Decentralized Finance: Current Landscape, Challenges and Growth Opportunities
Decentralized Finance (DeFi) is a term used for financial systems in the Cryptocurrency space that operates without intermediaries. Although Bitcoin is the first DeFi use case, the industry is built around Ethereum and blockchains such as Terra and Solana, each building its ecosystem. DeFi has enabled users to access financial services such as Borrowing and Lending, Investing, Yield Farming, and Asset Management in an open, permission-less way.
Current DeFi Landscape
Since its inception in 2018, DeFi has seen promising growth. Unlike the previous trends (referring to the ICO era of 2017), this proved that DeFi is built on solid fundamentals and is here to stay. The solid fundamentals were tested in March 2021 when the cryptocurrency ecosystem faced a 50% drawdown. As of today, the TVL locked in DeFi is about $90 billion.
The total DeFi users over time have also consistently grown. Where we stand now, it looks like the industry has captured the interest of early adopters. Yet, if we look at the Total Market share vs. the overall crypto landscape, DeFi’s Market Cap is still small and has the potential to increase its market share.
The existing crypto users can be categorized into three broad buckets: DeFi experts, DeFi newbies, and CeFi users. DeFi experts would usually be the first to explore these DeFi protocols, which has been the source of the initial growth. The next set of users, DeFi newbies, then contribute to the growth of DeFi protocols.
Existing bluechip DeFi protocols have reached a stage where their growth is slowing down. These protocols either need to build new features or need an influx of new users to keep growing.
So where will growth come from? Just before we answer this question, let’s look at the challenges that the industry faces.
Challenges in DeFi & their solutions
DeFi protocols have a solid product-market fit in a niche audience. In their current form, these protocols require time investment for learning the technical know-how. However, not everyone is comfortable with the technical stuff. Much like in the movie “Jobs”, the computer salesman says to Steve Jobs, “Not everyone is part of a computer club. They don’t care about assembling, they want to press the button and start the system”.
Below, we’ve highlighted a few problems that we see in the existing DeFi space, and how we can solve these.
Challenge 1: Fragmented Market
DeFi Market is split across multiple Dexes, Borrowing, and Lending Protocols. This fragmentation of markets makes it difficult for users to get the best possible rates and makes the liquidity pools more fragmented.
Solution: Aggregators can solve the issues of fragmented markets and fractured liquidity. These aggregators could either aggregate various DeFi services (InstaDapp), aggregate protocols offering one service (Matcha, 0x), or a mix of both (Zapper). If the user wants to lend assets to earn interest, these products look at multiple protocols to assess the best yield for the user.
Challenge 2. Poor User Experience
Existing DeFi protocols do not have the best User Experience. Most of the services are desktop first, while the majority of the people still access the internet on their phones. Existing designs make DeFi overly complicated for new users. It isn’t very comforting for users to manage their private keys. Additionally, there is the fear of losing all their funds if they lose their private keys. Mnemonic phrases are not good enough; they act as a single point of failure, require high mental overload, and still have security issues. (Reference to Vitalik’s Article on Social Recovery)
Solution: Protocols/Applications should focus on building the best user experience for users. This involves focusing on having the right information set, removing unnecessary steps, and using notifications throughout the app journey. Protocols/Applications can also experiment with building Smart Contract Wallets that use Social Recovery instead of Mnemonic phrases. Additionally, these wallets can also be integrated with Ethereum Naming System (ENS) so that the user has a better experience of remembering their public key (Easier to remember laveen.eth instead of traditional 0x1234…)
Challenge 3: High Transaction Fee
Higher transaction fees for users who are new to DeFi can lead to a poor user experience. By adding a smart contract wallet or additional UX improvements, the transaction fee increases quite significantly. Higher transaction fees deteriorate the user experience and make micro investing near impossible.
Solution: The future of DeFi is Layer 2 scaling. There are multiple Layer 2 scaling solutions, some are general purpose, and some are specific to particular use-cases. It is too early to assess which Layer 2 scaling solution will be the winner, but Arbitrum and Optimism nearing launches is a good sign for the Ethereum based DeFi ecosystem.
Growth Opportunity for DeFi
Like any other product, DeFi protocols and applications will also grow by adding new feature sets or enhancing existing offerings to be accessible to new users. The growth in this space would be in 3 different ways:
Opportunity 1: Fixing existing problems in DeFi
DeFi, in its current phase, isn’t suited for a user who is trying to invest somewhere below $1000. As more and more Layer 2 solutions go live, and there are necessary bridges between these solutions, L2s will solve a significant problem in the DeFi ecosystem. A quick look at L2Beat shows that TVL in Layer 2 solutions has been increasing over time.
Layer 2s, bridges and direct onramps to L2s will play a major role in increasing the adoption of DeFi among existing and new users. Right now, its unclear which Layer 2 solution will be a clear winner here, but the winner L2 would include the following:
- Winner would have a lower transaction cost and a faster settlement.
- Winner would have the biggest ecosystem of DeFi protocols.
- Winner would have a good connection with onramps, bridges, and other L2 solutions.
Opportunity 2: Fixing for FOMO in CeFi
CeFi users have shown interest in DeFi. Existing CeFi platforms are interested in integrating DeFi protocols into the applications. Coinbase, one of the biggest CeFi platforms, has announced the app’s integration with various DeFi protocols. Crypto.com has also released new apps to allow its users to access DeFi products.
These CeFi platforms will serve as onramps for DeFi applications and wallets. As more and more Layer 2 solutions go live, CeFi platforms will integrate wallets and applications on Layer 2 and directly onboard users on L2s.
Also, the usual trend in the investing space is that users start their investing journey by investing a little bit of money in ETFs, gaining more understanding, and then investing in a complex stock market. In the same way, we’ve noticed that users start their crypto journey by investing in Bitcoin and Ethereum via CeFi platforms and then move towards DeFi.
Token listings are usually slow on CeFi platforms. I can’t fathom if any of the top CeFi platforms have listed IndexCoop products. As the existing problems in DeFi are solved, the users on CeFi platforms won’t have to wait for these tokens to be listed; they download Argent or a competitor to Argent and start investing in DeFi products.
Opportunity 3: Fixing existing problems in TradFi
Traditional Finance has failed to evolve with technology. In the 1900s, it would cost you 3% and 2–4 days to transfer money from one bank to another. In 2020, it costs 3% and two days to wire transfer from one bank to another. TradFi is a physical location first and has become internet-enabled, but it still relies on traditional finance infrastructure with back offices. Financial infrastructure and monetary policies are negatively impacting the financial options of people globally. High inflation, low savings rates, slower settlements, and expensive international remittances are few problems that DeFi can fix in the existing TradFi ecosystem.
DeFi based banking applications have a tremendous opportunity here. If we look at the existing financial landscape, DeFi based banking can create a new market. New startups can now capture this market opportunity by building a new financial application or building APIs that offer DeFi-As-A-Service. These APIs could plug into existing applications such as Revolut and offer higher interest rates, better loans, and investment opportunities to their users.
The demand for better banking is already here. We’ve identified that TradFi users are looking for better banking solutions and would be open to switching to these products.
Closing Thoughts
Over the last few years, the DeFi ecosystem has evolved from a few billion dollars TVL to almost touching the $100 billion mark. New DeFi use-cases have emerged, and the industry has been innovating quite rapidly, building the new financial world of the future. As the industry tackles its existing challenges, it will continue to unlock new growth opportunities and develop new use-cases.
