#30 DeFi: Past, Present, & Future
To know where we're goin', you first need to understand where we've been
1 Take 🌶️
When it’s all said & done, DeFi will be THE lasting legacy of crypto.
Let’s start with a quick refresher on traditional finance (or “TradFi”). Whenever you make a financial transaction today (e.g. sending money to someone, getting a loan, buying or selling a stock, etc), you directly interact with financial institutions who serve as trusted intermediaries (we explored why this is in our prior edition on how crypto will impact you). These institutions provide the “rails” for all financial traffic — in order to transact, you must use them and play by their rules. And while this system has produced vast amounts of wealth creation, it hasn’t quite kept up with the times: Venmo transfers take 2+ days to settle, banks/brokerages are closed on weekends, users earn next to nothing on their deposits, and determining whether or not one can get a loan is an antiquated, subjective process. But it hasn’t improved since there hasn’t been any meaningful competition — until recently…
DeFi’s humble beginnings
There’s some debate within crypto circles about what DeFi’s (or decentralized finance) origin story is — but for me, the answer is simple: Bitcoin. Bitcoin created a brand new set of digital “rails” for financial transactions with the introduction of two important capabilities:
Trustless - Transferring value on Bitcoin is done without trusting anyone, which eliminates the need to play by the rules of a trusted intermediary. With Bitcoin, you can transfer value to anyone quickly, cheaply, and 24/7/365 in a way that’s censorship-resistant (e.g. no one can stop you).
Transparency - Transferring value on Bitcoin is done with a publicly accessible ledger (i.e. blockchain) that is open and immutable. Every transaction is 100% verifiable, has near-instant finality, and cannot be modified in the future.
Enter Ethereum and DeFi Summer 😎
You have to understand that in 2018-2019, most concluded that the ability to send magical Internet money to each other was useful for speculation, but not much else. That all changed with the next era of DeFi which added new capabilities to the stack thanks to Ethereum and smart contracts:
Yield Generation - Smart contracts introduced the ability to reward users with yield in a guaranteed way by taking a specific action. DeFi protocols such as Aave and Compound allowed users to borrow from and lend to one another. Decentralized exchanges (DEXs) such as Uniswap enabled users to earn yield by making their money available (e.g. providing liquidity) in order to create a marketplace between pairs of tokens. In both cases, smart contracts took the place of financial institutions: users would explicitly lock their funds with these contracts with pre-set rules, and trust them to execute.
Permission-less — Because DeFi protocols/smart contracts are launched on an openly accessible blockchain, they operate as publicly available building blocks instead of privately-owned companies. This composability allows other projects or applications to directly use these protocols without requiring permission. A good example of this is Metamask’s token swap functionality: Metamask uses Uniswap’s protocol under the hood for liquidity/price/etc and built its own user interface on top.
As you see above, DeFi kicked off in the summer of 2020 and rapidly rose throughout the bull market of 2021, peaking at over $100B in total value locked (TVL) in smart contracts. Beyond the numbers, these new capabilities underpinned innovation not only in specific projects such as NFT-backed loans or self-repaying loans, but also entire ecosystems like the Play-To-Earn (P2E) movement by making it simple for users to swap tokens they earned for stablecoins or other crypto.
The future of DeFi
Before we talk about the future, it’s important to understand DeFi’s current challenges:
Too hard to use - Existing DeFi applications require users to understand tokens, liquidity, wallets, or smart contracts with complex user experiences. Users don’t want to understand how things work the same way people don’t understand ACH or wire transfers in TradFi — what they want are delightful experiences that just work.
No customer service - All the responsibility in DeFi is on the user with no recourse for mistakes or hacks that result in loss of funds.
DeFi is clearly in the “New Possible but Not Good Experience” stage of the Hybrid Theory we laid out of how technologies & experiences evolve. So where do we go from here? We’ll have to build better experiences that abstract the complexity of DeFi away from users and make it simple & safe to use.
If we do so, DeFi’s opportunity is to serve as the rails for the entire digital economy, which will eventually be larger than the physical economy. Said another way, DeFi will one day be bigger than TradFi. Keep in mind that the digital economy will not only include native digital experience such as the crypto & the metaverse, but also bring digital experiences that currently sit on top of TradFi rails (think payments, insurance, investing, gambling to name a few) to use DeFi rails. One fascinating offshoot of this will be the ability over time for an infinite marketplace where you can swap any digitally represented asset for any other with maximum transparency on price and minimal fees. The potential for global participation, contribution and innovation is truly massive. I don’t know about you, but my message to TradFi: watch out, we’re coming!
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2 Things To Check Out 🤔
1. One of my favorite crypto thinkers just came out with his new book called “The Network State”. Its overarching thesis is that we tend to have much more in common with who we hang out with online than who we share proximity with IRL. In that world, Balaji postulates the formation of new country-like formations via digital networks, and how those new networks might compete with existing physical countries. Super fascinating to read.
2. Yes, this is all of us 😂
Always be learning,