- The growth of the Ethereum DeFi space was a key blockchain industry trend in 2019, with applications include stablecoins, lending, decentralized exchange, and synthetic asset issuance.
- Despite growth in Total Value Locked and number of users, DeFi-related tokens, including ETH, saw mixed returns.
- A variety of key challenges animate the ongoing development of DeFi heading into 2020, including the use of alternative blockchains, technical risk, and high collateralization requirements.
Though notably lacking a precise definition, the DeFi space includes finance-focused Ethereum applications with significant on-chain logic, spanning use cases such as lending, stablecoins, decentralized exchanges, and synthetic asset issuance. While it would be a significant stretch to say that any application, industry vertical, or project in the blockchain industry found mainstream use in 2019, the DeFi space -- evidenced by the range of innovative products being developed and their growing use -- stands out as possibly the closest.
Key 2019 Project Milestones
The Ethereum DeFi space saw a numerous significant milestones this year, as projects spanning a wide variety of use cases continued to develop their applications and platforms. Key events include:
- Multi-Collateral Dai Launch & MakerDAO Growth - Following the rapid growth in the ETH-collateralized version of the DAI stablecoin, the Maker community executed a key milestone of their roadmap in launching a DAI backed by a basket of ETH and a variety of ERC-20 tokens, known as Multi-Collateral DAI (MCD). This feature is intended to lend additional stability to the backing assets, theoretically reducing the possibility that Dai will lose its USD peg due to sudden price fluctuations of the collateral. The initial implementation of MCD utilizes ETH and BAT as collateral, with a variety of major ERC-20s under consideration. Notably, the ETH-collateralized DAI has (roughly) maintained its $1 peg since inception, despite an ETH price drawdown of 90% from peak to trough. The governance feature of MKR tokens was employed throughout this process to coordinate which assets would be included as collateral, key cutover dates, and implementation of the Dai Savings Rate.
- Compound Growth - Compound is a money market lending protocol that saw significant growth in loan originations throughout 2019, arguably enabling a similar use case as MakerDAO in allowing large crypto holders to obtain margin loans for leveraged trading. An interesting aspect of Compound’s growth is that other DeFi applications are beginning to use its money market pools as a backend service; for example, Pool Together is a ‘no-loss lottery’ utilizing interest earned from lending to Compound as the prize. Such applications are early instances of the composability of DeFi tools. Following such growth, illustrated in the chart below, Compound raised a $25m equity round in November, the largest equity fundraise for a DeFi project in 2019.
- Uniswap Growth - Despite the broadly lagging volumes of decentralized exchanges (DEXs) across the industry, Uniswap stands out with considerable volume and integrations with other applications. Launching in late 2018 from an Ethereum Foundation grant and later raising a $9m seed round in early 2019, Uniswap utilizes an automated market maker (AMM) model that facilitates trading against a smart contract. This approach is broadly similar to the Bancor model, though does not involve a token, and may provide advantages in combating the key issue of front-running that has plagued other DEXs. Uniswap saw the highest growth in the DEX space on the year, comprising over 30% of the market with weekly trading volume over $7m by the end of the year. Additionally, Uniswap established a variety of integrations with other DeFi projects, including lending protocol Compound.
- Synthetix Growth - Synthetix is an asset issuance protocol for synthetic digital assets, pegged to real-world currencies, commodities, and other cryptoassets, to those who stake the project’s main, non-synthetic asset, SNX, in smart contracts. Synthetix has seen growth in the form of issuing a greater variety and volume of assets, including a USD stablecoin and synthetic BTC, with $24m in various Synths issued to date.
- 0x v3 Launch - Following low trading volumes for many key 0x relayers, the project launched v3 in December. Major features of v3 include the introduction of a per-trade protocol fee, ZRX staking functionality that allows market makers to earn a portion of the protocol fee in proportion to their trading volume, relayer liquidity bridging with Kyber, Oasis, and Uniswap, and trading fees payable in any Ethereum token. While it is too early to judge if these changes are likely to revitalize the 0x ecosystem, they do represent meaningful experimentation within the DEX space.
- Augur v2 & Veil Shutdown - Prediction markets are an early-conceived use of blockchain technology that have recently come to be considered under the DeFi umbrella, in that they are effectively markets for betting on real-world events. Despite initial enthusiasm, Augur has seen minimal volume growth this year despite releasing a significant v2 update in April including trading in DAI and improvements to the reliability of the oracle system. Veil, which released a comparatively-centralized Augur fork, shut down citing regulatory uncertainty and a difficult user onboarding experience.
As previously discussed by Smith + Crown, the significant majority of growth in the DeFi space is attributable to lending protocols, most notably Compound, as well as stablecoin projects such as MakerDAO that effectively function as a margin lending protocol for ETH holders. Particularly towards the end of the year, increased asset issuance from Synthetix (which has a required 750% collateralization ratio) contributed to expansion in this measure.
Despite Increased Use, DeFi Tokens’ Market Performance is Mixed
While several of the major DeFi projects do not have associated tokens, including Compound, Uniswap, and dYdX, it is instructive to examine the market performance of those projects that do. An investor might expect a record of achieved developmental milestones and adoption to contribute to a project’s cryptoasset valuation. Yet, despite significant developments, token value accrual and price performance have remained quite mixed, though with notable standouts such as Synthetix’ SNX. In particular, note that the MKR price fell 12% on the year , despite the breakout success of MakerDAO as a stablecoin and collateralized lending platform by nearly any other measure (DAI stability, DAI issued, ETH locked as collateral, integrations with other DeFi protocols, etc). Further, DeFi traction did not translate to returns on ETH, which was roughly flat on the year.
Of course, such a divergence between project fundamentals and token price is neither unique to DeFi projects nor able to be ascribed causation, as the industry abounds with successful projects lacking a token design that captures value in current market conditions, and vice versa. This issue, broadly speaking, is one of the major unsolved aspects of cryptoeconomic design.
Open Issues for 2020
At a high level, most DeFi applications are currently experimental with usage constrained primarily to crypto-native users who are willing to navigate various usability hurdles and technical risks. Long term expansion of the sector likely requires broadening this user base towards the mainstream, as well as continually improving on the efficacy and security of these applications. Thus, looking forward to 2020, a wide variety of issues and trends animate the space, including:
- DeFi on Non-Ethereum Chains - While these applications have been overwhelmingly hosted on the Ethereum blockchain to date, little restricts much of the functionality from being recreated on other smart contract platforms. Early examples of MakerDAO-style applications include Kava (on Cosmos) and Money on Chain (on a Bitcoin sidechain using Rootstock). Given the variety of ‘next-generation’ smart contract platforms launching in 2019/20 - Polkadot, Cosmos, Tezos, Algorand, Solana, etc - and the traction of Ethereum DeFi, it seems quite plausible that projects will seek to migrate such functionality to new ecosystems.
- Overcollateralization - A core feature of lending platforms, such as MakerDAO and Compound, is their reliance on overcollateralization to enforce repayment of a loan in the event of a default. If the value of collateral drops below a threshold -- 150% for MakerDAO -- it may be liquidated to settle the loan. This represents a significant capital inefficiency. While many non-crypto loans do not require over-collateralization due to methods of estimating default risk (such as credit scores), the lack of effective identity protocols on Ethereum to date has prevented advancement of such under-collateralized loans. In order to expand the particular DeFi use case of lending beyond its current use by large holders of ETH and margin traders, some method of enabling undercollateralized loans and increasing capital efficiency is likely required.
- Technical Risk - Given the considerable complexity of the smart contracts that underlie DeFi applications, there exists significant technical and execution risk that the space must continually grapple with. Smart contracts can have errors, bugs, and unintended exploits; these become particularly critical when the contracts are complex, newly deployed, and responsible for millions in investor capital. 2019 saw a variety of such issues, ranging from a Synthetix contract exploit that allowed an attacker to mint millions in false trading profits to multiple potential exploits in MakerDAO. Completing robust auditing procedures and clearly communicating potential risks to users will benefit upstart projects, particularly those that aim to expand to beyond crypto-native audiences.
- Becoming More ‘Decentralized’ - An oft-lobbied criticism of many DeFi applications is the degree to which the project team retains a significant degree of centralized control, despite the ‘decentralized’ moniker. Here, projects face a delicate balance in execution: they aim to build permissionless, open source, ‘unstoppable’ financial applications in the ethos of the industry, yet face practical challenges in fixing smart contract bugs, monitoring price feeds, and funding development that make it appealing to retain some degree of control. In many cases, this centralized control is a positive feature for the project: in the Synthetix exploit mentioned above, the team was able to contain the issue and ultimately prevent any loss of funds because they retained some administrative controls. Further, governance systems such as MakerDAO’s arguably retain key aspects of centralization; for example, in the votes on collateral types for Multi-Collateral Dai, token holders could only approve/disapprove candidates assets selected by the MakerDAO Risk Team, not nominate assets themselves. Additionally, participation has been relatively low, with less than 10% of MKR participating in most votes, and the MakerDAO team and a small group of VCs holding a significant portion of the supply. A variety of other organizations, including 0x and Compound, are considering governance processes to promote decentralization. Thus, a key open issue for these applications, and indeed for the industry more broadly, is the extent to which a gradual process towards decentralization can be incentivized and balance various security needs.
While particular predictions are difficult, these themes will likely play key roles in the DeFi space moving into 2020 and are worthy of ongoing consideration. Moreover, it is worth emphasizing that DeFi’s present user base remains relatively niche and the significant majority of use cases are mechanisms for speculating on cryptoasset prices in various ways, albeit in a possibly more ‘decentralized’ fashion than exchanges. This characterization is particularly evidenced by the considerable growth in projects such as Compound and MakerDAO, which enable various forms of margin trading activity. It is not yet clear that DeFi’s potential advantages enable product offerings that are compelling relative to traditional financial services to a mainstream user base. As such, despite the considerable growth of the space within the blockchain industry in 2019, there remain open questions about how such developments will translate into broader adoption.