08.02.2023

Three maturity stages of a decentralized finance system

Stage 1: Efficient value transfers 

Until now, centralized exchanges and wallet providers have been the only successful blockchain business models at scale. The reason for the success of centralized exchanges is that they are the main entry point to the crypto space (see Figure 1). The common user needs to swap fiat money (e.g. US Dollar) against a cryptocurrency before being able to interact with services in decentralized finance. Furthermore, wallet applications are established that enable users to safely store and transfer their cryptocurrencies.

Based on those two applications, exchanges and wallets, efficient value transfers between unknown parties could be conducted for the first time without the need of traditional finance actors. This enabled the crypto space to fulfill limited functions of a financial system, namely speculation on (crypto) assets and the facilitation of payments. Thus, disintermediation of financial firms occurred – but only, if savers of traditional finance wanted to diversify their portfolio towards crypto assets or needed a frictionless payment system.

Stage 2: Connecting savers and borrowers

Still missing was the ability to deal with flows of funds from savers to borrowers and vice versa. In the following years, additional elements of a more advanced financial system were developed. The function of a payment system could be advanced with the development of stablecoins, decentralized exchanges, and borrowing/lending protocols. Thereby, DeFi developed the necessary platforms for facilitating the flows between savers and borrowers.

It might be no coincidence that the start of the explosive growth for the whole DeFi ecosystem could be observed with the advancement of the lending/borrowing protocol Compound. Since Compound started the distribution of its governance token, COMP, on June 15, 2020, the whole DeFi ecosystem showed a steep growth trajectory. Functioning lending/borrowing protocols, such as Compound, might have been the missing cornerstone for the foundation of a properly working decentralized financial system. This can be marked as the second maturity stage of the decentralized finance system.

Stage 3: Competing for traditional finance funds

DeFi can be described as a platform that is competing with traditional financial firms for the same resources. However, DeFi is an encapsulated system, which is not obeying the same rules as traditional finance. In particular, national law does not apply and regulatory policies can hardly be enforced in the DeFi space. This might be a major competitive advantage over the highly regulated traditional finance firms. 

For example, financial innovations can be freely developed and implemented in DeFi without regarding regulatory boundaries. On the other hand, the absence of common legislative and political principles has certainly major disadvantages. It can be doubted that mainstream savers would consider the current DeFi environment a trustworthy destination to invest their pension. Hence, the crucial question for the advancement of DeFi to the next evolutionary stage will be:

  • To which degree are savers of traditional finance willing to relocate their funds towards DeFi applications?
  • To which degree are borrowers of traditional finance willing to access funds from DeFi applications?

To answer both questions at the current point in time: Only to a very limited degree. The reason is that most traditional finance savers or lenders do not trust the crypto space or simply do not know about DeFi. The influx of capital into DeFi applications since June 2020 most likely stems from idle assets on crypto wallets, i.e. from a redistribution of assets within the crypto space. Nevertheless, the rising use of DeFi protocols proves that the system is scalable and working. Today, the users of DeFi belong to the group of “innovators” or “early adopters” (i.e. a very small proportion of households). Tomorrow, the users might be mainstream households.

DeFi has the potential to outperform the traditional finance system in the years to come

We argue that there are three reasons why DeFi has the potential to outperform the traditional finance system and to gain increasing attention in scientific, economic, and public debates:

  1. Speed of growth: DeFi is a highly scalable and global ecosystem. Once DeFi as a whole (or a specific DeFi application) proves its utility, exponential growth is possible. The website DeFi Pulse monitors the total value locked (TVL) on smart contracts on all relevant DeFi applications (i.e. how much money has been poured into the ecosystem by its users). The increase of TVL between June and August 2020 illustrates powerfully the exponential growth potential of DeFi. While 1st of January 2020 the TVL was at $0.7 billion, it started skyrocketing in June 2020, reaching 1.9 billion 1st of July, 4 billion 1st of August, and surpassed the $8 billion mark 1st of September 2020.
  1. Room for growth: According to Messari, a crypto market analytics firm, the capitalization of all DeFi applications was just at 1.5% of the total crypto market as of July 2020. Therewith, it could be argued that there is a lot of room for growth only by further asset redistributions within the crypto space. Looking beyond the crypto space, lets us derive the real potential of DeFi. According to the Institute of International Finance, global household debt alone amounts to 48 trillion US Dollar in 2019. If DeFi covers just 0.1% of that debt, DeFi’s TVL would grow by 500% compared to the beginning of September 2020.
  1. New market segments: According to The World Bank, 1.7 billion adults do not have access to banking services. DeFi is permissionless, meaning that anyone can access those financial services from anywhere in the world. In principle, just electricity, an internet connection, and smartphones are needed. DeFi could provide a viable option in regions, where banking services are too expensive compared to income, little trust in financial institutions persists, or if financial institutions are simply too far away. A prerequisite, however, for reaching unbanked adults is that DeFi applications develop more intuitive user interfaces and simplify the on- and off-ramp with fiat currencies.

Conclusion: Crypto-based finance is here to stay

For the first time in history, a financial system is developing without intermediaries at a large scale. So far, DeFi applications cannot compete in terms of security, speed, and ease of use with traditional finance solutions yet. But DeFi has produced real, working applications that have already managed to attract billions of capital. Those resources will be used to develop more competitive and user-friendly applications in the future.

Yes, there are parallels to the ICO hype of 2017, which resulted in a sharp increase and price crash across virtually all cryptocurrencies in 2018. Since then, the interest of mainstream media has diminished. However, it has been largely unnoticed that the influx of capital through ICOs has enabled the blockchain community to bring the technology to the next evolutionary stage. Now again, large sums are invested into blockchain technology. But in contrast to 2018, applications already have been developed and are running. While we might be standing at the verge of a new bubble, we might also be at the beginning of a new big development cycle for blockchain technology.

For sure, many more development cycles need to follow. However, it is not unrealistic to state that decentralized finance will be more efficient, convenient to use, and secure than traditional finance. It will be highly interesting to observe how the different actors in traditional finance will respond when profits start to deteriorate because of DeFi.

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