Perspectives | Ten Years of DeFi

If someone asks what DeFi will look like in the next ten years, we are likely to say the answer is "it's finance". I think this answer misses two levels. The first is time. Technology development takes a long time, much longer than expected by early adopters. People usually think, "Why can't such a good technology be popular?" However, it is very difficult to change the inherent behavior patterns, and it often takes decades to make the transition.

The second level is that it is unclear whether the decentralized coordination method can allocate capital more efficiently than the currently adopted centralized method, or even replace it completely. In essence, finance is the coordination of capital distribution and the maximum utilization of capital. For the past 500 years, the business model has been the best way to coordinate capital in modern society. For various reasons, DeFi offers another efficient way to allocate capital, but whether it can replace the current financial system in all aspects is unknown.

I believe that DeFi will eventually replace most financial coordination models, at least forcing it to develop into a new hybrid model combining DeFi and CeFi. I think the key reason for this is that efficient capital allocation requires competition, and in markets where there is no competition or less intense competition, capital allocation models tend to be poor. DeFi is a highly competitive corporate capital allocation model, which reduces the barriers to market access and improves the efficiency of competition among market participants to a new level. DeFi will increase the intensity of competition, promote healthy competition, and improve market efficiency.

The most efficient lending market

To better explain these two points, we take the decentralized lending agreement Compound as an example. The Compound agreement is a license-free lending market. The barriers to entry are virtually zero. The entry rules for participants are very clear and are predefined and cannot be changed. Compound is likely to be the most efficient lending market, but its lending mechanism currently has structural limitations that require excess pledges. Globally, anyone can deposit their assets in Compound for borrowing by others. Quite differently, in the traditional lending market, only a few companies compete with each other to obtain capital efficiently and then allocate it. In this model, the barriers to entry for both borrowers and lenders are high. Therefore, it is mainly competition between a few large companies. In these fiercely externally competitive companies, there is little competition between salespeople and other employees, but the company is highly structured internally. There are millions of sources of capital on Compound, all directly competing for capital allocation. At a higher level, there are other lending agreements that compete with each other for these sources of capital, bringing about even more intense competition. Therefore, DeFi's borrowing model will obviously attract more market participants and intensify competition among them. This trend has already appeared.

However, traditional lending companies have a great advantage in that they have more information about lenders and can rely on legal systems to force borrowers to fulfill their repayment obligations. As a result, they can provide unsecured or partially secured loans, thereby expanding the target market. At present, the structural inefficiency of decentralized lending agreements is difficult to expand in the lending market unless the problem can be solved or mitigated.

What are the current flaws in DeFi?

This brings us back to our original question. Is it possible to solve the structural inefficiencies that hinder the development of DeFi? In an environment where cryptocurrency protocols operate, anything that is allowed by the system can happen. In the traditional lending market, the mandatory nature of contracts is guaranteed by the legal system and ultimately relies on guns and iron cages. If DeFi cannot enforce the rules in the same way, can it still provide efficient partial mortgage services? If not, what does this mean for the development of DeFi lending business? I think DeFi can do it, but there are still some problems that have not been solved, such as the decentralized identity problem. In the field of DeFi, privacy is another barrier.

Despite these challenges, I believe DeFi will continue to create a new and efficient market. However, as long as the structural inefficiencies are not resolved, DeFi runs parallel to traditional finance. Most of the challenges currently facing DeFi will be addressed, and the increasing number of DeFi protocols will greatly increase the efficiency of capital allocation. The next question is, what would DeFi look like then? What impact will it have?

Trustless protocol using predefined rules

To understand how DeFi evolved, we must first understand the functions of these protocols and what type of capital collaboration process is most suitable for decentralization. Take Uniswap as an example. Uniswap is a decentralized exchange where people can trade ETH and ERC20 tokens. When most DeFi exchanges tried to replicate the order book model commonly used in traditional exchanges, Uniswap took advantage of Ethereum's trust-free feature, allowing each user to pool capital together to provide liquidity. No complicated tools and software are needed, you just have the money. You can bring yourself together with others, provide services to market participants (ie liquidity), and you can be paid based on your financial contribution. How powerful is this new collaboration model? We first give a general description of the DeFi protocol.

DeFi replicates existing financial services by creating trust-free protocols. The rules of these protocols are predefined and fully open to participation. The fees paid by consumers of these services are automatically allocated to the protocol participants.

This definition does not include services such as InstaDapp, DEX.AG, and, nor does it include wallets and other direct-to-user infrastructure. But I believe that it defines the most likely route for the underlying protocol; on the other hand, again, we are still very early in this stage and have done a lot of experimental things.

In practice, this means that you no longer need a business to coordinate capital allocation-only one agreement is enough. This will lower the barrier to entry to the industry, because the qualifications of participants are open to all who are willing to abide by the rules; it also improves efficiency because rules are enforced by smart contracts rather than the legal system, which should reduce risks and Implementation costs; it also lowers the threshold for new agreements. The remaining issue that is still important may be liquidity. But fundamentally, competition and the open source nature of these protocols will continue to breed experiments.

Challenges facing the new agreement

Liquidity remains the number one challenge for new protocols, and even the oldest and best-known protocols, such as Augur and 0x, are still worrying about liquidity. We have made some progress in using cryptoeconomic incentives to initiate liquidity mechanisms, but these mechanisms still require a certain initial capital investment. It was embarrassing that, due to the failure of the ICO in the previous market cycle, this process was again controlled by venture capital. But this is more of an implementation issue than a conceptual one. In order to thrive, DeFi needs to create both agreements that enable incentives for all parties to be compatible, and raise capital for those agreements. There are already successful examples of protocols like Nexus Mutual. Just like the prosperity of DAO in 2019, I believe that the decentralized investment will also recover within the next ten years, and ideally, it will give more incentive to compatible structures to the teams that create the agreement and the teams that initiate the liquidity. But if we can't alleviate the burden of the new DeFi team to visit Sand Hill Road (centralized for venture capital companies) for a week, it is difficult to imagine that we can realize the promise of DeFi. Until that day comes, the huge obstacle to financing will still exist and weaken the competitive nature of this market.

The meaning of composability

The last DeFi that should be considered is composability-any subject can connect to any DeFi protocol without permission. Although in the real world, we can also combine two independent services to produce a third type of service—there is always the case of a company forming a partnership or a joint investment—however, matters that need to be negotiated between companies are often It will take years. In the DeFi world, one hack pine weekend is enough to combine multiple protocols together. The best example may be InstaDapp, which bridges between the two major lending agreements, Maker and Compound, which improves the efficiency of the entire lending market, and the entire product is completed in a weekend. This is truly unprecedented and the most difficult DeFi feature to predict its actual impact. However, the obvious thing is that some of the most exciting products and services will be created in such a way to integrate two or more protocols into one interface to provide services to users.

New era

There are huge challenges and uncertainties ahead of this great financial change, and we are too small. However, its promise of success is so credible that we cannot tolerate it. DeFi is expected to lead us into the next era of productivity. Every individual will be covered, connected to a complex financial facility, and empowered by capital. This is the first time in human history. It is quite conceivable that if capital can flow almost without friction and be deployed almost instantly to any place where the need for capital is most urgent, the impact of all this will be huge. This vision is exactly why we gathered here, and then we will hopefully see it become a reality.

Thinking questions

Will DeFi become more efficient than traditional finance?

What hinders the development of DeFi today? Can these obstacles be overcome?