The coronavirus pandemic saw an increase in the flow of funds into cryptocurrencies and associated decentralized finance (DeFi) projects. But 2022 has been disastrous for this space so far, with words like “total disintegration”, “perfect storm”, “crash” and “collapse” now being used to describe what’s happening. However, it has happened before.
Bitcoin plummeted 80% in 2018, to USD 3,000 in December 2018, then rebounded magnificently to an incredible high of USD 64,000 and a market cap of USD 1,270,000,000,000 in December 2021 .Since then, the price has been set in USD. 20,000 and a market cap of $398 billion (as of early July 2022).
Given its history of volatile prices, you’d think it would bounce back. Why should this time be different?
On the other hand, some commentators see it differently this time around and see the fall as part of a broader retreat from risk assets, spurred by rising interest rates, inflation and economic uncertainty.
This retreat is leading to a lot of collateral damage, with the implosion of cryptocurrencies and DeFi platforms gaining momentum. The most recent high-profile case was the Celsius platform, which paused withdrawals and transfers between accounts. From this point of view, you might now conclude that cryptography is surely done and doomed.
In this short article, I provide an overview of DeFi, which has become the most active sector in the blockchain space and where, shall we say, cryptocurrency use cases have begun to emerge. DeFi still has a long way to go to reach maturity, but the progress made so far suggests that crypto is not dead and has a future, perhaps comparable to the dot-com bubble, which correctly predicted the future but too early.
Smart Contracts and DeFi Use Cases
The goal of DeFi is to use blockchain technology to develop an alternative to the centralized approach of the traditional financial system where central authorities, institutions and intermediaries such as banks and brokerages play the role of a trusted intermediary to allow two parties to transact.
The first generation of blockchain-based cryptocurrencies demonstrated that two parties can transact without relying on an intermediary to act as a validating agent. The emergence of the Ethereum blockchain, which is considered the foundation of DeFi, has further demonstrated that validation can be programmed directly into the Ethereum blockchain code.
These so-called smart contracts on the Ethereum blockchain have certain features that offer potential benefits and allow smart contracts to act as intermediaries, replacing conventional intermediaries and becoming the source of trust.
Programmability – Contracts are scheduled to run automatically. The terms are written into the smart contract code, known as algorithmic governance.
immutability – the terms cannot be altered or changed once the smart contract is started.
Interoperability and composition – The different components can be easily connected and interoperable.
transparency – transactions are published on the public Ethereum blockchain and can be verified by other users.
Without permission – anyone can, in theory, access DeFi applications.
Self custody – Users maintain custody of their assets and control their personal data.
There are many use cases in DeFi. Some are still quite aspirational, but others are perhaps more specific and include:
bet – the process of pledging crypto assets to support a blockchain network and then acting as a validator to verify the transaction for which the user receives interest and other rewards, part of the next generation Ethereum 2.0 based in a participation test instead of a Working Model test.
Peer-to-peer (P2P) savings and lending. – earn interest on crypto savings accounts – or crypto pledged to a group of loans.
trade – The DeFi trading space is very broad and includes derivatives trading, margin trading and token exchanges.
markets – NFT and DeFi protocols support a variety of online marketplaces that allow users to exchange products and services globally and P2P, from stand-alone coding gigs to digital collectibles to real-world jewelry and clothing.
There are now countless DeFi use cases, platforms, exchanges and initiatives:
New conceptual entities have emerged, including decentralized autonomous organizations (DAOs). These cooperate according to transparent rules encoded in the Ethereum blockchain, eliminating the need for a centralized administrative entity.
Stablecoins, a cryptocurrency pegged to fiat currency, gold or other more stable cryptocurrencies, remittance payments, lending and lending platforms, and even institutional use cases like central bank digital currencies (CBDCs).
With billions of dollars worth locked up in Ethereum smart contracts, decentralized finance has become the most active sector in the blockchain space.
The challenges of DeFi and the emergence of DeFi 2.0
All blockchain projects face a similar set of problems, known as the “blockchain trilemma,” which was coined by Vitalik Buterin, co-founder of the Ethereum blockchain. The trilemma posits that blockchain developers are forced to make trade-offs between decentralization, scalability, and security, and are unable to offer all three at the same level, at the same time.
Specifically, DeFi projects face more dilemmas around liquidity. Providing liquidity to a pool requires a user to commit their funds to a given pool of liquidity. This so-called “lock-in” of funds is a necessarily rigid structure, but it conflicts with the natural behavior of investors to jump between liquidity pools in search of better returns. In an attempt to retain the provider, groups will offer rewards in the form of native token.
However, short-term farm-and-dump behavior is common, leading to an inevitable and capitulated sell-off of the native DeFi token, causing major market disruption and inefficiencies. A DeFi 2.0 movement attempts to address these issues by developing sustainable methods that ensure long-term liquidity. Chief among these is to help users gain performance.
On a conceptual level, the idea of blockchain-enabled programmable smart contracts with immutability and transparency remains compelling. But efforts to turn theory into practice have not been without problems. As in conventional capital markets, the behavior of market participants remains irrational for a long time.
But overall, the progress made so far suggests that DeFi and crypto have a future. It will continue to be a bumpy road and may be much longer than initially expected. There is a temptation to dismiss the space and consign crypto to the history books of bubbles and fads, but to do so would be a mistake.
About Martin Koderisch
Martin Koderisch is a director at Edgar, Dunn & Company. He advises stakeholders in the payments ecosystem with a particular focus on recurring payments and helps e-commerce and subscription companies transform their digital payments capabilities to drive recurring revenue growth. Prior to joining EDC in 2015, he gained over 10 years of experience in the payments industry.
About Edgar, Dunn & Company
Edgar, Dunn & Company (EDC) is an independent global payments consultancy. The company is widely regarded as a trusted advisor, offering a full range of strategic consulting services, expertise and market insights. EDC’s expertise includes M&A due diligence, legal and regulatory support in the payments ecosystem, fintech, mobile payments, digitization of retail and corporate payments, and financial services.