Coinbase: DeFi locked value soared 2,500% in one year, regulatory issues still need attention

DeFi continues to maintain strong growth momentum amidst the epic crypto bull run, with the total locked value (TVL) of DeFi projects growing significantly from the summer of 2020 to date. We explored DeFi and the yield farming phenomenon in June 2020, but what happened since then? In short, the rapid development of DeFi continues. As we pointed out last time, the yield farming phenomenon still promotes growth. This creates a virtuous cycle: the yield farming mechanism induces participants to increase capital → increase TVL → drive governance token valuations → expand yield farming subsidies → continue the cycle.

Nevertheless, as part of the growth story, the real 0 to 1 innovations in the DeFi space cannot be ignored. These things include synthetic assets (such as Synthetix, UMA, and Mirror), financial products that provide capital efficiency (such as Aave, Compound), open financial access (including flash loans and emerging remittance use cases), and composable protocols that layer DeFi projects, such as Yearn, etc.

As of now, the total locked value of DeFi protocols has exceeded $25 billion, an increase of 2,500% year-on-year. This development speed is incredible. Similarly, the number of DeFi users has exceeded 1.2 million (defined by the number of unique addresses accessing DeFi services). Mainstream DeFi protocols such as Uniswap and Compound have 200,000-500,000 users, while most other DeFi applications have between 25,000 and 50,000 users.

Similarly, DEX trading volume has maintained strong growth since July 2020. As of now, the cumulative trading volume of DEX has exceeded that of most centralized exchanges. In January this year, all DEXs set a record of the highest daily trading volume of more than US$10 billion.

Volumes are driven by the growth of DeFi, but also by factors such as the broader crypto bull run, including access to new long-tail DeFi tokens and efficient exchange between highly correlated assets such as stablecoins.

However, today’s DEXs primarily settle trades on the Ethereum blockchain and are therefore subject to high gas prices during periods of high demand. This is a notable milestone as Synthetix has launched on Optimism, a rollup-based scaling solution, which has fueled continued interest in scaling solutions.

While it’s encouraging to look at the major metrics, the fact is that DeFi moves too fast for anyone to accurately track. Here are some interesting themes we’ve found:

1. DeFi projects are embracing composability : new DeFi projects are either introducing new primitives or bundling existing primitives to create new products. We can think of these primitives as Lego blocks. Six months ago, we were designing and building individual blocks. Today, we combine these individual blocks into cars, airplanes, and castles.

2. DeFi projects are starting to band together : DeFi projects are wrestling with key issues such as moats, defensibility, and revenue growth. Most projects seem to embrace open community collaboration, believing that the community will create moats (you can't fork a community). This exact vision initially led to the phenomenon of governance tokens and yield farming, and has now evolved into creative partnerships and collaborations, most notably in Sushiswap's 2021 roadmap.

3. Scalability is becoming a bottleneck, but solutions are coming : As the Ethereum base chain continues to scale, some protocols are openly exploring integration with Layer 2 networks or other blockchains. Expect major progress in 2021, especially in Ethereum rollups.

4. Regulatory uncertainty affects development : At the same time, the SEC's lawsuit against Ripple and the CFTC's lawsuit against BitMEX show that regulators are paying close attention to crypto assets and are beginning to charge the largest players in the field. We have reason to see regulators pay more attention to DeFi projects, and this uncertainty will continue to be affected by regulatory jurisdictions.

Speaking of regulation….

Two aspects of regulation

In the past quarter, both FinCEN and OCC issued regulatory guidelines for crypto assets, but their attitudes were diametrically opposed.

FinCEN is responsible for compliance with KYC/AML laws, which is particularly important for crypto exchanges such as Coinbase (“VASPs – Virtual Asset Service Providers”). Crypto asset exchanges are required to verify the identity of their customers (KYC) and use blockchain forensics tools to study crypto transactions to ensure that deposits do not come from potentially illicit sources.

FINCEN recently proposed amendments to the FBAR regulations of the Bank Secrecy Act specifically targeting crypto assets and VASPs. In summary, under the new amendments, U.S. citizens must report crypto asset holdings and transactions over $10,000, regardless of where the crypto assets are held. In summary, the amendments will essentially require U.S. individuals to report cryptocurrency holdings in foreign accounts over $10,000, and require cryptocurrency exchanges or wallets to store customer information related to any transactions over $3,000 and report any transactions over $10,000 to FINCEN.

Additionally, the announcement came with a limited comment period of 15 days during a U.S. holiday, making it difficult for crypto service providers to respond.

Many crypto asset service providers (Coinbase, Fidelity, Square, CoinCenter, ErisX, etc.) have expressed strong opposition to the proposed rules, highlighting the haste of the proposal and the lack of time.

The Treasury Department has since extended the comment period, and the future remains unclear given the new administration.

The Office of the Comptroller of the Currency (OCC), an independent agency within the Treasury Department tasked with helping “charter, regulate, and supervise banks,” went to the other end of the spectrum with recent guidance:

1. Federal banks can run public blockchain infrastructure [January 2021];

2. Federal banks can participate in stablecoin business [September 2020];

3. Federal banks can custody crypto assets [July 2020];

With this positive set of guidance, it is clear that national banks can now participate in the crypto economy through custody and settlement. Notably, the guidance released in January 2021 legalizes public blockchains as settlement infrastructure, which is equivalent to treating blockchain as equivalent to ACH or SWIFT.

In other words, federal banks could act as large validators (like miners) on the blockchain, or more realistically, banks might end up settling transactions in Bitcoin, Ethereum, or stablecoins.

Ultimately, this is the first step in the regulatory action needed to connect the crypto economy with traditional financial infrastructure. It is also important to note that while the Office of the Comptroller of the Currency (OCC) is a federal regulator, it is not the only one. Additionally, adoption will take time - blockchain is still relatively new and lacks some core features (e.g. privacy, scalability), but this is a promising development.

To its credit, the Treasury Department has since extended the comment period, and the proposal is likely to languish under the incoming Biden administration.