The Future of DeFi

The next wave of adoption could look very different from the last

Aug 02, 2022

Hello readers,

Over the last few years, we’ve witnessed a “proof-of-concept” for how financial services could be automated using blockchains and smart contracts. This has been a messy process at times — leading many to label DeFi as the “wild west” of finance. That said, the signal here is that this nascent tech is working. Revenues and users point to clear product market fit. And the tech is doing what tech is supposed to do - drive down costs and create efficiencies.

This week we are exploring what the future of DeFi could look like. Topics covered:

Regulation
On-chain Identity
How TradFi and DeFi could merge in the coming years

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Let’s go.

Regulation & Standardization

DeFi needs regulation. But we need thoughtful regulation. Not the regulation by enforcement that we have seen of late coming from the SEC. In this section, I’ll lay out some of the areas that are prohibiting the adoption of DeFi.

Smart Contract Risk

According to blockchain auditor Certik, there were over 44 DeFi hacks last year resulting in $1.3 billion of user funds lost. This is absolutely unacceptable and shows the nascent nature of the tech today. What we have seen play out to date is essentially a proof of concept for the viability of smart contracts and the automation of markets. A proof-of-concept with real, live money at play. To be clear, a smart contract hack is not the same thing as a blockchain being hacked, which is nearly impossible for the well-established public blockchain networks. [Bitcoin is the most secure digital network in the world due to its decentralized nature (no single point of attack) and the economic costs required to hack it].

That said, to utilize DeFi or any decentralized crypto-based services, smart contracts are in play. Therefore, solving or significantly mitigating risk is imperative for the growth of DeFi.

How do you solve smart contract risk?

1. Identity. This will be an overriding theme of this post. It will probably turn off some DeFi natives. That’s ok - they will come around when they accept that the only way to compliantly bring hundreds of millions of new users to DeFi is by bringing identity on-chain.

Institutions cannot come into DeFi if they cannot identify their counterparties and the smart contracts they are engaging with. Full stop.

In the not too distant future, we will see solutions come to market that will help users understand the nature of the smart contracts they are engaging with. Like who built them. Who audited them. And what kind of insurance they have.

OnchainID is one such solution.

2. Standardization. We have standards for accounting, lending, manufacturing, medicine, etc. There needs to be a similar framework that smart contract developers adhere to in the same way that publicly traded companies require 3rd party audits and restaurants require health inspections.

3. Insurance. A few solutions are already in the market and more are coming. Platforms such as InsurAce Protocol, Nexus Mutual, and Opium.finance seek to provide user protection against smart contract risk today. We should expect this space to evolve and look very different in the next cycle.

In addition to solving smart contract risk, we need clear guidance from regulators.

Are cryptoassets securities or commodities?

We do not have clarity on this just yet, but the bill put forth in Congress by Senator Lummis and Senator Gillibrand indicates that they believe most cryptoassets are commodities rather than securities — pointing to regulation by the CFTC rather than the SEC. The bill states that digital assets that do not represent debt or equity, do not create rights to profits, liquidation preferences, or other financial interests in a business entity, will be required to furnish disclosures with the SEC twice per year. Assets in compliance with these disclosure requirements are presumed to be commodities.

If some cryptoassets are deemed to be securities, does that mean centralized exchanges like Coinbase and decentralized exchanges like Uniswap must register with the SEC as broker-dealers? If they want to allow securities to trade on their platform, yes. The key question is whether this is a material % of the market cap of cryptoassets. My sense is it is a very small number. I have yet to see any tokenized securities (real estate, private equity, private debt, etc) traded on any of these platforms. There are 6 or 7 fully compliant, SEC-registered digital ATSs (Alternative Trading Systems) that will handle the trading of digital securities. Look for NASDAQ and the NYSE to eventually tap into these ATSs for additional liquidity in the not-too-distant future - this is an area I have a front-row seat to with my day job at Inveniam.

Note that The Responsible Financial Innovation Act is seen as a starting point for discussion within Congress and likely will not lead anywhere significant before next year.

On-Chain Identity

As I mentioned above, DeFi needs identity. This is a controversial topic for some crypto natives. But the bottom line is that institutions cannot come into DeFi if they cannot do two things:

Identify their counterparties
Identify the smart contracts they are engaging with: who built them, 3rd party audits, and insurance

Unless you have an ENS, your crypto address (public wallet) might look something like this: 0x084fcd3D9318bAa383B9a9D244bC0c32129EE20E. While blockchains are fully transparent, immutable accounting ledgers, your address makes you pseudonymous (at least until you exit at a regulated exchange).

In the not too distant future, services like onchainID will allow you to tie your identity (via your license, passport, etc) to your digital wallet address via a smart contract.

Here is how it works:

Disclosure: OnchainID is developed by Tokeny, a partner of my employer, Inveniam.

With this solution, your identity will be kept off-chain, with a trusted 3rd party KYC oracle. If you want to use a permissioned DeFi pool (institutions), you can simply reveal your identity via your smart contract for access to the pool. We can think of this as flashing your ID to the bouncer when entering a bar. Rather than typing your personal data into forms all over the internet (and leaving it susceptible to vendor hacks), you will control your personal data and grant access to companies as needed to prove who you are.

To me, this is the best of both worlds. You remain pseudonymous, but you can prove who you are when you need to. And you control your data - granting access and revoking it from online businesses and applications as you desire.

This will allow institutions to come into DeFi. And it could eventually spark mass adoption of the metaverse — serving as a single sign-on for web3. Anyone who has used their crypto wallet to sign into a web3 app knows that it’s a superior user experience to traditional log-ins.

This same solution could be used to identify the creator of smart contracts, the 3rd party auditor, as well as insurance.

I believe that once this tech and others are in place, we could see traditional banks, neobanks, and fintechs begin to offer access to DeFi protocols through their front ends, bringing millions of new customers into DeFi.

To be clear,on-chain identity does not change access to DeFi or make DeFi more centralized. Anyone can still spin up a crypto wallet at zero cost and gain access to financial services. I’m specifically speaking to DeFi protocols such as Aave, Compound, Uniswap, etc where institutions may want access but will look for permissioned pools so that they can understand the nature of their counterparties and smart contracts.

Remember: DeFi is about creating access to finance for everyone. It’s about new technology that drives new economic and business models. It’s about creating efficiencies, cutting out unnecessary intermediaries, and lowering costs. None of this changes when we introduce identity — we simply open up the gates to a much wider user set. It’s also worth noting that attaching identity to your wallet is a voluntary option — it is not a requirement for access.

Projecting the Merger of DeFi and TradFi

I see a future where fintechs like Robinhood offer access to decentralized exchanges through their user interface. Robinhood is required to do KYC (Know Your Customer) on its users. Therefore, if you want to access liquidity pools on Uniswap through Robinhood, you will have to identify yourself first. Again, I don’t think this will be a requirement to access Uniswap — you could always go to the app directly instead of through a fintech front-end, you just won’t be able to access the liquidity pools that Robinhood and other regulated entities are offering to their customers.

I believe we could see a similar concept play out with DeFi lend/borrow apps. What happens when one of Bank of America’s smaller competitors offers access to Aave, where users can get yields at 10x what BOA is offering? It turns into game theory at this point.

Of course it is also possible that these DeFi solutions build their own front-ends and find a way to onboard millions of users without partnering with existing fintech and TradFi firms. Time will tell.

Why DeFi is Here to Stay: Comparing a TradFi Trade to a DeFi Trade

Digital Artwork by Laerta Premto

There are 6 intermediaries between a user and a trade settling today in TradFi. Each of these intermediaries is a private entity. It takes 2 days to complete this process.

Using an automated market maker (e.g. Uniswap, Sushiswap, etc) there are *zero* private entities involved, which happens in a peer-to-peer manner and settles on a layer 1 blockchain with finality and transparency. As we can see, we cut out the broker, custodian, and transfer agent in version two. This process takes a few minutes.

Great tech cuts out friction, reduces costs, and drives efficiencies. This is what we see playing out here. Today 100% of the revenues that traders pay on Uniswap go to the decentralized set of liquidity providers. The token is likely to see a % of these fees distributed as dividends in the future. In fact, the Uniswap DAO is currently debating turning on the “fee switch” as we speak.

Keep in mind that we should expect to see service providers enter the fray at the candy-coated user interface layer. These are companies that are providing access to DeFi protocols, blockchain infrastructure, custody (self custody key management), etc. Fireblocks is an example of one of these companies that also helps users secure their private keys. Zerion and Zapper are a few others (interface only).

Important Note: history tells us that waves of innovation come from the introduction of new open-source technologies. This disrupts the status quo monopolies, enables new efficiencies and business models, and eventually centralizes again with a small number of players taking a large piece of the value accrual. We should expect to see this slowly play out across the blockchain ecosystem.

That said, the interesting thing with web3 is that at the end of the day, the biggest winner could potentially be a layer 1 blockchain. And keep in mind that the infrastructure of public blockchains is decentralized - anyone can access them, build on them, etc. This creates intense competition at the user interface level and a completely different dynamic from what we see on web2 networks such as Google and Facebook.

Capital Efficiency

DeFi lend/borrow applications performed flawlessly throughout the intense market volatility in May and June of this year. As a quick aside, can someone explain to Jon Sindreu of the Wall Street Journal that Celsius, BlockFi, and Voyager have nothing to do with DeFi? Here is what he wrote on June 30, 2022:

“Cryptocurrencies keep nosediving…The chaos has spread to DeFi: Celsius, a crypto lender with assets of around $20 billion, was recently forced to freeze deposit withdrawals. Last week, crypto exchange FTX said it was bailing out of of Celsius’ troubled rivals, BlockFi, with a $250 million loan, not long after rescuring crypto broker Voyager Digital.”

Scratch that, Dan Morehead from Pantera Capital already tried:

DeFi does not have an existential problem, because borrowing requires over-collateralization to receive a loan. This is precisely why it is working, and why no user funds were lost as a result of intense volatility caused by poor risk management of “CeFi” banks.

That said, requiring over-collateralization to get a loan is not very capital efficient. This ultimately centralizes power to those with resources. The point of lending is to get resources to those that do not have them — to allow them to start businesses and create products and services that drive productivity.

For this reason, over-collateralization is not the long-term answer. As I mentioned, we are seeing a “proof-of-concept” for what is possible for financial markets utilizing blockchains and smart contracts. Therefore, over-collateralization is a must-have today due to the volatile nature of the collateral.

Undercollateralized lending based on credit and reputation is needed to grow the space. On-chain identity, and on-chain credit will likely drive growth in this area in the coming years.

Conclusion

We are witnessing a live “proof-of-concept” today. Therefore, we cannot jump to conclusions as to the long-term viability of DeFi based on some of the shortcomings at present. The bottom line is that DeFi is faster, cheaper, and better than the status quo. DeFi is introducing new business models that spread the benefits of capitalism across a much wider set of individuals. Meanwhile, some of the brightest engineers in the world are working every day to bring products and services to market that will attract the next 100 million users.

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