Decentralized Exchanges (DeFi) continue to gain an increasing number of users as the level of trading and the wide selection of assets and services they offer grows.

DeFi’s total asset value now exceeds $ 84 billion, down from just $ 1.8 billion in June 2021. So what is driving this expansion of DeFi?

DeFi allows cryptocurrency owners to earn interest and allows borrowing, lending, and purchasing insurance, or simply trading speculatively.

Indeed, DeFi aims to offer cryptocurrency owners a range of services in a decentralized manner – typically offered by traditional financial markets that rely on centralized exchanges and clearing houses.

Blockchain Hype Cycle – July 2021:

Source: Gartner.com

Gartner estimates that DeFi has two to five years to reach a productivity plateau – that is, when the technology begins to be adopted by the general public, which, in reality, is not very long for. technology that could shake the foundations of the financial services industry.

By using smart contracts, DeFi seeks to ‘eliminate’ much of the friction costs that accumulate due to the need to deal with multiple intermediaries as well as the need for audits and controls, regulatory compliance monitoring. and associated fees and costs – all of which stifle many traditional financial services that exist today. Interestingly, Harvard Business Review cites a comparison between Yield Farming and Foreign Currency Carry Trading:

“The search for passive returns on crypto assets – “Yield farming” – is already taking shape on a number of new lending platforms. Compound Labs has launched one of the largest DeFi lending platforms, where users can now borrow and lend any cryptocurrency for the short term at rates determined by algorithm.

“A Prototype Yield Farmer moves assets around pools on Compound, constantly chasing the pool with the highest annual percentage return (APY). In practice, this echoes a traditional finance strategy – a foreign currency carry trade – where a trader seeks to borrow the currency at a lower interest rate and lend the one offering a higher yield.

“Crypto yield farming, however, offers more incentives. For example, by depositing stablecoins to a digital account, investors would be rewarded in at least two ways. First, they get APY on their deposits. Second, and most importantly, some protocols offer an additional subsidy, in the form of a new token, on top of the return it charges the borrower and pays the lender.”.

Interest in using DeFi loans has increased as more people access pools of loan facilities, whether they are digital asset holders looking to generate a return on debt. digital assets they own or borrowers wishing to increase their exposure to this asset class.

Forbes described DeFi loans as: “Unlike a traditional bank, borrowers using DeFi apps cannot be held accountable for physical assets if they are unable to repay a loan effectively. DeFi apps are similar to smartphone apps, but they’re built with smart contracts”.

CoinmarketCap, which tracks cryptocurrency prices in real time, lists a variety of other DeFis lenders and apps where farm yields range from 0.2% per year to over 40%.

The three largest providers of DeFi applications – Aave, Compound and MakerDao:

Source: Dune Analytics @hagaetc

In turn, Harvard Business Review proposed that: “DeFi offers a less volatile and more accessible entry point than other markets – and may have just enough appeal to bring blockchain into the mainstream. “

If this prophetic statement were to turn out to be true, then it’s easy to see why DeFi could prove to be so attractive – not only to borrowers and lenders, but also very disruptive to other sectors of the financial services industry.

A combination of greater transparency, afforded by the use of blockchain technology, and the use of smart contracts to eliminate human error should lead to more robust systems and procedures including regulators, investors and investors. service providers can benefit.

The losers will potentially be the middlemen, auditors, lawyers and compliance consultancies that are currently so prevalent in the financial services industry. It is indeed a powerful and alluring prospect that DeFi offers the potential for lower transaction costs, greater transparency (hence increased trust) and a more robust compliance infrastructure.

If this turns out to be the case and DeFi is indeed capable of handling large volumes of transactions, traditional financial services firms are likely to adopt this low-risk, alternative way of doing business, or be forced to do so by regulators.

One of the challenges DeFi faces is that currently many DeFi services are built on the Ethereum blockchain and the price of transactions (gas fees) can mean that the costs outweigh the benefits.

Ethereum is trying to sort out the gas charges, but for now DeFi is heavily reliant on Ethereum. So expect to see other DeFi platforms created using other Blockchains.

Mathew McDermott, Head of Digital Assets at Goldman Sachs, recently said: “Over the next five to ten years, you might see a financial system where all assets and liabilities are native to a blockchain, with all transactions occurring natively on the chain. So what you are doing today in the physical world, you are simply doing it digitally, creating huge efficiencies.

“And it can be debt issues, securitizations, loan arrangements; essentially you will have an ecosystem of digital financial markets, the options are quite extensive. “

However, for mainstream adoption, regulators will surely seek some degree of responsibility for a hack or a DeFi application not delivering what was promised.

One possible solution would be to see regulators look to blockchain providers, such as Ethereum, and have them act essentially as gatekeepers to control organizations that use their blockchains and build DeFi applications.

Could we see Ethereum and other blockchains set up some type of investor compensation regime, and then the DeFi platforms that run on their blockchains get regulatory approval?

Alternatively, will we see some traditional exchanges such as NASADAQ or the London Stock Exchange offering DeFi platforms, so that regulators have a known entity to hold accountable?

Dr Jane Thomason of Novum Insights (a firm specializing in DeFi asset analysis) when asked for her thoughts, said: “”DeFi investors can lose money because the activities are not regulated, moderated, intermediated, hosted or validated by a central authority, only driven by smart contracts.

“If the smart contract is malfunctioning, hacked, or has some other problem, there is no recourse. Who and what is regulated? It is a 24/7 global market without borders. Regulators must think about it and learn to audit the code! It’s a brand new ball game. “

The balance between fully decentralized systems and procedures where it may be difficult to hold an entity accountable in a particular jurisdiction (and thus be able to reward and protect investors) will need to be addressed.

Increasingly, as our societies and lifestyles become increasingly online and digital, protecting investors is likely to become increasingly difficult for regulators and governments.

What will not change and can potentially be even more relevant is surely:

“Bouncer warning”

Let the buyer beware.