Guide: In 2019, Ethereum has brought a new open financial system, established an agreement that will become the basis of a new financial economy, and major progress has been made in decentralized financial (DeFi) agreements such as MakerDAO. In 2020, new and existing companies will develop on the basis of loan agreements, which will increase efficiency and develop new products. There will be more development in 2020.
So far, in the historical story of the blockchain, an overall trend can be refined every year. The theme of the 2009 story is Bitcoin. Ethereum in 2015. 2017 was an ICO. And this year, 2019, the answer is obvious: the Decentralized Finance (DeFi) movement, which is the most influential trend in the cryptocurrency and blockchain ecosystem.
To understand why 2019 is the year of DeFi, let's break down what makes the open financial movement so revolutionary and study the progress that this phenomenon has made in building an open financial system.
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Image source: ConsenSys
Open finance (or decentralized finance) refers to the paradigm shift from today's closed financial system to an open financial economy based on open protocols that are interoperable, programmable and composable.
As the crypto ecosystem expands, "open finance" will more accurately describe the intended destination, as Ethereum is creating a new on-chain economy that integrates with the current financial system. Open finance is not about creating new systems from scratch, but about democratizing existing systems and using open protocols and transparent data to make them more fair.
The nature of open finance
The current financial system consists of walled gardens with limited transferability or two-way access. Where interoperability is possible, it is controlled by middlemen and renters. Open finance is defined by platforms that can cooperate with each other with a certain degree of transparency and have complementary functions.
Bitcoin has completely changed the definition of currency. Ethereum enables new financial instruments and assets that are more customizable than existing products and services. Digital assets and securities will usher in a new era of financial mechanisms and growth.
For many people, Lego toys are a favorite childhood toy of growth, and what you can create is limited only by your imagination. Composability refers to the concept that items can be selected and assembled in multiple combinations (ie, Lego toys). Ethereum has shown the value of composability, and it has become the underlying protocol for other protocols (such as Maker, UMA, Augur, Compound, etc.).
Standards for an open financial economy
Every financial system needs to have many characteristics to become an economic engine, but first, we must define these standards. Here are some of the recognized characteristics that can constitute any economic system.
A functioning financial system can accommodate globally efficient markets, with:
- A borrower's ability to transfer capital
- Exchange and transaction (ie derivative) processes with the necessary liquidity
- Means of personal / investor transfer, preservation, raising and distribution of capital
- Ability to offset and manage risk
- Regulatory protection for investors and individuals
Therefore, an open new financial system must meet these attributes while removing typical intermediaries or centralized control points. Let's examine the above characteristics and how they compare to the Ethereum ecosystem.
For a financial system to be able to provide borrowers with appropriate market liquidity, it needs lenders, and to get lenders, the system also needs borrowers. Chicken or egg first, this problem was initially solved speculatively. Cryptocurrency is a speculative asset class, and some interesting lending agreements have now been successfully created.
MakerDAO was the first agreement to create a way for individuals to continue speculation through mortgages. The MakerDAO vault (formerly known as CDP) enables users to borrow Dai using ethereum (ETH) as collateral, and these new lending protocols will dominate the cryptocurrency industry for much of 2019. Both Compound and Fulcrum have created fund pools, enabling users to borrow or borrow crypto assets, including Dai, USDC (Coinbase's stablecoin), Ethereum, and more.
Dharma originally competed with Compound and now uses Compound's agreement to offer its customers the best possible interest rates. Dharma achieves this with its "smart wallet", which automatically deposits customer funds into the Compound protocol.
Recently, MakerDAO has successfully completed the upgrade from single collateral (Sai) to multiple collateral (MCD). The Maker Agreement upgrade also comes with a new Dai Savings Rate (DSR), which enables individuals who keep Dai in the Maker Agreement to earn interest. In the short term, DSR is a smart contract that can be integrated into any other exchange and may become the basic interest rate in the field of cryptocurrency DeFi.
In the long run, in the most optimistic scenario, DSR may become an unsecured savings rate, similar to the way Treasury bills are used as risk-free rates. The difference between no trust and no risk is subtle and obvious. Although Maker's protocol carries risk elements such as smart contract risk, it does not require the trust of any single entity (the protocol is managed by MKR token holders). Eliminating dependence on large organizations, including governments, is a powerful tool for reducing systemic risk.
These different protocols demonstrate the power of composability: Dharma uses Compound's open protocol to provide an open platform for lending and borrowing Dai stablecoins created using the MakerDAO protocol, all based on Ethereum.
Exchanges and transactions
The financial system operates through an open market and requires strong mechanisms to transact and transfer value. The trading landscape in 2019 is dominated by some large players, mainly Coinbase, Kraken, Gemini, Bitstamp, Bitfinex, and Binance.
In the last year, cryptocurrency exchanges have been prepared to become a user interface for investments, trading and other activities. Most major exchanges offer dozens of new trading pairs and develop new products or services, such as mobile wallets, educational tools, and token products. Similar to the stickiness of Apple products, cryptocurrency customers may still be loyal to one or two cryptocurrency exchanges due to the long product launch process and people wanting to host assets in one location.
It's worth noting that some exchanges have decided to focus on attracting institutional clients, setting up escrow solutions or acquiring the necessary infrastructure. Although centralized trading has become popular (and profitable), it is not the new financial economy that most crypto enthusiasts and entrepreneurs want to achieve.
Uniswap went online this year and became a decentralized exchange (DEX) that trades cryptocurrencies in a de-intermediary manner. In November 2019, Uniswap reported daily transaction volume of more than $ 8 million. Uniswap currently accounts for 33% of all DEX trading volume, surpassing IDEX and Kyber. DYdX, another decentralized exchange, has developed a platform that combines trading and lending. dYdX DEX aggregates spot prices and loan liquidity across multiple exchanges for users. It is worth noting that Binance also provides customers with lending capabilities through its centralized exchange.
IEO was very popular in the first half of 2019, with centralized exchanges serving as a platform for token sales. In essence, the exchange acts as a gatekeeper for these token sales and only allows verified customers to participate. Token sales are usually carried out using exchange tokens, such as Binance Coin (BNB), which can enjoy benefits such as reducing transaction fees and repurchases. They effectively raise the price of holders by burning tokens.
A report released by TokenInsights in mid-2019 shows that IEO did the initial hype in the first few months of 2019 and then gradually disappeared. Despite considerable fraud and abuse by IEO, ICO and STO (Securities Token Issuance), the ability to raise funds is an essential tool for any financial system.
Capital investment and distribution
In the originally proposed definition, DeFi also had the ability to formulate capital and transfer funds. Ethereum mainly solves these two problems through the following ways: firstly through the ability to transmit Ethereum, and secondly through the aforementioned securities or token products.
Of course, investments in crypto assets have grown throughout 2019 and will continue to expand in the coming years. Speculation remains the most prominent use case for cryptocurrencies, however, many believe that this feature is completely negative. Speculative tools and mechanisms are an important part of all new asset classes, especially those designed to be the foundation of an open financial system. One of the most important and subsequently difficult aspects of building a new financial system is generating the necessary liquidity needed for effective investment.
Liquidity is the ability of investors to quickly convert any asset into cash. The term also refers to an individual's ability to buy or sell financial instruments without affecting asset prices. When the value of the entire crypto economy at the time of writing was less than $ 200 billion, this was obviously very difficult. Highly liquid assets consist of trillions of dollars in total value, which makes it easy to buy and sell any given asset. The market value of the six largest companies in the world is more than three times larger than the market value of all cryptocurrencies.
How about other assets:
- Gold: $ 7 trillion.
- Stock market: $ 70 trillion.
- Global debt: more than $ 200 trillion.
And derivatives: more than $ 550 trillion. Futures, options, swaps and other contracts based on the performance of assets, indices or entities.
So how do new asset classes attract liquidity? By allowing anyone to create and trade assets that are not traded elsewhere. The best part is Ethereum, which literally enables entities or individuals to build new financial instruments and products, which will be one of the biggest financial explosions of our lives.
A key aspect is that these agreements are open. UMA is creating a derivatives platform to provide standardized contracts for financial products. Synthetix protocol can be used to create and issue synthetic assets such as cryptocurrencies, fiat currencies and commodities. The synthetic assets and derivatives provided by the open source agreement will create value for investors looking for hedging risks and diversifying capital allocation and looking for mechanisms to increase return on investment. For traditional assets and crypto assets, the types of derivatives are endless. Dai already has more than a dozen variants created by other DeFi protocols.
Staking is increasingly becoming a method of capital deployment. The concept of collateral has emerged with the development of crypto networks, especially the Proof-of-Stake (PoS) blockchain. Staking is a broad term, but usually refers to a mechanism that requires individuals to support their beliefs through capital action. Numerai's stock prediction contest requires data scientists to pledge their forecasts with their capital (NMR tokens). Data scientists are then rewarded for the accuracy of the predictions and the amount of money invested. The stronger the belief, the greater the risk the individual is willing to take.
Staking models of other blockchain networks such as Ethereum will require 32 ETH to participate in block verification. If a person acts maliciously, the agreement will confiscate the capital they have mortgaged. Various proof-of-stake blockchains such as Cosmos and Tezos also have other Staking models with unique attributes, including governance (such as voting) and rewards.
With the growing popularity of loan and mortgage agreements, companies are seeking to help individuals manage their capital and mortgage businesses. Coinbase mortgages Tezos on behalf of customers and deposits rewards directly into customer accounts. Many exchanges have started or will offer similar products in the near future.
Another way to pledge your investment is through non-exchange custodians, such as Staked and Atlas, which provide mortgage services to individuals. Although centralized trading has all the opportunities to provide this feature to its existing users, if individuals are more interested in proactive governance of a specific crypto network than simply getting rewards, dedicated services may be able to capture a certain percentage of the market share. Lending agreements like Composite may eventually provide mortgage-as-a-service capabilities. As Ethereum is moving to Proof of Stake (PoS) and launching multiple PoS blockchains, more exchanges and applications will provide mortgage services in 2020.
Risk management and regulatory protection
It is acknowledged that the risk management and regulatory protections are less robust than previous categories of Ethereum and the entire crypto space. Overall, Ethereum essentially mitigates certain risk factors in the current financial system, which come from opaque information, intermediaries, proprietary systems, and less effective social coordination (e.g., trust). However, Ethereum currently has its own set of trade-offs. These trade-offs are caused by rapidly developing technologies, such as smart contract design errors or manipulation if they cannot be created correctly. In addition, from a risk management perspective, the nuances of insurance risk, liquidity risk, and crypto networks complicate open finance.
ConsenSys Codefi's DeFi Score score provides a deeper overview of many of these risk factors. DeFi is a fast-growing field in Ethereum, and over the past year, as companies, individuals, and developers have sought to minimize these risk factors, many issues have become the focus of attention. Of course, solutions and new business models will help eliminate or at least reduce some of these problems, although it may take some time.
From a regulatory perspective, the situation is improving, but this is mainly waiting to observe the SEC, CFTC and other global regulators' evaluation of crypto assets. In 2019, regulators have made clear regulations on transactions, issuance and use of crypto assets, and have become more explicit. However, there are still hundreds of subtle questions that need to be answered, and then, cryptocurrencies will require dozens of laws before they may be widely adopted. Cryptocurrency price fluctuations and the entry of large multinational companies like Facebook have always made crypto asset regulation a focus of attention.
New categories of new financial economy
Innovative technologies can create new or change existing business models to generate profits and invest. The Internet has improved crowdfunding efficiency through websites such as GoFundMe, Kickstarter and Indiegogo. StockX has created a strong market for those who love sneaker culture, thereby adding liquidity and value to collectors.
Although not a necessary requirement of the financial system, new markets open up potential for further management and hedging of risk types. Prediction markets and information markets are situations where thousands of people can use their knowledge collectively or independently. For example, Augur's prediction market is used to bet on election results, and as organizations around the world seek to understand the possibility of political results, election results may have inestimable value over time.
Numerai's Erasure protocol provides a data market where individuals can use their specific knowledge to sell forecasts or information about the world, which is transparent and enforceable through smart contracts.
Another aspect of betting is the lottery, which is known to be not worth playing. However, PoolTogether created a new "lossless lottery" that leverages other open financial protocols. For example, PoolTogether allows anyone to buy a lottery ticket at Dai's price, and then keep the proceeds in the Compound (producing interest) for a certain period of time (week, month, year). The winner of the lottery receives accumulated interest from all pooled funds, and the other owner (loser) will also recover their original money. An interesting new lottery mechanism like this can reduce the negative results individuals get from traditional lotteries. More importantly, this is another perfect example of how to create new content with open protocols and applications.
A stablecoin is a crypto asset that maintains a stable value relative to a target price (such as the US dollar). In the past two years, various types of stablecoins have emerged. MakerDAO created Dai. Facebook is preparing for Libra. Wal-Mart is preparing for Wal-Mart Coin. USDC issued by Coinbase can be used in more than 80 countries. Binance recently announced Venus. JP Morgan created a digital asset to resolve transactions between institutional clients. The International Monetary Fund said that "stable currency is a threat to banks and cash."
Each of these organizations is taking a specific approach to adopting stablecoins. MakerDAO hopes to reshape the financial system and create a more stable cryptocurrency. Facebook's goal is to use its social media strength to become a payment company. JP Morgan and other banks are working to improve operational efficiency. USDC has been used as a trading pair for crypto assets and more recently as a lending agreement. Walmart may use its stablecoin as an upgrade to loyalty points. Each of these approaches to mainstream adoption is slightly different, so it will be interesting to see which approach proves to be most effective.
In the short term, fiat currency collateralized stablecoins will dominate, as they solve the various problems of our current system: cost, coverage, speed and openness. As a digital currency, stablecoins can provide near-instant transfers at low cost anywhere in the world. Digital currencies can be programmed, tracked and embedded in digital applications. Fiat currency-backed stablecoins can become the home of social media and have the potential to reach millions of people who have never had traditional financial services. Venmo, WeChat, Apple and other companies around the world have already promoted this movement.
Non-fiat currency mortgage stablecoins may take longer to be widely adopted because it requires rethinking the way of thinking about value. The new form of currency and its adoption will largely depend on its availability as a store of value and a means of payment / exchange medium. Ethereum has become the de facto collateral that supports many existing open financial protocols. As more and more protocols issue new derivatives and securities, they may also seek to use Ethereum as collateral to further consolidate Ethereum's position as an open financial center.
Looking forward to 2020
Obviously, Ethereum has established a protocol that will form the basis of a new financial economy. In 2020, new and existing companies will develop on the basis of loan agreements, which will increase efficiency and develop new products. Some of them have been created, such as Idle and Staked's revenue-generating robotic consultants. There will be more developments next year.
Crypto companies are strengthening their capabilities to facilitate better transactions and new products and services. Coinbase and Binance will continue to expand rapidly through acquisitions and product launches. For ordinary users and even mobile local users, decentralized exchanges are expected to become easier.
Synthetic assets and new derivatives will surge, creating tens of millions of dollars in value by 2020, and ultimately billions of dollars in value. Some will be (literally) suck, while others will be novel. The continuous development of new financial products and tools will bring more liquidity and potential profits to investors.
With the development of crypto assets and the development of new investment categories such as mortgages and information markets, speculative activities will continue to grow in 2020, but some unthinkable new ideas will further create value for individuals, entities and investors. Through the natural expansion of security-focused entities such as MythX and Quantstamp, a more comprehensive analysis of the risks associated with open finance can continue to improve risk management. In addition, the regulatory guidelines will become clearer and hopefully will also facilitate continued use of crypto assets and blockchain networks.
The open financial system based on Ethereum has interoperability, programmability, and composability, laying the foundation for a new financial economy. Keep in mind, however, that this movement does not mean that the old financial system will necessarily be abandoned, but that it is integrated with the current system where possible and created when necessary. The new financial system must serve everyone. Finally, building a new financial system will take time. Significant progress has been made in the development of decentralized finance (DeFi) in 2019, but it seems to be a leap forward in 2020.