DeFi Trends for 2020

From our Crypto Theses for 2020 - download the full report here.

1 Maker: No longer the end-all be all for DeFi. The incredible progress of DeFi in 2019 can largely be traced back to MakerDAO, the industry’s most systemically important protocol. Maker’s Dai underpins the majority of the DeFi ecosystem and remains the largest and most battle-tested collateralized stablecoin solution. However, it’s no longer the only important DeFi protocol, and will likely face steep new competition on the lending and stablecoin fronts. MakerDAO led much of the growth in value locked in DeFi through the first half of the year, doubling from ~$250 million in January to ~$500 million in July. That’s when the rise of new DeFi protocols began in earnest. Maker now locks ~$330 million of ETH in DeFi, while protocols like Synthetix and Compound have locked $260 million combined. Maker “dominance” dropped from 90% in the beginning of the year to just below 50% today.

Maker realized its long time vision of launching Multi-Collateral Dai last month, which introduced support for new collateral types besides ETH and added the critical new Dai savings rate (DSR), a “risk-free rate” on Dai that will help ensure Maker stability fees are kept in check, as Maker holders now have an alternative lever to pull to increase Dai demand (like anonymized central bankers). These feature additions should attract a new collateral base in 2020 that sparks growth and adds new stability mechanisms for Dai.

2 Synthetix Soars. Synthetix, a protocol for issuing synthetic assets, has seen its volumes grow from under $1m in August to nearly $10 million in December (based on 30-day moving average), and introduced a new stablecoin, Synthetix USD (SUSD) that could rival Dai. While SUSD’s market cap of ~$10 million is still an order of magnitude lower than Dai’s, Synthetix as a platform is growing fast, and is bound to attract attention now that its token soared 3300% in 2019. We don’t think this project is a flash in the pan, though there is some concern about the reflexivity of the Synthetix token (the value locked in Synthetix while minting new types of synthetic tokens is the SNX token itself, which screams “systemic risk”).

We wrote last year, “dollar-backed stablecoins would catapult “open finance” into mainstream adoption. The idea of dollar backed stablecoins will be generalized to other asset classes, i.e. a token that tracks S&P 500. New crypto indices that mirror traditional asset performance (synthetic crypto securities) are a massive untapped (but technically illegal) market that could pick up steam in 2019.”

How can you mimic returns in the S&P for an investor in Indonesia that can’t buy the index directly? Synthetix is on the bleeding edge of answering that question, though again we’ve already seen the risks that stem from their reliance on immature oracles to power these contracts. (More on oracles below.)

3 Not-so-DeFi. DeFi protocols tout themselves as open, permissionless, censorship resistant etc. but it’s a bit early to trust those sweeping, aspirational claims. Earlier this year, an audit found Compound had administrative privileges that allowed the team to change various parameters and censor transactions. The team quickly upgraded the protocol, but the message should have been clear: don’t trust the “De” in DeFi during these beta stages. If anything, it’s a good thing some of these early stage networks have strong community leads at the helm. Consider the contrast between the speed at which the Maker Foundation addressed a recent vulnerability with that of Augur, whose community struggled for months to reel in the malicious behavior of a single anonymous prankster as he created a number of sham prediction markets throughout 2019.

4 Superfluid collateral (aka “how can I destroy the system?”) and on-chain derivatives. To date, DeFi participants have mostly behaved benevolently towards their peers. This may be due to the fact that most early adopters are ideologically aligned early token holders. That will change as DeFi’s growth continues to explode, and investors figure out how to put on effective short positions. Critics have pointed out security holes in these DeFi systems before, and some may begin attempting to break contracts and seize collateral soon. Risks compound as protocols continue to build atop one another. Much like the mortgage-backed security crisis, it will be tough to unwind collateralized DeFi positions in the event of a system-wide “black swan” event. In fact, I’m convinced the Defi space must have a major exploit a la “The DAO”, where investors get completely wiped out, before resetting and rebuilding with a bit more rigor.

Given the risks of systemic DeFi failures, most practitioners will require better hedging tools before they put any real capital at risk. Ohmydai, based on the Convexity protocol white paper is an early example of ways users might be able to buy put options on Dai (sell Dai for 1 USDC at any point in the future). It’s like a credit default swap on a protocol that already mimics credit default swaps (I love crypto), but it makes sense! If you’re making a good net interest margin on your Dai lending book, you might happily pay a point of spread for this sort of insurance. If 2019 was the year of DeFi lending, 2020 will be the year of DeFi derivatives. Long hedging, short risk.

5 Departments of DAOs While the original DAO had a grandiose vision of something akin to a leaderless Softbank Vision Fund for the people, we saw a resurgence of much smaller and careful experiments in DAO design. Examples include MolochDAO (allocation of ETH 2.0 funding grants), MetaCartel (Web 3.0 dApp development grants), and the MarketingDAO (a community governed marketing fund for Ethereum). So far, these have worked because they have managed public goods and expense accounts, not investor capital. But the 2019 successes showed how DAOs could effectively coordinate human financial actions. That’s big. In 2020, the first “for-profit” DAOs won’t be very far behind.

6 Centralized exchanges experiment with Open Finance This past year we watched every exchange do what they do best - follow Binance. Most of the non-US exchanges have already followed Binance’s lead in selling their own exchange tokens. After the release of the Binance Launchpad, nearly every single major global exchange followed suit with an IEO platform. When Binance launched its own blockchain, others followed. Exchange tokens represent a new breed of affinity tokens - part loyalty coin, part lottery ticket, part equity share. And as some exchanges migrate tokens to their own native blockchains and decentralized exchanges (vs. Ethereum), the line between company and network begins to blur. It could make sense for a large exchange chain (like BNB) to fork a DeFi protocol like Compound that already has demand, but negligible relative liquidity. If exchange tokens (and their corresponding liquidity pools) can entice DeFi users to switch networks, then Ethereum’s DeFi protocols could be relegated to testbeds.

7 Decentralized exchanges experiment with centralized finance. In the world of exchange, liquidity is king. That’s true in both the centralized and decentralized world, and that was further validated by P2C (peer-to-contract) models like Uniswap, an automated market maker that enables anyone to get paid in return for depositing capital into a shared liquidity pool. The P2C model is particularly effective because it removes the need for a counterparty along with the associated complexity of providing liquidity to a decentralized order book. That’s why Uniswap is thrived at a time when P2P models were sucking wind.

Source: Defi Pulse

Now it looks like Uniswap could be the solution to making illiquid security token markets as well. With some legal engineering, it may be possible to create a whitelisted security token for a defined type of (KYC’d) traders and facilitate trading on a P2C market. RealT just sold a property in Detroit to investors across the world with a Uniswap-supported security token that represents fractional ownership and rental income rights for holders. Centralized securities token exchanges may take years to build sufficient liquidity and secure regulatory licenses before they become interesting or available to end issuers. Uniswap could be faster to market because the stakes are smaller (for now).

Uniswap is the lone bright spot amidst a disappointing year for DEX projects and their trading volumes (down with the rest of the market). These protocols may be essential for cross-chain application interoperability (contract to contract or machine to machine payments), and could still win out over centralized exchanges when it comes to trading less liquid or difficult to support tokens (privacy focused or quasi-securities), but spreads will remain high, and centralized exchanges and OTC desks will still account for 99% of volumes for the foreseeable future.

8 Lending Markets Lending has emerged as a growth market in general, but it’s especially huge in DeFi. Over the course of 2019 DeFi protocols originated $650 million in loans, with $450 million currently locked up as collateral and ~$75 million in loans outstanding. Compound (which does not have a token), is now second in value locked behind Maker amongst lending protocols, and has drawn the attention and investment of top crypto investors. (Is there a long-term business model, though, if billion dollar exchanges fork your code without repercussions?)

Collateralized lending is a start, but a new financial system won’t be built on collateral-based lending alone. We’re still waiting for better decentralized identity and credit scoring apps to fill the void in today’s DeFi lending equation. Until we get there, lending will be limited by the value of all crypto held as collateral. That’s probably a good thing for this experimental stage, as the real risks are around smart contract security, governance, and collateral auditability. The potential for a DeFi bank run is under discussed, but Alethio explained the mechanics well in an excellent post here.

9 DeFI Wallets Monthly originations in DeFi lending increased by 5x to over $100 million per month this year. As crypto-collateralized lending began to find product-market fit, attention shifted (naturally) to capturing the user relationship. New DeFi interfaces are aggressively competing to become the one-stop-shop where users can hold, transact, exchange and lend all in the same place. The most successful interfaces will be the exchanges (existing audiences) and the tools that best abstract away the complexity. Betterment-LendingClub- Robinhood hybrids like InstaDapp and Zerion raised money from prominent investors like Pantera Capital and Placeholder. I’m expecting these teams and others (Linen, Argent) to raise more money in 2020 to compete as the gateways to crypto for “self-sovereign” crypto users.

10 What’s changed from last year? I thought prediction markets, token curated registries, and “continuous organizations” were exciting earlier this year. I suppose I still do, but prediction markets have taken a serious step backwards. Augur has just 13 active markets with under $3mm in locked value today, and its most promising startup shut down in July after just six months of operations. (To be fair this may be predictable in the lead up to Augur v2 in Q1.) The 1.0 incarnation of TCRs are static dogshit. No one has innovated in that area since 2017, and the curation market design we initially proposed for Messari’s own token registry will end up looking more like a DAO / work token when it eventually goes to market. ICOs/IEOs are on their last legs, but will be put down like the lame horses they are soon enough. (We just need to get through this spring’s round of disastrous private SAFT liquidations.) I’m still excited about the concept of “Continuous Organizations”, which seem like they could be like this year’s “Uniswap” of ICOs. (Keep an eye on projects like Fairmint.)

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