This is the third of a multi-part series on decentralised finance (DeFi). DeFi is a blockchain use case that is potentially disruptive to the traditional finance industry. The first part of the series explains what it is and the philosophy behind the movement. The second part of the series delves into the state of the DeFi ecosystem as of October 2020. A primer on blockchain (including examples of insurance use cases) is available in this paper I co-authored.
The story so far
Let’s get up to speed. DeFi applications provide fully digital and automated financial services (payments, savings, lending/borrowing, trading, insurance etc.). They are implemented using “smart contracts” deployed on permission-less blockchains. Ethereum is the first smart contract platform on which most DeFi applications are built.
The current version of the Ethereum blockchain has a low throughput, resulting in slow and expensive transactions when the network is congested. The low throughput is due to Ethereum’s design which favours security and decentralisation at the expense of scalability. Completing a transaction on the Ethereum blockchain could take minutes or hours, depending on how much transaction fees the user is willing to pay. Transaction or gas fees paid to miners (who help secure the blockchain) have been at ungodly levels, deterring the average user from using DeFi applications.
Binance Smart Chain (BSC), a smart contract platform like Ethereum, launched in September 2020 and quickly gained users with its relatively high throughput (BSC has been designed to favour scalability over decentralisation). As BSC is Ethereum Virtual Machine (EVM)-compatible, DeFi applications originally built for Ethereum was forked/copied and ported to BSC with ease, creating a thriving DeFi ecosystem on BSC almost overnight. Meanwhile, Ethereum “killers” such as Solana and Polkadot are slowly gaining traction; it’s taking considerably longer because developers need to build applications from scratch (as opposed to the less strenuous endeavour of copying and pasting existing DeFi apps’ source code).
Layer 2 scaling solutions
On Ethereum, the long awaited “Layer 2” scaling solutions are finally here. Polygon is live and is fast gaining developers and users. Arbitrum One and Optimism will be launching imminently. Broadly, Layer 2s work by offloading transactions from Ethereum onto a separate network optimised for scalability (watch Layer 2 Scaling Explained to learn more). Ethereum, which is optimised for security and decentralisation, acts as a trusted base layer for settlement assurance.
Layer 2 solutions are making DeFi applications more accessible. For starters, user experience on Layer 2s is greatly improved, thanks to the near-instantaneous transaction confirmation. More importantly, the near-zero transaction fees on Layer 2s make micro-transactions economical, allowing users to interact freely with DeFi applications.
Case in point: on Ethereum, most users could ill afford to make frequent transactions. To save on transaction fees, they have little choice but to limit their interaction with DeFi smart contracts. For instance, users would not move their deposits in a DeFi savings product even though higher yields are available on a different DeFi product as transaction fees would eat into any gain in yield.
The low transaction fees on Layer 2s allow users to switch from one DeFi application to another to maximise yields and become, in crypto parlance, the degenerate yield farmer they were born to be.
Fragmented DeFi ecosystem
One of the advantages of DeFi over traditional finance is composability. A transaction can be “composed” to interact with multiple smart contracts on the same blockchain, allowing DeFi products to be built on top of other DeFi products. In the traditional finance world, the Open Banking initiative has the same intention but it is harder to implement programmable money on legacy infrastructure.
As more Layer 2 networks launch, there is concern that DeFi protocols will be scattered across different incompatible networks; this fragmentation of the DeFi ecosystem will stymie composability. So far, the concern is unfounded as DeFi protocols are being ported to multiple Layer 2s. There is precedent to this; think of how apps (or their close equivalents) are available on both iOS and Android.
A legitimate concern is the fragmentation of liquidity across Ethereum and different Layer 2s. This is a pertinent problem for decentralised exchanges (DEXes) which rely on large liquidity pools (i.e. pools of assets which users can trade against) to prevent slippage. DEXes are currently offering generous fees and rewards to incentivise liquidity providers but this is unlikely to be sustainable in the long term.
Accelerating DeFi adoption 🤷♂️
The amount of money in DeFi, as measured by TVL – total value locked – in smart contracts, has skyrocketed from c. US$11 billion during the height of DeFi Summer (the DeFi craze in the summer of 2020) to c. US$62 billion (at time of writing). Layer 2 scaling solutions are likely to accelerate TVL. However, there are still a number of missing pieces preventing the mainstream adoption of DeFi:
- User experience is not sufficiently intuitive. Users need to be somewhat tech savvy like knowing-how-to-get-a-blockchain-transaction-unstuck savvy.
- Self-custody and being one’s own bank is great but most users won’t be able to stomach the responsibility. The very real prospect of losing access to one’s non-custodial wallet is scary. There’s no customer support to call.
- It’s the Wild West; bad actors are perpetrating exit scams and rug pulls. Proportionate regulatory oversight and consumer protection are badly needed.
Nascent Layer 2 scaling solutions have provided a glimpse of the future of DeFi. Despite existing limitations, it’s looking more probable that financial products and services built on decentralised networks will gain market share. In time, DeFi may even replace the existing financial system. One could dream or buidl.
The bottom line: DeFi applications provide fully digital and automated financial services (payment, savings, lending/borrowing, trading, insurance etc.). Mainstream adoption has been slow in part because transactions on the current version of Ethereum are slow and expensive. Layer 2 scaling solutions for Ethereum are now in production. Transactions are near-instantaneous and fees are near-zero on Layer 2 networks, making DeFi accessible to more users.
Disclaimer: This is NOT investment advice/recommendation. I write on this blog in my personal capacity; my views and opinions are NOT endorsed by my employer or the actuarial profession. Smart contract platforms and Layer 2 scaling solutions mentioned in this post are the most notable examples to use to illustrate a point. Mentioning them does not imply endorsement or recommendation. Using DeFi applications or investing in their governance tokens could potentially result in severe financial losses (getting “rekt” in crypto parlance).