Upcoming trends in DeFi — Open Finance 2023 Thesis

Upcoming trends in DeFi

Decentralised Finance was the first category of decentralised applications to have some product market fit, even though this adoption was limited to few early adopters for several years. The main challenge for the early iterations of DeFi was in bootstrapping these marketplaces: finding a counterparty willing to trade or lend/borrow against you was hard when there were only a few thousand “active” DeFi users and especially when these were nearly exclusively retail users.

The early DeFi applications which struggled to grow exponentially were marketplaces with peer-to-peer models (most likely because they were too early compared to the number of DeFi users). On the trading side, Etherdelta was running a rudimentary order-book-based exchange, with deposits and on-chain order matching. It had real traction by virtue of being the only platform to trade newer tokens post ICO, a role that is now generally fulfilled by Automated Market Maker (AMM) exchanges and Uniswap in particular.

Equally, the early lending protocols like Etherlend (ancestor to AAVE) were matching lenders and borrowers peer-to-peer. Overall the user experience was poor: users had to wait to be matched for a trade or a loan, the market was inefficient, and the only reason to use DeFi was really to experiment or to avoid centralised exchanges.

DeFi needed to fulfil users’ expectation of immediacy, so instead of the peer-to-peer model, the peer-to-contract model became dominant. The first success was MakerDAO with single-collateral DAI in December 2017, allowing anyone to instantly borrow DAI against their ETH. On the trading side, this was the gradual take-over of the AMM model, with Uniswap in November 2018, so that traders could buy and sell instantly. On the lending/borrowing side, we also had the introduction of pooled liquidity: users were now earning interest instantly, or borrowing against their collateral instantly. The user experience significantly improved, leading to DeFi properly taking off in 2020 (fuelled by token incentives from these DeFi Protocols). However, there was a trade-off with these instantaneous solutions: some value was left on the chain. The liquidity was always there, but it was not as optimised as possible.

DeFi also grew in popularity at a time where it was still affordable (relatively speaking) to use it on Ethereum. This increase in popularity attracted professional actors, as these new markets were less optimised and it was possible to extract value.

Of course the popularity of Ethereum grew beyond DeFi since 2020, as the chain also became a settlement layer for NFT projects and cross-chain operations, and it rapidly became prohibitively expensive to use the network for most. Nowadays it is frequent to spend $50 or more in network fees just to perform simple operations, which is objectively limiting the growth of DeFi on the network. It has reached a point where only low latency applications are accessible to the wealthiest users: an occasional DeFi trade, an occasional DeFi loan, but nothing that is intensive.

Where does this leave us?

It may not have been the original vision of Ethereum to become this premium chain at all costs, but the technical complexity to scale a blockchain where billions are backed by proof-of-work is not an easy task, and it’s increasingly likely that Ethereum will remain the most secure settlement layer only the wealthiest can interact with, directly, whilst most of us indirectly leverage its security.

This is acceptable as decentralisation is a spectrum and not every application requires the same level of trust assumption. The Web3 ecosystem has actively been tackling this issue, with the introduction of other layer-one blockchains (e.g. NEAR*, Polkadot*, Solana, Avalanche, Fantom, Polygon) and layer-two scaling solutions (e.g. Aurora*, ImmutableX*, Arbitrum, Optimism, ZKSync, Starknet). These solutions have a range of trust assumptions and network fees, which should have its own limitations for the use cases that can be built there. This is an important topic in itself but I will voluntarily avoid covering it to keep it short.

What could the future hold for DeFi?

We are clearly past the point where DeFi has only a couple thousand users: according to this Dune dashboard, there are 4.5 million active wallets in DeFi. I believe this will enable three major trends going forward:

1. The professionalisation of DeFi, with more complex financial primitives and Real World Assets.
2. DeFi innovation on cheaper chains will increasingly return to the peer to peer model.
3. Sustainable token designs

Trading

The AMM model is great, but it is not perfect. I expect this design will lose market share over time with the return of peer-to-peer trading solutions. There are already credible alternatives, such as dYdX’s derivative protocol on StarkEx or ZigZag on ZKsync.

There has been another interesting trend allowing DeFi users to trade with professional counterparts. It started with aggregators like 1inch* or matcha including trading routing to market makers, and more recently Hashflow* is enabling traders to trade directly with professional market makers in a request for quote format. Hashflow in fact is one of the most gas efficient ways to trade on Ethereum today, cheaper than trading on uniswap V2 (which used to be the gold standard of efficiency), so it is actually well suited for L1 trading ; but I think their protocol is really poised to shine on cheaper chains with faster settlement.

Hashflow is also gradually rolling out a feature allowing users to lend liquidity for professional market makers to market make on Hashflow. This is a credible alternative to being a liquidity provider on AMMs for those seeking yield on their asset.

Protocols like Hashflow, enabling trading directly with professional market makers, seem to be the credible path forward for giving always-on access to the more sophisticated financial products like options ; because so far we have seen few market participants willing to leave resting offers on p2p DeFi options trading marketplaces.

Sophisticated asset management strategies

Today, it is basically impossible to trade options peer to peer in DeFi, because the options protocols remain too illiquid. Of course that did not stop the DeFi builders, with solutions like StakeDAO*’s or Ribbon’s allowing anyone to take part in covered call or covered put selling strategies, but it remains very hard for a given user to buy or sell options.

DeFi summer introduced attractive yield, and now DeFi users are hungry for more and they are willing to take increasing risk to build a portfolio of such strategies. It’s likely that we continue seeing innovation like the covered call strategies, such as introducing the cash-and-carry trade to everyone in similar vaults of pooled liquidity, especially thanks to on-chain derivative exchanges and their funding rates.

Smaller users enter the space to earn yield

With cheaper chains, it will be credible to have users with a couple hundred or thousand dollars/euro enter the space to start earning yield. This is where user-friendly wallets like unstoppable finance*, with easy on-boarding processes that integrate other currencies than the dollar, will shine.

On-ramp solutions that properly support layer-two, like Ramp*, will explode in 2022. They will become the cheapest way to on-board smaller users ; and mobile wallets like Argent* will be how these users interact with this new world.

DeFi will remain largely USD denominated, but more fiat currencies will enter the space, starting with the Euro

Angle* which launched in late 2021 is already the most liquid and scalable euro stablecoin, and I think this trend will continue with other currencies. This is particularly important as DeFi yields compress over time and as users will not want to worry about the foreign exchange rate between their currencies and the dollar.

Peer to peer lending

Lending in DeFi has only been feasible in pool models with solutions like AAVE and Compound. As we have mentioned before, whilst this is very convenient (can earn interest or borrow instantly), it’s rather inefficient because borrowers’ accrued interest are being split with all the suppliers, even though most of that liquidity usually isn’t used.

Now that DeFi is actively being used and that there are significant number of users lending and borrowing, we can experiment with going back to a peer to peer model, which is what a protocol called Morpho is building, where they are matching users peer to peer whenever possible, and if impossible, they fall back to the AAVE/Compound markets. I suspect we will see more protocols bootstrapping peer-to-peer lending marketplaces (and especially to address borrowing against NFTs).

MEV will still be a major problem for L2

With cheaper transaction fees, this also means that it will be economic to front run DeFi traders much more often. It is quite likely that this will remain a problem on all chains, so it will be interesting to watch solutions like Flashbots* being integrated in more places.

The dynamic of miner extractable value in proof-of-stake chains is much more interesting than in proof-of-work chains. It is certainly in the interest of market participants to find solutions to retain the value within the network validators (which, in scalable blockchains, are the stakers), as opposed to leaving that on the table for value extracting arbitrageurs and front runners. This is likely to slightly increase the average transaction fee for users, at the benefit of increasing revenue for network validators, which may increase the appeal to own and stake the native currency of these chains, which may allow to reduce the inflation rate to achieve the same level of security …

If addressed properly, this is bullish for the assets of these chains that will properly address MEV, because they are now adding a hidden tax on traders as opposed to increasing transaction fees for moving assets around.

For readers interest in learning more about the topic, Alex Obadia and Alejo Salles gave an excellent presentation at EthCC4, available here:

https://www.youtube.com/watch?v=XhZ2FDMdVUM

Financialisation of NFTs

Now most of the world knows these three letters, and there has been legitimate excitement around the potential of having unique assets on-chain. This trend has taken off in gaming and in collecting digital art, but gradually this will enable bringing a wide range of financial assets on chain.

• Solutions like Centrifuge*’s Tinlake allow borrowing against real world assets (market already live on AAVE)
• Solutions like StakeDAO*’s NFT allow rewarding loyal users with gated access to unique trading strategies
• Blackpool* enables investment strategies around NFTs, initially with games like Sorare*, Axie Infinity*, and Guild of Guardians*. Beyond that, Blackpool is well suited to start deploying capital in financial NFTs as well to become a real on-chain hedge fund.
• YGG* enables the financialisation of the gaming economy, coordinating economic actors on top of games.
• There will be dedicated lending/borrowing marketplaces for financial NFTs that are easier to value.

This is going to be a major trend in DeFi going forward.

Whilst we are on the topic of NFTs, it is clear that few marketplaces have been dominant, but we expect that aggregators like Genie will increasingly gain traffic as the easiest place to place offers on all marketplaces in one go, or to purchase NFTs.

Real World Assets?

As TradFi yields have gone up significantly, there is appetite to bring off-chain yield on chain, whether that’s treasury yield or lending to off chain companies.

This vertical is promising as it can enable access to excellent financial product to many more potential investors across the world, who were otherwise excluded from accessing these.

Example of projects working on this: https://backed.fi/, Spiko, Tranched Finance, Open Protocol, etc

Conclusion:

The DeFi space is clearly maturing, and whilst the early iterations had to address first a lack of users, and then prohibitive network fees, these two set of challenges are progressively disappearing.

We think this will translate in the introduction of more professional financial primitives, i.e. a professionalisation of the space, and equally, a return to the more efficient order book model for many financial primitives. Furthermore, as awareness increases, we foresee a more mass market participation given the search for better yields, with more retail being able to participate in these cheaper chains.

Finally, we do not believe that the pooled model popularised on Ethereum will be disappearing either. It is still very well suited to Ethereum for users that value the reduced trust that Ethereum enables. As a result, innovations will continue to happen there too, where capital is being pooled to offset the cost of moving capital around on Ethereum.

Disclaimer: Fabric Ventures has invested in a number of projects mentioned in this article — these companies are highlighted in the text with an asterisk (*).

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