In mid-February 2020, the total value locked in decentralized finance (DeFi) applications previously exceeded $1 billion. Prompted by the DeFi heat of 2020, it will not take even a year to multiply 20 times to reach $20 billion and only another ten months to reach $200 billion. Given the pace of growth so far, it does not seem strange to imagine that the DeFi market will reach a trillion dollars in a year or two.
We can attribute this huge increase to one thing – liquidity. Looking back, the expansion of DeFi can be defined in three eras, each representing another significant development in removing liquidity constraints and making markets more attractive and efficient for participants.
DeFi 1.0 — Addressing the Chicken and Egg Problem
DeFi protocols existed before 2020, but they faced a “chicken and egg” problem in terms of liquidity. Theoretically, one could lend or swap pools to provide liquidity. Nevertheless, there are not enough incentives for liquidity providers unless there is a critical mass of liquidity to attract traders or borrowers who will pay fees or interest.
Compound first solved this problem in 2020 when it introduced the concept of the Farming Protocol token. In addition to interest from borrowers, lenders on Compound can also earn Comp Token rewards, which provide incentives from the other amount they deposit.
This Defy proved to be a starting pistol for the summer. The “Vampire Attack” of Sushi Swap on Uniswap provided further impetus for the project founders, who began using their own tokens to encourage on-chain liquidity, taking the produce farming craze seriously. .
related: Liquidity mining is booming – will it last, or will it be busted?
DeFi 2.0 — Improving Capital Efficiency
So, that was DeFi 1.0, roughly the era that took us from $1 billion to $20 billion. DeFi 2.0, a period that saw further growth of up to $200 billion, brought improvements in capital efficiency. This saw the growth of the curve, which honed Uniswap’s automated market makers (AMM) model for stable assets, offering more focused trading pairs with less slippage.
Curve also introduced innovations such as its vote-escrow token model, which incentivizes liquidity providers to lock funds for longer periods to further increase the credibility of liquidity and reduce slippage.
Uniswap v3 brings further improvements in capital efficiency with its customizable liquidity position. Beyond Ethereum, the multichain DeFi ecosystem began to flourish on other platforms including BSC, Avalanche, Polygon and others.
So, what will propel DeFi through the next phase of growth to reach $1 trillion and beyond? I believe there will be four major developments.
DEXs go hybrid
The AMM model that has proved so successful in DeFi was developed after it became clear that Ethereum’s slow momentum and high fees would not serve the order book model well enough to survive on-chain.
related: Automated Market Makers Are Dead
However, the existence of DeFi on a high-speed low-cost blockchain means that we may see an increase in the number of decentralized exchanges (DEXs) using order book models. Fast settlement times reduce the risk of slippage, while minimally negligible fees make order book exchange profitable for market makers.
There are many examples of decentralized exchanges using already emerging central limit order books – Serum, built on Solana, Dexlot on Avalanche and PolkaDex on Polkadot, to give several examples. The existence of order book exchanges can make it easier for institutional and professional investors to engage, as they allow limit orders for a more familiar trading experience.
cross-chain composibility
The proliferation of the DeFi protocol on blockchains other than Ethereum has resulted in a significant fragmentation of liquidity across different ecosystems. To some extent, developers have tried to overcome this with bridges between blockchains, but recent hacks such as Solana’s Wormhole Bridge hack have raised concerns.
Nevertheless, secure cross-chain composability is becoming essential to unlock fragmented liquidity in DeFi and attract further investments. There are some positive signs – for example, Binance recently made a strategic investment in Symbiosis, a cross-chain liquidity protocol. Similarly, Thorchain, a cross-chain liquidity network that was launched last year and recently implying a clear appetite for cross-chain liquidity, has quickly gained ground in price locking.
Blockchain and DeFi have begun to merge in the financial markets
Now that crypto is becoming a recognized global financial asset, it is only a matter of time before the boundaries with blockchain and DeFi begin to blur. It is likely to move in two directions. First, by bringing on-chain liquidity from the established global financial system, and second, by institutions adopting crypto-related decentralized financial products.
Several crypto projects have now launched institutional-grade products, with more in the pipeline. There is already a Metamask Institutional Wallet, while Away and Alchemy operate Know Your Customer (KYC) pools for institutions.
On the other hand, Sam Bankman-Fried is flying the flag for bringing the financial system on-chain. In March, he spoke at the Futures Industry Association in Florida, proposing to US regulators that risk management in financial markets could be automated using practices developed for crypto markets. The tone of the FT piece covering the story is telling – far from the dismissive, even contemptuous attitude used toward crypto and blockchain in the traditional financial press, it is now fraught with intrigue.
One’s guess is when DeFi reaches the trillion-dollar milestone. But, those of us observing the current pace of growth, investment and innovation feel quite confident that we will be there sooner rather than later.
This article does not contain investment advice or recommendations. Every investment and trading move involves risk, and readers should do their own research when making a decision.
The views, opinions and opinions expressed here are those of the author alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.
jimmy yin is the co-founder of iZUMi Finance. Before entering the world of DeFi, he was a researcher at the North American Blockchain Association and a community member of the World Economic Forum. His PhD was supervised by Max Shen at UC Berkeley and HK University. Jimmy strives to increase liquidity in both crypto and spirit.
