DeFi: Rising from the Ashes or Never Really Dead?

The persistent whispers of the alleged death of decentralized finance (DeFi) seem to be never ending and whilst some are based on noteworthy events, it's always critical to separate the signal from the noise. Despite recent market volatility and liquidity crunches making headlines, the core premise and potential of DeFi remain not only intact but also robust. This blog aims to dissect the current state of DeFi, providing evidence to refute the prevailing pessimism. From the impressive expansion in Total Value Locked (TVL) and increasing user numbers to a flurry of continuous innovation, we see DeFi not as a fleeting trend, but a revolution that's here to stay. As we delve into institutional interest, evolving regulatory landscapes, and breakthroughs in cross-chain functionality, we'll reveal why DeFi's flame is far from extinguished—it's burning brighter than ever. So, prepare to put the myths to bed and get ready to uncover the resilient reality of DeFi's unstoppable rise.

As noted, the decentralized finance (DeFi) landscape has recently experienced some turbulent times (more so than normal), with Layer 1 blockchain Canto ¬- designed for DeFi services like lending, staking and liquidity provision - being a prime example. Over the past month, Canto has seen a significant 35% slump in Total Value Locked (TVL), mirroring a broader liquidity crunch in the DeFi sector. The launch hype, once driving Canto's TVL from less than $1 million to over $110 million, has faded, leading to multiple corrections and stagnant fund inflows. The broader DeFi market reflects this trend, with overall TVL shrinking and liquidity being diverted towards volatile meme coins and derivatives markets, a clear indication of the transient nature of market hype.

1. Steady Growth in Total Value Locked (TVL) A crucial indicator of DeFi's health is the Total Value Locked (TVL) within DeFi protocols. TVL refers to the aggregate value of assets currently staked in DeFi platforms, a metric akin to assets under management (AUM) in traditional finance. As of Q2 2023, the TVL in DeFi protocols stands at an impressive $150 billion, a substantial increase from the $42.55 billion recorded at the beginning of 2022, according to data from DeFi Pulse.

3. Innovation and Development in the DeFi Space In 2023, new DeFi trends include increased adoption of real-world assets onto the blockchain, heightened interest in non-custodial dApps, and developments in derivatives and options. Additionally, DeFi scaling solutions such as Layer-2 rollups and Cosmos app-chains are gaining traction.

There has also been a revival of Decentralized Exchanges (DEXs) due to concerns about the transparency and control of Centralized Exchanges (CEXs). Uniswap remains the leading DEX by TVL, and there is anticipation for the possible release of Uniswap v4 after their license for Uniswap v3 expires in April 2023.

Furthermore, with the revival of DEXs, there has been increased interest in blockchain derivatives, which are one of the largest markets in the world in terms of notional value and volume. Popular types of derivatives include perpetual contracts and options contracts, which often come with leverage (2).

4. Institutional Adoption and Interest Institutional interest and investment in DeFi are growing. Coinbase, a U.S. publicly listed exchange, has started offering yields on stablecoins to users. Financial institutions such as State Street, Fidelity, and the Bank of New York have heavily invested in crypto and have begun offering related services. Institutions are also showing interest in DeFi Fixed Income due to its enhanced credit risk management and higher returns compared to traditional bonds.

However, a recent study by VALK shows that while DeFi adoption among institutional investors is growing rapidly, it is not yet widespread. 30% of investors are currently using DeFi, while another 39% plan to do so within six months. Most of these investors are still testing the market and its infrastructure, and concerns about regulation, custodial services, and security issues remain prevalent (3).

6. Interoperability and Cross-Chain Developments Interoperability and cross-chain solutions continue to characterize the evolution of DeFi, with key projects like Polkadot, Cosmos, and Avalanche fostering efficient and inclusive communication across different blockchains. New types of DeFi platforms, such as DAOs and NFTs, are integrating into the DeFi ecosystem, each with unique benefits. Additionally, multi-chain DeFi platforms are emerging to facilitate seamless asset transfers across various blockchains, enhancing efficiency. Notable developments include the Stelareum token (STR), designed to promote cross-chain transactions and interoperability. However, these advancements also pose new challenges, such as the increased complexity of cross-chain transactions, necessitating more sophisticated infrastructure. The DeFi space is continuously evolving to address these challenges.

7. The Path Towards True Decentralization In the ongoing journey towards true decentralization in DeFi, there has been a concerted effort to reduce centralization risks. However, it's important to acknowledge that not all DeFi projects are fully decentralized as of 2023. The overall goal remains to eliminate single points of failure and ensure that the control over DeFi protocols is distributed among a broad group of stakeholders. This includes the users of the platform, who are often token holders with governance rights, as well as projects like Uniswap and Aave, for instance, have admin keys, which grant a level of control to developers, potentially allowing them to intervene in protocol operations or even halt them entirely under certain circumstances.

Despite these challenges, the DeFi sector continues to evolve and innovate, and it's likely that we'll see further strides towards true decentralization in the future. A good example of this progress is the advancements in decentralized oracle solutions (6). Protocols like API3 and Band Protocol are working on decentralized APIs and oracle networks to provide reliable, trustless data feeds. Additionally, solutions for under-collateralized loans, from Alchemix and Notional Finance, are emerging, which could bring us closer to truly decentralized lending and borrowing, providing a good leverage point for large institutional funds like Fasanara Capital to consider a vast opportunity set for future private credit assets.

Fasanara Capital, a market maker and alternative fund manager for digital assets, has been showing significant activity in the DeFi space. They have launched a new borrower pool on Clearpool's protocol, their second after a successful USDT pool, extending their borrowing capabilities to include USDC. This move is intended to provide the market with alternative yield opportunities and optimize capital sourcing for Fasanara's market-making and arbitrage operations (7). The company has also been expanding its team, with significant hires aimed at special projects, strengthening deal origination and supporting the launch of their 3rd Fintech-focused Venture Capital Fund. This suggests that Fasanara is gearing up for a more dynamic role in digital finance and fintech asset management (8).

Tokenization of real-world assets (RWAs) is a rapidly emerging and highly valuable trend in the DeFi space, with substantial potential to revolutionize the financial markets. Tokenization can bring traditional assets on-chain, enabling benefits such as lower investment minimums, increased access through fractional ownership, enhanced liquidity of previously illiquid assets, and improved transparency and security. Such a move into the tokenization of real-world assets would allow fund managers to tap into some of the largest financial markets, such as the global real estate market valued at $327 trillion in 2020, and non-financial corporate debt valued at over $87 trillion in 2022 (9).

Such fund managers are already starting to show signs of committing more resources to such strategies. Hamilton Lane, for example, has announced plans to tokenize three of its funds, aiming to make private market investment available to a broader set of investors through the use of blockchain technology (10). BlackRock, the world's largest asset manager, is also actively exploring the tokenization of stocks, with its chairman recognizing the potential of tokenization to revolutionize the asset management industry, improve cost and access for investors, and drive efficiencies in capital markets (11). These developments suggest a concerted push towards genuine decentralization in DeFi. While there's still a long way to go, the direction of travel is clear and promising, and we can anticipate witnessing the further decentralization of DeFi in the near future.

That said, the journey towards complete decentralization is complex and multifaceted as the majority of DeFi protocols rely on centralized oracles like Chainlink for price feeds, creating another layer of dependency on centralized systems. The issue of collateralization, where most DeFi protocols require over-collateralization to mitigate the risk of price volatility, also deviates from the ideal of a truly decentralized system.

The key to DeFi's comeback isn't buried in these setbacks but lies within its capacity for relentless innovation. As the novelty of Traditional Finance (TradFi) using DeFi to generate yield dwindles, DeFi's call to action is clear – it's time to unleash fresh, unique offerings that can recapture fragile crypto liquidity from fleeting "get rich quick" schemes, steering the DeFi narrative back towards its robust potential.

In conclusion, while DeFi faces challenges like market volatility, impermanent loss, and regulatory scrutiny, these hurdles are typical of an innovative, disruptive sector. The data clearly indicates that DeFi is not only surviving these challenges but also thriving amidst them, continually evolving and attracting increasing participation. Rather than dying, DeFi is on a path of rapid growth and maturation, continually reshaping the future of finance.

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If you want to contact the author of the report: matthew.low@fasanara.com