DeFi (decentralized finance) is quickly becoming a FinTech area of development and product distribution. In fact Defi industry as itself really boils down to the cost of product distribution. The advent of mass internet use in early 1999–2000 brought costs of implementation close to zero for the content. However, in global world of finance the costs of creating financial products for everyone have not gone close to zero, yet.
As USA continues their decade plus long initiative of near zero % interest rate to fuel USD based assets and financial markets, we are in era of quasi bubble in asset prices as well as living in depressed economies brought upon by global pandemic and weak economic inflation rates that have be government supported. China’s own central bank warned that the prolonged presence of ultra-low interest rates in some economies is storing up financial stability risks and causing spill over effects for other countries. As stated by their own central bank; “Low interest rates implemented in developed economies haven’t reached the desired effects,” as inflation levels have stayed below target for a long time, the People’s Bank of China said in its quarterly monetary policy report. Stated that low interest rates can hardly change structural issues in those economies, have worsened banks profit and caused credit tightening effects in some circumstances. So are we in Defi bubble as well as generally found in global economy?
Even with possible bubbles around DeFi, the community continues to draw attention from crypto traders and mainstream media as well as founders whom continue to build out their projects. Different applications have come into the spotlight after Compound project first came into industry knowledge and awareness. Crypto industry as whole continues to view the biggest issues are token valuations and a lack of understanding among participants of their risks. These risk have occurred this year with hackers abusing DeFi products and finding technology loophole weakness in order to steal from their platforms. In this past June and April, a hacker drained approximately $500,000 from DeFi service Balancer and $25 million was stolen from dForce respectively. Ignoring the risks involved, the Defi industry continues forward without a hitch.
The interest in DeFi was initialized with growth of Compound lending platform launching their COMP token. There was also a concerted awareness and industry push towards decentralized lending services as well as “yield-farming.” DeFi’s popularity and investor interests has been surging recently this past year time frame. The total number of DeFi users over time is edging towards estimate of 600K in June 2020, according to Ethereum (ETH) analytics platform Dune Analytics (Fig 1), below shows ETH price changes, percent % wise in $USD, for year to date time frame(12/31/19–08/31/20). Aside from March lows stemming from global pandemic market reactions, ETH prices changes in $USD have been in a range. This can be infer to mean ETH supply in open markets might be moving into staking and Defi platforms and less likely be short term and intraday traded. This ETH % movements can also mean that there is more demand to own it because of Defi platforms.
There have been enormous $USD percent capital gains among the decentralized finance (DeFi) tokens which have been compared to the 2017 initial coin offering (ICO) craze and phenomena. In (Fig 2) , shows some sparse data sets that gives some perspective on size of $USD involvement in ICO raises, EOS project was largest ICO raise of $4.2 billion. Defi relative market capitalization is around $15 billion and with about $9 billion locked up. ICO projects have raised $25 billion since inception up to Nov, 2019 data. Interesting note here is Defi was a recent industry movement then ICO industry scene which debuted sometime in 2017.
The 2017 ICO scene saw several hundreds of token launches in which the assets, majority wise via Ethereum blockchain. There were about 435 ICO projects “listed” with average raise of roughly $12.7 million, for a total of USD 5.6 billion. Financial news outlet, CNBC had reported the ICO capital raises which mired the amount of money raised through ICOs had surpassed “…early-stage venture capital funding for internet companies….” Legal and regulators were very vehemently open about risks and illegal financial securities being issued. In February of 2019, U.S. Securities and Exchange Commission (SEC) would create guidelines that would provide enforcement against ICO projects due to securities law violations.
The ICOs phenomena and DeFi products have investors both experiencing capital appreciation of assets such as Compound’s COMP governance token and via the actual use of DeFi, i.e. yield farming. The total capital locked in various DeFi platforms has risen from roughly USD 1.1 billion to 9.2 billion year to date (Fig 2). With the exception for the leading MakerDAO, have seen incredible price appreciations this year such as Compound’s COMP governance token saw nearly 5x gains in the first few days after its launch in mid-June and has $763M locked in its Defi platform. A project with a protocol Aave’s LEND token has seen over 6x gains from the end of May with $1.2B locked up. Another project called Synthetix’s SNX token has also seen an over 5x increase since the end of May with $833M locked up. See (Fig 3), graph, the price increases on a percentage wise scale from the more popular Defi related tokens have outpaced the general financial index such as SP500 over 1 year time frame. Even with rapid upward pricing movements of “FAANG” stocks, Tesla, the collection of Defi tokens still had outsized percentage price increases. The surge in DeFi projects and staking is one of many reasons for ethereum’s (ETH) ongoing pricerally, which has seen estimate ~70% increase, from $225 on June 30 to nearly $500( Sept 1, 2020) price range points (Fig 4). DeFi represents Ethereum best use case so far and points to increasing usage of the network year to date for 2020, (Fig 5).
The project was made aware that anonymous developer created smart contracts and around 80,000 CRV tokens were reportedly pre-mined before the Curve team verified the deployment. The team members at Curve was initially “skeptical,” but eventually discovered that the deployment had “correct code, data and admin keys.” Interesting enough, Curve project has continued business as usual and it seems embrace this change in project planning.
“Due to the token and DAO getting traction, we had to adopt it,” said Curve, adding: “The launch has happened.” The early pre- launch of Curve’s DAO and CRV token has been viewed by Defi industry with skepticism and concerns for fraudulent endeavors. The technical essence in nature of permission-less blockchain networks means any developer can deploy smart contract codes. Various Cryptocurrency exchanges such as Binance, OKEx and Poloniex, have supported the sudden launch of CRV token.
There are technology risks involved in Defi projects and example of this would be Yam Finance, an experiential Decentralized Finance protocol. The Yam project saw its market dollar cap crash to zero within minutes on August 13, 2020. The crash of YAM market value which caused price volatility to suddenly increase for all of the major DeFi tokens such as Compound, Yearn Finance and Balancer. On twitter, Yam co-founder Brock Elmore reveal that their project’s protocol had a fatal technical bug that rebase supply feature of Yam tokens. This technical flaw caused governance system issues of the protocol by rebasing and following the initial rebase would mint more YAM tokens than intended. Yam had staking pools for Compound, Aave’s Lend, Chainlink’s Link, Wrapped ETH, YFI, Synthetix, Maker, and Uniswap V2 LP tokens which all had pricing corrections in Defi trading markets when rebasing bug was known. Systemic risks in Defi markets are also an area of concern when multiple token projects are tied together as such in staking processes.
DeFi will eventually draw regulators out of woodwork and have more oversight towards the space. There will be inevitably invite difficult legal questions and regulatory scrutiny. For example, Synthetix is going offer token like equities for Tesla and Apple stock which can potentially cause some legal issues. SEC enforcement ended ICOs in USA and created more legal oversight in other countries. Given the legal precedent for ICOs, Defi investors should exercise caution while seeking this kind of investment exposure. Further discussions and deep dive legal analysis is needed for self-regulatory approaches to identifying Defi projects with best practices on platform security, financial token design, and proper legal structures. There will also be need for legal professionals to help in deciding what regulatory bodies will need to be involved, lobbying parties, Defi funds for lobbyists, and other initiatives that will try to defend and educate the real world benefits that these cryptocurrency based technologies are trying to provide.
DeFi tokens today follow some themes that have help it gain traction these days. The most popular theme for DeFi project launches have been those that follow, lending protocols and on-chain derivatives platforms. The project valuations on these themes have recurring simple yields and characteristics. With relative ease, new DeFi products and services can be launched and traded into exchanges via trading crypto markets, has caused some alarms of makings of asset bubble.
Defi Market, with no restrictions or oversight can create innovation and growth of newly founded financial technology applications. The practice of yield farming from DeFi project have decentralized the financial investment application by removing middleman of finance world, banks. Defi projects can be created and listed on decentralized exchange such as Uniswap with very little barriers to entry or friction. But when a Defi project list a 10% yield annual return on a token $ USD asset that can fluctuate in price too often; this can lead to investment bubble-like situations.
Vitalik Buterin quote; “Honestly I think we emphasize flashy defi things that give you fancy high interest rates way too much. Interest rates significantly higher than what you can get in traditional finance are inherently either temporary arbitrage opportunities or come with unstated risks attached.”
On contrary DeFi network protocols are being used as utility tokens, in which they do have some kind of functional mechanics that gives them valuation and usage. DeFi might seem less interesting to those that don’t follow crypto industry or retail Robinhood stock investors whom learned hard lesson from their past investments in ICO tokens. Defi projects due to its complex technical structure, is very likely to suffer from high volatility and sudden price drops. Only DeFi projects that have real business and technical sophistication in nature will surpass and grow more so than your average ICO tokens from 2017. Sound and well thought out Defi projects probably will still not get average investors to buy into ecosystem and would limit non qualified investors due to geographical location. DeFi protocol projects that create real world economic value will thrive and become industry leaders. Projects whom just reuse and recycle trading arbitrage gains for speculators will enjoy their short term financial success. We should get ourselves comfortable with that fact. Future token price volatility and market corrections can only strengthen DeFi mass adoption perspectives if industry continues to build and stop worrying about yields.