The year 2021 will bring DeFi into adolescence

Following the explosive growth of decentralized finance in the second half of 2020, we’re asking ourselves what the next chapter will look like. What would it take for DeFi to expand beyond crypto-native assets and communities and start eating financial services as we know it?

The second half of 2020 surpassed many of our expectations, and the market has only accelerated since then. Total value locked in DeFi rose from less than $1 billion at the start of June to $13 billion at the end of the year and over $27 billion since then. Catalyzed by Compound’s COMP token launch, we saw a wave of yield farming and a rapid inflow of assets.

Related: Was 2020 a ‘DeFi year,’ and what is expected from the sector in 2021? Experts answer

Perhaps more excitingly, we’ve started to see the foundations of a new financial system taking shape — with applications that enable everything from self-custodial exchanges to lending and borrowing, payments, portfolio management and insurance. New forms of value are being created: not just the promise of yield in a low-rate environment but also access to financial services for crypto-exposed businesses and individuals and for the underbanked more generally.

Today, DeFi is the preserve of a small subset of crypto-native users and assets and is seen by its critics as the wild west. Will this change? Here are a few thoughts on what comes next.

New asset types — New sources of liquidity in DeFi

The first iterations of decentralized exchanges were fraught with liquidity issues. Early adopters faced a significant lag in order matching, and token pairs were limited. Automated market makers and liquidity pools have become a widespread solution to this, with daily trading volumes on decentralized exchanges currently on the order of $2 billion — and DeFi projects continue to find innovative ways to incentivize the provision of liquidity. This will continue. For borrowers, we believe there remains a clear need to bring down collateralization requirements and indeed to use alternative forms of collateral.

Perhaps the greatest opportunity lies outside the universe of crypto-native assets. There are trillions of dollars of potential collateral up for grabs in real-world assets: Users want to borrow money against the assets that they already have and often cannot access the liquidity they need by conventional means. Tokenization of real-world assets can dramatically increase the size of the DeFi universe.

Scaling issues addressed at layer one and/or layer two

Ethereum’s scalability constraints are often cited as a factor limiting the adoption of DeFi. High gas prices and indeed high Ether (ETH) prices can render lower-value transactions unviable. This limits the attractiveness of nonfungible token marketplaces and other retail-focused services. Meanwhile, high-frequency professional trading requires layer-two solutions due to limited on-chain transaction throughput.

Related: Second layers will save the day in 2021, bolstering Ethereum and DeFi

It’s plausible that we’ll see this resolved in 2021, with at least three possible paths:

• The successful rollout of Ethereum 2.0.
• The emergence of dominant layer-two scaling solutions on Ethereum.
• Widespread adoption of cross-chain interoperability solutions.

These three phenomena need not be mutually exclusive, and they collectively give us optimism that 2021 will be a year of significant progress on DeFi scalability.

Institutional demand — Convergence between CeFi and DeFi

We are beginning to see crypto-native institutional investors seek higher yields via stablecoins. Many of these investors use centralized exchanges, at least initially, but a handful of institutional-focused self-custodial products has emerged. Regulatory scrutiny on DeFi is likely to increase as these services gain traction.

Meanwhile, regulators around the world have enacted stricter rules for virtual account service providers, such as centralized crypto exchanges. The Financial Action Task Force’s travel rule and Europe’s 5th Anti-Money Laundering Directive demonstrate the movement toward stricter Know Your Customer standards in cryptocurrency, and October’s BitMEX charges brought this into sharp relief. This will ultimately touch DeFi: In the near term, we expect to see institutional products implementing pseudonymous/zero-knowledge solutions for self-sovereign identity.

There are ideological and practical questions that need to be addressed. Is KYC fundamentally incompatible with DeFi? And which regulatory frameworks actually apply to DeFi today and in the future? Trustlessness will be defined subjectively, and we’ll see a spectrum from truly decentralized products — built and used by anonymous users outside the purview of the Bank Secrecy Act — to products with a database of verified counterparties.

Better UXs for retail participants: DeFi that doesn’t feel like DeFi

For many users, the on-ramp into DeFi is simply too steep. A certain degree of sophistication is needed simply to set up a MetaMask wallet, buy ERC-20 tokens, and start lending. Meanwhile, many centralized products have grown thanks to intuitive interfaces resembling traditional digital banking products. We are now starting to see this trend play out in DeFi where one could ultimately enjoy a faster, cleaner onboarding experience, given the lack of KYC. As a good example, Yearn.finance was a pioneer in this regard, focusing on usability and lowering the barriers to entry that existed before its launch.

Adjacently, other Ethereum-based applications — such as NFT marketplaces for collectibles and digital assets — will continue to innovate the user experience. In 2021, we expect to see a wider emergence of Ethereum-based applications where customers do not know they are transacting on a blockchain at all.

More exploits as more capital flows in: Potentially the biggest constraint to growth

Given the increasing amount of capital at stake, it’s unsurprising that we have seen a rise in exploits. In 2020, approximately $100 million was lost in hacks, notably flash loan attacks, and this trend is likely to continue. For institutional investors, exploits will inevitably alter the perception of DeFi’s risk-adjusted yield opportunities.

Related: Roundup of crypto hacks, exploits and heists in 2020

This will be a critical factor influencing the scale of adoption and will bring a rise in demand for smart contract auditing and insurance, both of which have seen limited investments to date. Greater collaboration between DeFi projects is also a potential response to the rise in exploits. Such partnerships will allow projects to pool and strengthen their talent, security and treasuries, helping to prevent and mitigate the impact of future exploits.

The rise of crypto in the last decade has transformed the way we think about stores of value. The rise of DeFi in 2020 transformed the way we think about the future of financial services and true innovation in a space that changes very slowly. As the dust settles on a remarkable 2020, we now expect to see a massive increase in scale and professionalization as DeFi captures more regulatory and institutional attention.

This article was co-authored by Toby Coppel and Chandar Lal.

This article does not contain investment advice or recommendations. Every investment and trading move involves risk, and readers should conduct their own research when making a decision.