The market cap for DeFi grew by 7,000% last year (and that is not a typo!)
The market cap for Decentralized Finance (DeFi) is $70B today (see Exhibit 1). It was $1B twelve months back. DeFi promises to disrupt traditional Banking & Financial Services (BFS) unlike anything we’ve seen so far. Rolling your eyes when you hear the name “DeFi” is over is a thing of the past.
Exhibit 1: The exponential growth in market cap for DeFi
Source: defipulse.com, Jun 3, 2021
What is DeFi?
Decentralized Finance (DeFi) is a blockchain-based form of finance that does not rely on central financial intermediaries and instead utilizes smart contracts on blockchains.
A recent report by Bank of America speaks to its potential:
“DeFi does, however, show the opportunity which [distributed ledger technology] offers to finance. We believe that one of the best differences against being disintermediated by DeFi would be mainstream finance grasping these opportunities.”
— “Bitcoin’s dirty little secrets,” a report by Bank of America released on Mar 17, 2021
The blockchain 6-pack is powering the DeFi revolution
What makes DeFi so innovative (and scary) is that it removes the need for a centralized intermediary (i.e., banks, brokerages, exchanges, or frankly, any other financial institution). The fundamental premise behind DeFi is shifting consumers’ trust in a financial institution to a blockchain-based smart contract that operates autonomously. Six built-in features of blockchains manifest into this disruptive potential of DeFi (see Exhibit 2).
Exhibit 2: The blockchain 6-pack powering DeFi
- Automated smart contracts promote touchless interactions. Blockchain protocols like Ethereum are driving the DeFi momentum because of their built-in smart contract functionality. These are computer protocols that facilitate, verify, or enforce a contract’s negotiation or performance, or prevent the need for a contractual clause. This allows contracts to auto-execute based on pre-set conditions or triggers and enables much higher levels of straight-through processing.
- Distributed shared data over peer-to-peer (P2P) networks makes DeFi global by definition. The most fundamental difference between distributed ledger technologies (DLT) and the way we store data today is that distributed ledgers do not have a central administrator. A distributed ledger is replicated, shared, and synchronized digital data geographically spread across multiple sites, countries, or institutions. This makes information available across the network in a fully transparent and autonomous way.
- Consensus-driven trust cuts out the middleman. In blockchains, there is no need for a middleman that you must trust. Trust is driven by consensus algorithms such as proof-of-work (PoW), proof-of-stake (PoS), proof-of-authority (PoA), Byzantine fault tolerance (BFT), and crash fault-tolerant (CFT). As a result, you don’t need to worry about unreliable, inaccurate, dishonest, or overpriced intermediaries.
- Immutable transactions drive auditability. Each block in a blockchain contains a timestamp and a link to a previous block. By definition, blockchains are inherently resistant to modification of the data. Once recorded, the data in any given block cannot be altered retroactively without altering all subsequent blocks and a collusion of the network majority creating a single source of truth, making it especially attractive to finance executives in search of an auditable trail.
- “Permissionless” blockchain removes entry barriers. Much like public and private clouds, blockchains can be private (permissioned), public (permissionless), or somewhere in between (hybrid). DeFi applications are built on permissionless blockchains, which essentially means that anybody can participate and use them. You simply need to access the dApp (decentralized application). Blockchains use cryptographic hash codes to verify data that drives up integrity and creates strong resilience to cybersecurity concerns. However, while blockchain drives better security, data privacy is a potential concern, especially in permissionless blockchains. In a typical blockchain setup, all transactions are broadcast to all participants. The details of interactions meant for two parties are visible to others, resulting in a breach of confidentiality requirements. However, emerging zero-knowledge proof (ZKP) techniques and off-chain data management are helping manage blockchain-related privacy concerns.
- Stablecoins provide a reliable and familiar base and help bridge the gap between volatile cryptocurrencies and fiat currencies (typically USD but could be anything else like gold, silver, diamond, or oil). Today, the top 3 stablecoins by market cap (USDT, USDC, BUSD) are all Ethereum-based, are pegged to USD, and account for over 90% of the ~$70B DeFi market cap.
DeFi for lending, payments, asset management, derivatives … you name it!
DeFi offerings are coming fast and furious. Here is a sampling of current offerings:
- Aave is a leading DeFi lending solution that allows users to deposit and borrow stablecoins at ridiculously low rates. It charges a mere 0.00001% of the loan amount from borrowers on loan origination.
- Flexa for payments does not need users to send sensitive account information to make payments; it is global with zero foreign exchange fees and is now connected to popular payment systems like NCR, Aurus, and Shopify.
- Vesper provides asset management functionality for crypto-assets. It pools capital from a group of users and deploys it to generate interest across various DeFi protocols.
- Synthetix allows derivatives trading in DeFi and currently supports synthetic fiat currencies, cryptocurrencies, and even commodities.
- Uniswap as an example of an automated market maker (AMM) that enables DeFi services by creating liquidity and trading ERC20 tokens on Ethereum.
The Bottom Line: Open your eyes to the change or be prepared for an “oh crap, I wish…” moment down the line
Over the last year, the exponential growth of DeFi exemplifies how rapidly we are approaching Horizon 3 (the Hyper-Connected enterprise) of HFS’ Innovation framework (see Exhibit 3). The scope of innovation is quickly expanding beyond the functional silos. It needs to extend beyond the four walls of your organization, and it requires collaboration across multiple organizations with common objectives around driving entirely new sources of value. Even the traditional boundaries of industry definitions are blurring, and new industries are getting created.
Exhibit 3: HFS Enterprise Innovation Framework
Source: HFS Research, 2021
Horizon Three: Hyper-Connected is powered by emerging technologies (blockchain in DeFi) but requires an infinite mindset and an uber-collaborative approach. The infinite mindset goes beyond the traditional metrics of success (like market share, growth, profitability) but fundamentally new sources of value. The uber-collaborative approach believes in open-source technologies and a sharing culture where value is not created by locked-in secrets but by inviting others to build on your ideas.
But most importantly, what the rise of DeFi tells us is that Horizon 3 innovation is not some futuristic sci-fi. It is happening right now in front of our eyes. We just need to remove the dark glasses clouded by legacy thinking.