The coronavirus pandemic saw a rise in the flow of funds into cryptocurrencies and associated Decentralised Finance (DeFi) projects. But so far, 2022 has been disastrous for this space, with words such as ‘full meltdown’, ‘perfect storm’, ‘crash’, and ‘collapse’ now being used to describe what is going on. Yet it’s happened before.

Bitcoin plummeted 80% in 2018, down to USD 3,000 in December 2018, then recovered magnificently to an incredible peak of USD 64,000 and a market cap of USD 1,270 billion in December 2021. Since then, the price has tanked to sit at USD 20,000 and a market cap of USD 398 billion (as of early July 2022).

Given its volatile price history, you might think it will recover. Why should it be any different this time?

On the other hand, some commentators see it differently this time – and regard the fall as part of a broader pullback from risky assets, spurred by rising interest rates, inflation, and economic uncertainty.

This pullback is resulting in a huge amount of collateral damage, with the implosion of cryptocurrencies and DeFi platforms gaining momentum. The most recent high-profile case was the platform Celsius, which paused withdrawals and transfers between accounts. From this point of view, you might now conclude that crypto is surely done for and doomed.

In this short article, I provide a recap of DeFi, which has become the most active sector in the blockchain space and where use cases for cryptocurrencies have, shall we say, started to emerge. DeFi still has a long way to travel to reach maturity, but the progress made so far suggests that crypto is not dead and has a future – perhaps comparable with the dot-com bubble, which correctly predicted the future but much too early.

DeFi smart contracts and use cases

DeFi’s goal is to use blockchain technology to develop an alternative to the centralised approach of the traditional financial system where central authorities, institutions, and intermediaries, such as banks and brokerages, play the role of a trusted middleman to enable two parties to transact.

The first generation of blockchain-based cryptocurrencies demonstrated that two parties are able to transact without relying on a middleman to act as the validating agent. The emergence of the Ethereum blockchain, which is considered the foundation for DeFi, has further demonstrated that validation can be programmed directly into the code on the Ethereum blockchain.

These so-called smart contracts on the Ethereum blockchain have certain characteristics that offer potential benefits and enable smart contracts to function as intermediaries, replace conventional middlemen, and become the source of trust.

The characteristics include:

• Programmability – contracts are programmed to execute automatically. The conditions are written into the code of the smart contract – known as algorithmic governance.
• Immutability – the conditions cannot be altered or changed once the smart contract is launched.
• Interoperability and composability – different components can easily connect and interoperate.
• Transparency – transactions are published to the public Ethereum blockchain and can be verified by other users.
• Permissionless – anyone can, in theory, access the DeFi applications.
• Self-custody – users keep custody of their assets and control their personal data.

There are many use cases in DeFi. Some are still fairly aspirational – but others are perhaps more concrete and include:

• Staking – the process of committing crypto assets to support a blockchain network and then acting as a validator to verify the transaction for which the user receives interest and other rewards – part of the next-generation Ethereum 2.0 based on Proof of Stake rather than a Proof of Work model.
• Saving and peer-to-peer (P2P) lending – earning interest on crypto saving accounts – or crypto committed to a lending pool.
• Trading – the DeFi trading space is very broad and encompasses derivatives trading, margin trading, and token swaps.
• Marketplaces – NFTs and DeFi protocols are supporting an array of online marketplaces that allow users to exchange products and services globally and P2P – everything from freelance coding gigs to digital collectibles to real-world jewellery and apparel.

There are now countless DeFi use cases, platforms, exchanges, and initiatives:

• New conceptual entities have emerged, including decentralised autonomous organisations (DAO). These cooperate according to transparent rules encoded on the Ethereum blockchain, eliminating the need for a centralised administrative entity.
• Stablecoins – a cryptocurrency pegged to fiat, gold, or other more stable cryptocurrencies – remittance payments, lending and borrowing platforms, and even institutional use cases like central bank digital currencies (CBDCs).

With billions of dollars worth of value locked in Ethereum smart contracts, decentralised finance has become the most active sector in the blockchain space.

DeFi challenges and the emergence of DeFi 2.0

All blockchain projects face a similar set of issues, referred to as the ‘blockchain trilemma’, which was coined by Vitalik Buterin, co-founder of the Ethereum blockchain. The trilemma postulates that blockchain developers are compelled to make trade-offs between decentralisation, scalability, and security – and are not able to deliver all three at the same level, at the same time.

Specifically, DeFi projects face further dilemmas around liquidity. Providing liquidity to a pool requires a user to commit their funds to a given liquidity pool. This so-called ‘lock-up’ of funds is a necessarily rigid structure, but it conflicts with the natural investor behaviour of jumping between liquidity pools to seek out better returns. In an attempt to retain the provider, pools will offer rewards in the form of a native token.

However, short-term farm and dump behaviour is common, leading to an inevitable, capitulated sale of the native DeFi token, causing huge disruption and market inefficiencies. A DeFi 2.0 movement is attempting to address these issues by developing sustainable methods that ensure long-term liquidity. Chief amongst these is to assist users in earning yield.

Conclusion

At a conceptual level, the idea of programmable smart contracts with blockchain-enabled immutability and transparency remains compelling. But efforts to convert theory into practice have not been without problems. As in conventional capital markets, the behaviour of market participants remains irrational for a long time.

But overall, the progress made to date suggests that DeFi and crypto do have a future. It will continue to be a bumpy path and may be much longer than initially expected. There is a temptation to dismiss the space and consign crypto to the history books of bubbles and manias – but to do so would be wrong.

This article was first published by The Paypers, the Netherlands-based independent source of news and insights for professionals in the global payment and e-commerce community.

The content of this article does not reflect the official opinion of Edgar, Dunn & Company. The information and views expressed in this publication belong solely to the author(s).

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