some major DeFi metrics, such as the total value locked (TVL) in all DeFi protocols or the trading volume of decentralized exchanges (DEXs), do not show us the whole picture because they are always correlated with current market conditions.

We have to look more closely inside DeFi to understand what is being built and its impact on the future.

L2 (second layer network) scalability solutions are obviously a major development that can significantly increase DeFi adoption by reducing costs and increasing transaction speeds.

Optimism   and Arbitrum   Their codes are being improved to make them cheaper and cheaper to use.

Polygon   There are already many scalability solutions including ZK Rollup technology, such as Hermez, Nightfall, and Maiden.

After successfully scaling single-purpose protocols like dYdX, DeversiFi, and Immutable X, StarkWare is developing a more general ZK Rollup network called StarkNet.

Meanwhile, other L1 chains are not slowing down .

DeFi on other L1 chains such as Avalanche, Fantom, Solana, Terra, etc. is also experiencing a period of rapid growth.

Although at present, most of the DeFi protocols on these alternative L1 chains, especially those on EVM-compatible chains, are forked versions of the DeFi protocols originally built on Ethereum, there are also many new things being tried and built.

Despite some initial criticism, we can see that the multi-chain theory is working and bearing fruit.

In the search for DeFi returns, users are keen to bridge their assets to other chains.

This all looks very exciting, but we need to remember that cross-chain bridges are inherently problematic. Transactions between two different chains protected by different consensus mechanisms cannot simply be executed as one atomic operation, so assets crossing chains either require trusting a more centralized "bridge" or relying on a relay network rather than relying on the consensus of the two chains we are bridging .

Bridging assets to an L2 network (such as Optimistic Rollups or ZK Rollups) is a bit safer because most L2 networks have escape mechanisms that allow funds to be withdrawn directly from Ethereum L1 if problems arise .

Projects focused on multiple chains, such as Cosmos and Polkadot , may also be interesting solutions, since in such networks bridge transactions are usually protected by 1 consensus mechanism , but this does not solve the problem of cross-chain between two different L1 chains.

When it comes to DeFi 2.0, certain mechanics of this paradigm shift (primarily around incentivized liquidity) may prevail despite the market’s excesses.

DeFi protocols like Tokemak maintain over $1 billion in TVL and introduce new and useful features to the entire DeFi ecosystem.

Other   It remains to be seen whether DeFi 2.0 protocols , such as Olympus , can shine again and regain their initial power.

Currently, the market capitalization of the Olympus Protocol token OHM is largely supported by the value of the vaults controlled by its underlying protocol, so to some extent, the protocol is operating as expected in the worst case scenario.

Other more mature DeFi protocols are not resting on their laurels.

Aave recently launched V3 of its protocol, which introduces better capital efficiency and improved risk management.

Bancor also announced V3 of its protocol, which reduces transaction costs, allows unlimited deposits, and provides instant impermanent loss protection.

Thorchain has recovered from the hack and recently introduced synthetic assets, aiming to increase network usage, network TVL, and the depth of liquidity pools. This also allows it to provide cheaper token swaps and higher income for liquidity providers (LPs).

MakerDAO is discussing a new, aggressive growth strategy that involves expansion into more real-world assets as collateral for DAI.

Sushiswap is working on Trident, a framework for creating AMMs and Shoyu 2.0, an NFT marketplace.

The Curve protocol , which powers most stablecoin swaps in DeFi, has also not slowed down. Curve’s token economics model has incentivized many other DeFi protocols (such as Yearn Finance, Convex Finance, [REDACTED] Cartel, etc.) to compete to capture CRV token revenue. Due to the competitive nature of this, this competition has been called the “Curve Wars.”

The CRV model has become so popular that it is being copied by many other protocols in the DeFi ecosystem.

As for Ethereum itself, EIP-1559 , despite some initial concerns, has been steadily working since its implementation, destroying ETH every day. Recently, a total of more than 2 million ETH has been destroyed since the change was deployed.

There has also been a big growth in liquidity staking . Lido dominates this space, with over $8.5 billion worth of ETH staked through the protocol. The protocol also supports staking on other blockchain networks, with a staggering $7.5 billion worth of LUNA staked through the protocol .

Another liquidity staking protocol Rocket Pool   Opting for a harder path and deciding to start from a more decentralized state, the protocol has also shown impressive growth, with nearly $500 million in ETH already staked.

Although not exactly DeFi itself, NFTs , the metaverse , and crypto social media (including the Web3 social protocol Lens Protocol launched by the Aave team ) have become hot topics.

This could bring more people into the crypto space and allow them to discover DeFi as well.

Apart from this, it is worth mentioning that even during the market cooling period when users are less willing to invest in new projects, venture capital will not sleep and will pour billions of dollars into the DeFi ecosystem and the entire crypto space.

This provides enough funding for early-stage projects to focus on building rather than worrying about how to survive until the next bull run.

As we can see, the DeFi ecosystem is thriving despite the market downturn, and it won’t stop here — let’s take a quick look into the future.

future

The Ethereum merge is an event that has been widely discussed and is getting closer and closer.

The merger will cause Ethereum to transition from PoW to PoS and significantly reduce the issuance rate of ETH, which is very likely to cause ETH to fall into deflation .

Currently, the Ethereum merge is estimated to arrive between June and August of this year, but of course, this depends on further testing. This is one of the biggest changes to the Ethereum protocol ever, so it cannot be rushed.

The merger drives one of Ethereum’s current narratives and could drive the next bull run for ETH and DeFi.

There are many other improvements planned for Ethereum.

For example, EIP-4488 can reduce the transaction cost of Rollup by reducing the gas cost of calling data.

Ethereum-based L2 networks are another catalyst that could drive users to rediscover DeFi.

Through the L2 network, DeFi will not only be cheaper and faster than ever before, but will also enable new DeFi protocols that were previously impossible on the Ethereum L1 network.

Most L2 networks also have a secret weapon. They will likely all launch a native token and quickly spur growth. I wouldn’t be surprised to see some inflection point that causes all the major L2 networks to launch tokens one after another in a very short period of time.

There are many teams working on L2 scaling, and one of the most anticipated events is the full launch of StarkNet , which will provide a general-purpose ZK Rollup network.

NFTs , the Metaverse , and DAOs can also drive DeFi, which could become the backbone of these emerging ecosystems.

Tokenize NFTs and trade them on AMMs? This is DeFi.

Creating an escrow contract to swap tokens between DAOs? That’s DeFi.

Trading virtual plots of land in the metaverse? That’s DeFi too.

Even the NFT marketplace could be considered DeFi.

Another segment of the DeFi market that could experience rapid growth is indices .

In traditional finance, indices such as the S&P 500 and FTSE 100 have experienced a huge growth cycle and become a significant part of the overall market. This has not been fully utilized in DeFi.

I would not be surprised to see more and more attention paid to indices in DeFi , especially since the nature of smart contracts allows for the easy creation of a variety of indices, from DeFi blue chips to the metaverse to NFTs . Smart contracts also allow for the automation of index rebalancing.

For example, Index Coop ’s DeFi Index, Metaverse Index, and other indexes are among the prominent projects in this category.

One thing we need to clarify soon is the laws and taxation around DeFi. The current unclear rules stifle innovation and create an unfriendly environment for DeFi founders and users.

Eventually, I think most liquidity will move on-chain and DeFi will attract most banks, hedge funds, and other financial firms.

Although there will be many blockchains, each with a running DeFi ecosystem, naturally, liquidity will be concentrated on a few chains .

When it comes to the market, it’s hard to say what will happen to prices in the short to medium term, but I wouldn’t be surprised to see DeFi tokens revive again as the world realizes what is being built in the space.

Summarize

Despite the current market cooling period, the DeFi space is still developing at an incredible pace. While people’s attention shifts away from prices, long-term builders continue to create value and constantly come up with new ideas to provide nutrients for the next market cycle.

During these seemingly calm times, it’s extremely important to keep up with the latest trends in order to capture the biggest gains when attention finally returns to DeFi.

So, what do you think of the current state of DeFi and what are your predictions for 2022 and beyond?