The last couple of weeks have been quite a test for cryptocurrency markets in general and DeFi in particular. On Black Thursday (March 12), BTC/ETH prices declined by ~50% and DeFi’s flagship project, MakerDAO, ended up with ~$5 million USD in unbacked DAI. You can read Tom Schmidt’s excellent postmortem of what happened here. This event was a powerful reminder that while DeFi is extremely exciting in the long-term, it’s still very much in the early adopter experimental phase. I see at least three main challenges for DeFi to overcome in its quest for mainstream adoption.
The most obvious challenge that Maker’s struggle highlights is the need for orders of magnitude more throughput on whatever blockchain, sidechain, or layer 2 solution that DeFi ultimately gets built upon. While Ethereum’s current block size seems suitable for most use cases most of the time, on days when markets panic and liquidations occur, we can expect at least an order of magnitude more transactions competing for finite block space. It’s more or less the same story we saw with CryptoKitties back in 2017. A promising use case with insufficient infrastructure. Perhaps Ethereum 2.0 will end up solving this problem at the base layer. Or perhaps a new layer 1 like Near will emerge. My bet, however, is that a sufficiently decentralized layer 1 blockchain will never be able to handle massive usage spikes on days when 7+ billion people are using DeFi. And that’s the ultimate goal. I’m therefore very excited to see more experimentation with DeFi apps built on layer 2s or sidechains.
2. Collateral and Liquidity
While it’s incredibly exciting to see how much ETH has been locked up in DeFi in a relatively short amount of time, it’s important to remember that potential collateral and liquidity for the system is currently bottlenecked by reliance on purely Ethereum based assets. Today, DeFi contracts are essentially collateralized by 3 assets: ETH, DAI, and USDC. While each has its own pros and cons around volatility, liquidity, and centralization, it’s important to remember that approximately two thirds of all liquidity in the cryptocurrency markets are in bitcoin and therefore currently excluded from DeFi. What’s more, March 12 was a good reminder that black swan risk seems highly unlikely until it’s not. Collateralizing the entire system with assets tied to one major black swan risk – that of ETH going to or close to 0 – seems like a really bad idea. The obvious solution is to figure out how to bring other collateral types to DeFi. And the first, and most important, is bitcoin. I’ll be exploring this idea in much more detail next week. Suffice to say for now that this appears to be top of mind for some of crypto’s most important leaders, including Vitalik himself.
3. Use Cases
As Josef Tetek articulates in this excellent article, the primary (perhaps only?) use case for DeFi today appears to be facilitating leveraged longs on ETH. That means that, as you would expect, we see general DeFi interest rates skyrocketing during bull markets when people want as much leverage as possible and declining substantially in bear markets when betting cools. While this is a fine initial use case, I look forward to the development of more p2p lending for productive purposes (think microfinance, small businesses lending, or venture capital), which will help to create actual new wealth and dampen volatility.
With all of that said, I’m still extremely bullish on some version of p2p finance or DeFi eventually dominating financial markets. Its benefits are too big: fairer rates via cutting out middlemen, global access via trustless smart contracts, and composability via open source, auditable code. I just think this is going to take longer than I initially expected.
In the meantime, I’m most excited to see some of the risk in the field being reduced by projects like Nexus Mutual and Opyn. Nexus Mutual made its first payout following last month’s bZx attacks and Opyn continues to move at lightning fast speed, most recently releasing ETH puts denominated in USDC. Exciting times ahead!