Decentralised Finance (DeFi): Transforming the Global Financial System

Interest in decentralised finance has climbed steadily in the last five years, peaking in 2021 as the world grappled with the economic ramifications of the pandemic lockdowns and people sought more control over their money. 

Decentralised finance (DeFi) is a financial system that does not rely on central authorities such as banks or governments. Instead, it is based on blockchain technology and smart contracts. DeFi allows people to borrow, lend, trade, and earn interest on their money without the need for a third party.

People started to become interested in DeFi in 2017, when the first DeFi project, MakerDAO, was launched. MakerDAO is a decentralised lending platform that allows people to borrow and lend DAI, a stablecoin that is pegged to the US dollar.

DeFi has seen rapid growth in recent years, with the total value locked in DeFi protocols reaching over $100 billion in 2022. This growth is being driven by a number of factors we will identify as trends.

DeFi is still in its early stages, but, like the innovative blockchain technology that powers it, it has the potential to revolutionise the financial system. 

People are interested in DeFi because of the benefits it offers to users such as transparency: DeFi is transparent because all transactions are recorded on the blockchain. This means that anyone can see how their money is being used.

DeFi is efficient because it eliminates the need for intermediaries, leading to lower fees and faster transactions. Also, it is accessible to anyone with an internet connection. This means that people in developing countries can have access to financial services that were previously unavailable to them.

Since the emergence of DeFi, many trends in the space have been identified, and we’ll highlight the major ones below. 

Past decentralised finance trends (and what to learn from them)

As an alternative to popular CeFi (Centralised Finance) providers such as Coinbase and Binance, DeFi quickly established itself and brought these trends to life:

The rise of decentralised exchanges (DEXs): DEXs allow people to trade cryptocurrencies without the need for a centralized exchange. Famous Dexs include Uniswap, SushiSwap, and PancakeSwap.

The development of yield farming: Yield farming is a process of earning high interest rates on crypto assets by providing liquidity to DeFi protocols. Yield farming became popular in 2020, and it has since become a major driver of growth in the DeFi ecosystem.

The increasing popularity of decentralised derivatives: decentralised derivatives allow people to trade financial contracts without the need for a broker. The first decentralised derivatives exchange, dYdX, was launched in 2017. Since then, there have been many other decentralised derivatives exchanges launched, including Synthetix, Perpetual Protocol, and Aave.

Today, DeFi is enjoying growth in these areas. 

The growth of DeFi lending and borrowing: DeFi lending and borrowing is a major segment of the DeFi ecosystem. In 2023, the total value locked (TVL – an important industry metric) in DeFi lending and borrowing protocols reached over $50 billion.

The development of decentralised insurance: decentralised insurance is a new type of insurance that is based on blockchain technology. decentralised insurance can provide coverage against a variety of risks, including smart contract hacks, loss of funds, and theft.

The increasing adoption of DeFi by institutional investors: Institutional investors are starting to adopt DeFi. In 2021, Grayscale Investments launched a DeFi fund that invests in DeFi tokens.

Nobody can predict the future, but it is likely that as DeFi continues to grow, these trends will emerge thanks to new blockchains, improvements to existing blockchains and increased governmental scrutiny.

The growth of DeFi 2.0: DeFi 2.0 is a new wave of DeFi that is focused on improving the scalability, security, and usability of DeFi protocols. DeFi 2.0 protocols are built on newer blockchains, such as Solana and Terra, that are more scalable and secure than Ethereum.

The development of DeFi on Layer 2: Layer 2 is a scaling solution for Ethereum that allows DeFi protocols to process more transactions per second. DeFi protocols that are built on Layer 2 can offer lower fees and faster transactions than DeFi protocols that are built on Ethereum.

The increasing regulation of DeFi: Governments around the world are starting to regulate DeFi. In 2021, the United States Securities and Exchange Commission (SEC) filed charges against a DeFi project for violating securities laws. The SEC’s actions have raised concerns about the future of DeFi.

It is difficult to say whether DeFi is the finance of the future because we do not know if it will be more widely used than Central Bank Digitial Currencies, which will put CeFi firmly back on the map. 

Both types of finance have their own advantages and disadvantages and it is possible one will be regulated and the other deregulated. 

DeFi is appealing to people who want more control over their finances and who are not comfortable with the idea of their data being stored by a central authority, and it seems likely after the last few years that the number of people feeling this way is growing. 

However, DeFi is still in its early stages of development, and it is not without risk.

The technology is complex, and there have been some high-profile hacks of DeFi protocols. Additionally, DeFi is not regulated, which means that there is no one to protect users if something goes wrong.

CBDCs, or central bank digital currencies, are digital versions of fiat currencies that are issued by central banks. They are designed to be more efficient and secure than traditional cash and electronic payments. CBDCs could offer a number of advantages over DeFi, including:

Widespread adoption: CBDCs would be backed by the full faith and credit of governments, which would make them more widely adopted than DeFi, which is still a relatively new and untested technology.

Regulation: CBDCs would be regulated by central banks, which would provide users with some protection against fraud and theft.

Stability: CBDCs would be pegged to a fiat currency, such as the US dollar, which would give them a stable value. This would be in contrast to DeFi tokens, which are often volatile in price.

However, CBDCs also have some potential drawbacks, including:

Centralization: CBDCs would be centralised, which means that they would be subject to government control. This could be seen as a disadvantage by some people who value decentralisation.

Privacy: CBDCs could be used to track and monitor people’s spending habits. This could be a concern for people who value privacy.

Security: CBDCs could be vulnerable to cyberattacks. This is a risk that would need to be addressed before CBDCs could be widely adopted.

It is too early to say whether DeFi or CBDCs will be more widely used. Both have their own advantages and disadvantages, and it is likely that both will coexist in the future. Either way, we will find out pretty quickly.

This publication is for informational purposes only and is not intended to be a solicitation, offering or recommendation of any security, commodity, derivative, investment management service or advisory service and is not digital asset or cryptocurrency trading advice. This publication does not intend to provide investment, tax or legal advice on either a general or specific basis.