One of the main areas of growth in crypto 2019 was decentralized finance (DeFi). DeFi is defined as an ecosystem of financial products built on blockchain to provide lending and borrowing. The value proposition for decentralized finance over the existing financial landscape is transparency, less friction and borderless. Users have control over their digital assets and can choose to maintain full custody without reliance on third parties. Instead of one institution being in control, DeFi allows for deployment via code embedded on smart contracts and accessible by anyone with an internet connection globally through Dapps. Ultimately, the greater bet is changing the whole aspect of banking.
Moving beyond trading
Enabling users to buy and sell crypto in a safe and easy to use interface continues to be the main focus of most crypto exchanges. Most people’s first-time contact with the crypto world is through centralized crypto exchanges, especially those with fiat-to-crypto on-ramps. Exchanges and wallets focus on having a user-friendly interface that allows for easy set-up of accounts to buy/sell crypto assets. As trading continues to pick pace, the next step is to ensure user retention by offering additional services. This is where decentralized finance comes in. Just like ‘uberization’ trend that starts by offering trips and then going further to offer food deliveries, shopping among others, DeFi is seeking to extend service offering beyond buying and selling of crypto assets into new areas such as lending and borrowing.
Lending: the 2017 ICO bull run introduced the world to a new method of fundraising through the issuance of tokens. Even if the landscape has recorded mixed outcomes because of obvious scams, the genie was already out of the bottle. The industry started to look for new ways of offering financial products that are better than the existing one. Crypto lending has emerged as one of the areas. Holders of crypto tokens are able to earn returns from their holdings without having to liquidate the tokens. Within the last 2 years, dozens of lending products have been introduced.
ETHLend: this is a P2P marketplace that supports borrowers and lenders who can set terms for loans, accepted coins, and rates that. The platform matches borrowers and lenders using smart contracts. The platform does not hold funds but instead, the terms of collateral are stored in pre-programmed smart contracts. Started in 2017, it was among the first platform to explore DeFi currently accepting mostly ERC-20 tokens and bitcoin.
BlockFi is also another example of a company offering crypto-asset loans. BlockFi enables users to deposit their bitcoin or ETH and take loans against their crypto collateral. Depositors can also earn interest on their deposits. BlockFi then lends the crypto to institutional investors and earn interest.
MakerDAO: This is the leading platform for issuing Dai, its native stablecoin. DAI is pegged on 1 USD per token. Users earn governance fees from MakerDAO governance token allowing them to participate in operational earnings. Ethereum holders can use their Ethereum to take a DAI loan against volatile ETH. Maker is not peer-to-peer instead; it issues coins by pooling its reserves together. Maker is the largest participant in the DeFi ecosystem with close to $500M or 1.5% of Ethereum’s total supply locked on Maker according to Binance research.
Dharma: this is a P2P crypto lending platform that matches lenders and borrowers enabling them to borrow and lend assets at a fixed interest rate typically for 90 days. It supports more assets: ETH, DAI and USD coin.
This is a concept that entails earning interest or rewards by holding and locking certain cryptocurrencies in your wallet. In traditional finance, it mimics schemes that allow investors to earn interest from their fixed deposits in banks. Unlike trading, anyone can take part in staking as it requires less technical skills know-how. Staking is being used by proof-of-stake (PoS) blockchains. Staking ensures more participants are taking part and voting for the future of the network and not just a few miners and traders.
Different companies are exploring different staking options in order to avoid regulatory hurdles especially in relation to offering custody of funds. The mainstream approach is direct while others such as Coinbase are pursuing a different approach. Coinbase stakes the coins itself by using the funds in its custody account. The interest generated is then distributed to token holders (in this case Tezos) based on how much they hold. It gives holders a 5% annual return after an initial holding period of 35-40 days.
Ethereum leader: Ethereum has been leading the world of decentralized finance. In January 2020, Binance research reported that the number of ETH locked in DeFi applications exceeds 3 million. DeFi on Ethereum is expected to become even more visible with the transition to proof of stake with Ethereum 2.0.
The cumulative market cap of all crypto assets supporting staking as of October 2019 was $25.8 billion.
Source: Binance Research
According to StackigRewards which tracks crypto assets with staking programs, the average reward rate (APR) is 12.26%. There are currently 75 staking crypto assets. Major staking platforms are Everstake, SNZPool, Binance, 01node among others.
The value proposition of decentralized finance for lenders and borrowers
Holders of crypto assets such as Ethereum may choose to lend their assets because:
- Lenders can get returns on investment which currently is higher than the interest offered by banks
- Borrowers can short an asset similar to margin trading
- Ability to participate in governance on the blockchain
In addition, the research shows high volatility and spreads in the DeFi ecosystem. The lowest lending rates are from REP (Augur), ETH (Ethereum) and 0x token. High borrowing rates are recorded for DAI (4.16%) and USDC (9.34%).
Bitcoin’s Lightning network
Apart from Ethereum, other blockchains are also exploring different aspects of DeFi. Bitcoin’s Lightning network is one of the main use cases, a layer 2 solution on top of bitcoin blockchain in order to ensure faster payments. The research by Binance reveals that the adoption of lightning network remains low with total capacity being around 854 BTC (about $6.5M).
EOS has also waded into the ecosystem with EOSREX registering significant growth with 4million EOS locked as collateral by end of 2019.
Nonetheless, the Decentralized finance still remains small compared to the greater crypto ecosystem. Staking is much more significant with about $6 billion estimated to be locked up in staking. The report concludes by highlighting that the overcollateralized nature of DeFi landscape remains a challenge especially in addressing the needs of the unbanked. It is expected that more innovations will continue in the space in 2020 and beyond.