2020 was an unforgettable year. As COVID-19 spread like wildfire throughout the world and local shutdowns forced millions into furlough or unemployment, governments responded with unprecedented stimulus packages and unchecked QE. Caught between a rock and a hard place, one might argue that they had very little choice. Yet, the trillions of dollars of value created out of thin air have created a ticking time bomb.
As interest rates hover around zero and the world’s global reserve currency continues to decline, an alternative financial system has been steaming ahead offering investors a real opportunity to seek sizable returns on their capital away from traditional finance.
Decentralized finance (commonly known as DeFi) has been the overwhelming headline of 2020 in the cryptocurrency space – at least until Bitcoin made its spectacular moves in the final weeks of the year. Still, DeFi’s developing economy facilitating lending and borrowing and highly attractive yield enhancement products has captured the attention of investors of all stripes from retail to large institutions.
The unstoppable rise of DeFi in 2020
DeFi first began to really make a splash when it passed an important milestone in February of this year. As the cumulative value of all tokens locked inside its applications reached more than $1 billion, it was clear that the flame had been ignited.
Despite suffering some setbacks from the March selloff that left no market unaffected, DeFi has grown exponentially and investors’ attention on how to earn interest on crypto assets has never been higher. In fact, today the combined locked value in DeFi protocols has reached more than $16 billion.
There is a burgeoning ecosystem catering to the needs of different participants – from those who cannot get credit, use a traditional bank, or whose fiat currencies are collapsing – to savvy investors looking for generous Annual Percentage Yields (APY)and more ways of making their money work for them without engaging in high-octane crypto trading. Whether that’s taking out a low-interest loan or making a yearly yield in some cases in excess of 100%.
Through yield farming, otherwise known as liquidity mining, DeFi protocols can attract much-needed liquidity to their networks by offering generous rewards for investors who lock up their tokens. Interest in this practice reached fever-pitch in August as bitcoin displayed several weeks of uncharacteristic lack of volatility, further spurring investors to place their money into altcoins.
Some of the key protocols to drive the growth in DeFi are decentralized oracle network Chainlink, which saw its LINK token explode in value by over 1,000% at its height. Lending protocols such as Compound and Maker have also seen massive traction, with Maker currently holding the most locked total value with 18% dominance.
Institutional interest in DeFi
Unsurprisingly, parabolic token gains and sky-high APYs placed DeFi tokens among the best-performing crypto assets of 2020. With plenty of them, such as Aave (LEND) and Bancor (BNT), seeing gains well in excess of 300%. Of course, smart money does not turn a blind eye to gains of such magnitude. While the DeFi space still remains largely driven by retail investors, institutional funds are starting to appear.
As cryptocurrency becomes a legitimate asset class, a recent survey by Fidelity Asset Management has found that as much as 80% of institutions now find investing in digital assets appealing. The regulatory framework is now in place, the infrastructure is more robust, the derivatives market is more efficient and sophisticated, and the trading and arbitrage opportunities are abundant.
And beyond investing in well-known digital assets like Bitcoin and Ether, traditional investment firms are turning their attention to DeFi to further the development of the space. Members of the Chicago DeFi Alliance, for example, include behemoth players like TD Ameritrade, CMT Digital, and Arca Labs in an initiative to support promising DeFi startups and push for improved regulation.
In this regard, a major breakthrough was achieved in July this year when the Securities and Exchange Commission of the United States approved Arca’s digital shares ArCoins to be traded on the Ethereum blockchain. This milestone marked the first time that the SEC had allowed a fund with cryptographic tokens to enter the investment markets – a huge step forward in unifying traditional finance with digital asset investment.
The future of yield-enhancing products
Not everything surrounding DeFi has been rosy, however. A largely unregulated decentralized landscape promising seismic overnight gains and a project initiation cost at near-zero was always going to be a recipe for disaster. Unsurprisingly, DeFi suffered its fair share of rogue projects, exit scams, rug-pulling tactics, and fake pre-sales all serving to dupe investors out of their money and siphon hundreds of millions out of victims.
The combination of emerging technology with vital flaws and the sheer volume of unsavory market practices has led to a cooling-off of interest in DeFi projects. Investors are far warier of shiny new projects offering unsustainable APYs, leading many to question whether DeFi was little more than a bubble and if that bubble has indeed burst.
However, rather like the ICO boom in 2017-2018, rogue projects, bad actors, and unsustainable practices are gradually being weeded out of the space. The reputable players are emerging and continue to build and improve the infrastructure and the technology to provide a safer and more transparent experience for users.
This means leaving behind unrealistic 1,000% APYs and token gains and moving to more robust and trustworthy protocols and borrowing and lending platforms that still present a highly attractive alternative to traditional finance. Earning less than 0.5% in interest on fiat savings which are rapidly devaluing due to looming inflation or more than 10% on crypto assets that are rising in value. Which would you choose?
With the launch of Ethereum’s Beacon chain in December marking the start of its transition to ETH 2.0, DeFi’s full potential comes ever closer to being realized. With the lion’s share of DeFi protocols built on top of Ethereum, the upgraded Proof of Stake (PoS) blockchain when it’s completed will allow DeFi to scale to accommodate a meaningful number of users. In fact, Ethereum’s contribution to DeFi and its transition ETH 2.0 has been fueling its stellar price momentum, delivering a staggering 400%+ YTD return for investors in 2020.
DeFi’s technology is still in its early stages and it would be foolish to push the sector to run before it can walk. Yet, even as issues of scalability, usability, interoperability, or lack of regulatory clarity continue to hamper the space, the promise of DeFi as a viable alternative system for lending, borrowing, and making passive income is undeniable and its value is impossible to ignore.
The future of yield-enhancing products, therefore, looks very promising indeed as DeFi eventually transitions real-world assets to the blockchain and creates a more equal and universal financial system for all.