No crystal ball can tell us exactly what the Future of France will look like, and that is what makes DeFi so fascinating. This article will briefly review where DeFi has been, how it has been shaped by the constraints the space was operating in, then it will focus on emerging trends that are worth watching in DeFi.
Decentralised Finance was the first category of decentralised applications to have some product market fit, even though this adoption was limited to few early adopters for several years. The main challenge for the early iterations of DeFi was in bootstrapping these marketplaces: finding a counterparty willing to trade against you was hard when there were only a few thousand “active” DeFi users (and especially when these were nearly exclusively retail users).
The early DeFi applications which struggled to grow exponentially were marketplaces with peer-to-peer models, most likely because they were too early compared to the number of users. For example, the early lending protocol Etherlend (ancestor to AAVE) was matching lenders and borrowers peer-to-peer, leading to a relatively poor and slow user experience.
On the trading side, 0xprotocol based exchanges like radar relay also struggled to gain adoption with their orderbook based on-chain exchange, because there were not enough users for trades to be matched rapidly, providing a sub-optimal experience compared to their centralised counterparts.
Etherdelta was also running a rudimentary order-book-based exchange, with deposits and on-chain order matching. It actually had real traction by virtue of being the only platform to trade newer tokens post ICO, so there was a real product market fit incentivising people to actually learn how to use the dApp. The application was popular in 2017, but it rapidly lost relevancy from 2018 as centralised exchanges started listing these assets and with the introduction of Uniswap.
DeFi needed to fulfil users’ expectation of immediacy, so instead of the peer-to-peer model, the peer-to-contract model became dominant. The first success was MakerDAO with single-collateral DAI in December 2017, allowing anyone to instantly borrow DAI against their ETH. On the trading side, this was the gradual take-over of the AMM model, with Uniswap in November 2018, so that traders could buy and sell instantly. On the lending side, we also had the introduction of pooled liquidity: users on Compound and AAVE were now earning interest instantly, or borrowing against their collateral instantly. The user experience significantly improved, leading to DeFi properly taking off in 2020 (fuelled by token incentives from these DeFi Protocols). However, there was a trade-off with these instantaneous solutions: some value was left on the chain. The liquidity was always there, but its utilisation was not as optimised as possible.
DeFi grew in popularity on Ethereum at a time where it was still affordable (relatively speaking) to use the chain. Of course the popularity of Ethereum grew beyond DeFi since 2020, as the chain also became a settlement layer for NFT projects and cross-chain operations, and it rapidly became prohibitively expensive to use the network for most. Nowadays it is frequent to spend $50 or more in network fees just to perform simple operations, which is objectively limiting the growth of DeFi on the network. It has reached a point where only low latency applications are accessible to the wealthiest users: an occasional DeFi trade, an occasional DeFi loan, but nothing that is intensive.
It may not have been the original vision of Ethereum to become this premium chain at all costs, but the technical complexity to scale a blockchain where billions are backed by proof-of-work is not an easy task, and it’s increasingly likely that Ethereum will remain the most secure settlement layer only the wealthiest can interact with, directly, whilst most of us indirectly leverage its security.
This is acceptable as decentralisation is a spectrum and not every application requires the same level of trust assumption. The Web3 ecosystem has actively been tackling this issue, with the introduction of other layer-one blockchains (e.g. NEAR*, Polkadot*, Solana, Avalanche, Fantom, Polygon) and layer-two scaling solutions (e.g. Aurora*, ImmutableX*, Arbitrum, Optimism, ZKSync, Starknet). These solutions have a range of trust assumptions and network fees, which should have its own limitations for the use cases that can be built there. This is an important topic in itself but I will voluntarily avoid covering it to keep the article short.
We are clearly past the point where DeFi has only a couple thousand users: according to this Dune dashboard, there are 4.5 million active wallets in DeFi.
I believe this will enable two major trends going forward:
It is also clear that the success of the vote-escrow token model popularised by Curve’s CRV has taught us the importance of sustainable tokenomics in DeFi; although sustainable can mean many things depending on what each project is optimising for… Nevertheless, it’s clear that the trend going forward will be one of carefully designing token incentive mechanisms to ensure that users who commit to a protocol over the long term are the ones most rewarded.
With this in mind, here are some potential areas to watch for in the main DeFi verticals:
The AMM model was great, but it is not perfect. I expect this design will lose market share over time with the return of peer-to-peer trading solutions. There are already credible alternatives, such as dYdX’s derivative protocol on StarkEx or ZigZag on ZKsync.
There has been another interesting trend allowing DeFi users to trade with professional counterparts. It started with aggregators like 1inch* or matcha including trading routing to market makers, and more recently Hashflow* is enabling traders to trade directly with professional market makers in a request for quote format. Hashflow in fact is one of the most gas efficient ways to trade on Ethereum today, cheaper than trading on uniswap V2 (which used to be the gold standard of efficiency), so it is actually well suited for L1 trading ; but I think their protocol is really poised to shine on cheaper chains with faster settlement.
Hashflow is also gradually rolling out a feature allowing users to lend liquidity for professional market makers to market make on Hashflow. This is a credible alternative to being a liquidity provider on AMMs for those seeking yield on their asset.
Protocols like Hashflow, enabling trading directly with professional market makers, seem to be the credible path forward for giving always-on access to the more sophisticated financial products like options ; because so far we have seen few market participants willing to leave resting offers on p2p DeFi options trading marketplaces.
As mentioned, it is basically impossible to trade options peer to peer in DeFi, because the options protocols remain too illiquid. Of course that did not stop the DeFi builders, with solutions like StakeDAO*’s or Ribbon’s allowing anyone to take part in covered call or covered put selling strategies. This is the continuation of a broader trend that was started with yearn.finance to enable the pooling of capital to effectively perform asset management strategies whilst optimising network fees for strategy participants.
DeFi summer introduced attractive yield to Ethereum in 2020, and now DeFi users are hungry for more. They are willing to take on increasing amount risk to build a portfolio of such strategies, so it is likely that we continue seeing innovation like the covered call strategies, such as introducing the cash-and-carry trade to everyone in similar vaults of pooled liquidity.
With cheaper chains, it will be credible to have users with a couple hundred or thousand dollars/euro enter the space to start earning yield. On-ramp solutions that properly support these cheaper chains, like Ramp*, and interfaces that integrate them, are set to do well. They will become the cheapest way to on-board smaller users ; so mobile wallets like Argent or user-friendly interfaces like unstoppable finance* will shine as the easiest way to on-board the next million users.
Today, DeFi is priced in US dollars, but as the space matures and yields compress, its users will have to think about the consequences of buying dollars. It was easier to build USD stablecoins for the longest time, but with protocols like Angle*, which launched in late 2021 and rapidly became the most liquid euro stablecoin in DeFi that year, I think we will see a trend where other currencies are also readily accessible in DeFi.
In fact, even if DeFi continues to be USD denominated, protocols like Angle also allow currency hedging, which will enable packaged strategies that deploy USD in DeFi and hedge the Forex risk, enabling for example europeans to earn a yield on their euro without worrying about the EUR/USD rate.
On the topic of hedging, and as the DeFi space matures, more professional market participants look for more advanced financial primitives. This also goes together with the trend of seeing a wider range of strategies in order to build portfolios of yield-generating opportunities.
One primitive to look for is interest rate swaps which enables hedging interest rates fluctuation, whether that’s for a lending/borrowing marketplace like AAVE, or whether that’s a funding rate for dYdX or FTX.
Broadly speaking, there are two categories of solutions for hedging interest rates in DeFi:
The first category of products takes yield-bearing asset, such as aUSDC (USDC on AAVE earning interest every block), and split it into the principal (here the USDC) and the yield (here the interest on the USDC). Examples of projects building in that space are APWine (launched with public sale on Balancer), Element.fi and Pendle ; and the main criticism with this category of solution is that it is generally capital inefficient for users, because you need to lock the value of the entire position (principal) in a smart contract.
The other way to build Interest Rate Swap Protocols is via the derivatives approach, which can be significantly more capital efficient. As opposed to locking the asset looking to be hedged, derivative protocols allow market participants to only lock their realistic losses over time (or however much they want in oder to manage liquidation risk), and it is the protocols that manage the collateral required to maintain the position at the risk of being liquidated (forced to close the position). In this category, there are Strips Finance* and Voltz*. Strips is going the pure derivative approach, and Voltz is using Uniswap v3’s concentrated liquidity in their automated market maker product. Both Strips and Voltz have an interesting approach to building interest rate swaps, and they are building these on different tech stacks and on different chains (Strips → Arbitrum first, Voltz → Ethereum first).
This is definitely an area to watch, especially for building more sophisticated strategies for asset management protocols like yearn.finance or StakeDAO, or simply for users looking to speculate or hedge on interest rates. For example, Strips Finance recently went live, enabling trading the funding rates of BTC centralised derivative markets from FTX and Binance.
Lending in DeFi has only been feasible in pool models with solutions like AAVE and Compound. As we have mentioned before, whilst this is very convenient (can earn interest or borrow instantly), it’s rather inefficient because borrowers’ accrued interests are being split with all the depositors, even though most of that liquidity usually isn’t used.
Now that DeFi is actively being used and that there are significant number of users lending and borrowing, we can experiment with going back to a peer to peer model, which is what Morpho is building for example, where they are matching users peer to peer whenever possible, and if impossible, they fall back to the AAVE/Compound markets. I suspect we will see more protocols bootstrapping peer-to-peer lending marketplaces (and especially to address borrowing against NFTs).
With cheaper transaction fees, this also means that it will be economical to front run DeFi traders much more often. It is quite likely that this will remain a problem on all chains, so it will be interesting to watch solutions like Flashbots* being integrated in more places.
The dynamic of miner extractable value in proof-of-stake chains is much more interesting than in proof-of-work chains. It is certainly in the interest of market participants to find solutions to retain the value within the network validators (which, in scalable blockchains, are the stakers), as opposed to leaving that on the table for value extracting arbitrageurs and front runners, because extra revenue for validators is effecitvely an additional security budget for these proof-of-stake chains that could enable lowering token inflation.
The likely increase in average transaction fee for users due to MEV is most likely inevitable, so if at least it is to the benefit of increasing revenue for network validators, which would increase the appeal to own and stake the native currency of these chains, this could allow to reduce the inflation rate to achieve the same level of security for these networks. Some sort of value added tax from DeFi users, effectively… that is best spent in increasing the reliance of these networks rather than going into the hand of random actors.
Assuming MEV happens everywhere, this could be positive for the networks that will properly address MEV. For readers interested in learning more about the topic, Alex Obadia and Alejo Salles gave an excellent presentation at EthCC4, available here:
Today, most of the world knows the acronym NFT, and there has been legitimate excitement around the potential of having unique assets on-chain. The trend really took off in gaming and in digital art, but gradually this will enable bringing a wide range of financial assets on chain or the introduction of innovative financial products too.
This is going to be a major trend in DeFi going forward.
Whilst we are on the topic of NFTs, it is clear that few marketplaces have been dominant like Opensea or Looksrare, but we expect that aggregators like Genie will increasingly gain traffic as the easiest place to place offers on all marketplaces in one go, or to purchase NFTs.
The DeFi space is clearly maturing, and whilst the early iterations had to address first a lack of users, and then prohibitively expensive network fees, these two set of challenges are progressively disappearing.
This should translate in the introduction of more professional financial primitives, i.e. a professionalisation of the space, and equally, a return to the more efficient order book model for these financial primitives. Furthermore, as awareness increases, it is foreseeable that a more mass market audience will arrive, disappointed by the traditional financial system and in search for better yields, and they will enter the space via these cheaper chains.
Finally, the pooled model popularised on Ethereum is unlikely to be disappearing either. It is still very well suited for users that value the reduced trust that Ethereum enables, at least until these newer networks are battle tested. As a result, innovations will continue to happen there too, where capital is being pooled to offset the network cost.
Disclaimer: Fabric Ventures has invested in a number of projects mentioned in this article — these companies are highlighted in the text with an asterisk (*)
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