02 January 2023 20:46, UTC
Reading time: ~7 m
Decentralized finance (DeFi) is defined as any product or service offered by the Web3 world that helps users conduct financial activities such as payments, borrowing, lending, investing, trading and staking.
Several Web3 use cases, including DeFi, GameFi, SocialFi and nonfungible tokens (NFTs), emerged through the last bullish cycle. DeFi has been the largest market cap activity within Web3, with a peak total value locked (TVL) of over $175 billion at the peak of the 2021 bull market.
DeFi: The primary use case for blockchain?
Things have not been the same since the Bitcoin genesis block was created. Thanks to the rise of Ethereum that followed, DeFi has seen product market fit. Through the previous Bitcoin (BTC) bull market, DeFi TVL rose from $600 million in January 2020 to $180 billion in December 2021.
The TVL within DeFi has held on to over $39 billion despite the market crisis in 2022. DeFi has democratized access to financial services, as it doesn’t need a centralized organization to onboard users. Apart from the democratization, DeFi has also opened up new models like automated market making.
All these innovative elements have catalyzed the growth of DeFi protocols and applications. This has also helped other adjacent use cases such as NFTs and GameFi to grow. For instance, lending models with “NFTs as collateral” have seen good uptake. Additionally, DeFi-based models and marketplaces for gaming NFTs have emerged, allowing gaming guilds to tap into them.
Despite these interesting developments, DeFi shrank to a mere $39 billion in 2022. Let us see what transpired in 2022 and what we can expect in 2023 for DeFi.
Fall from grace
The year 2022 started with a broader market fall. Within the Web3 ecosystem, Solana’s Wormhole bridge was hacked leading to $310 million worth of crypto assets being stolen. Thanks to a few projects on the Solana ecosystem, they managed to emerge out of this abyss.
However, in March, rumors about the credibility of the Terra ecosystem and its algorithmic stablecoin started to emerge. As the market took a further fall through April and May, the network collapsed leading to a broader market sell-off.
1/ I’ve spent the last few days on the phone calling Terra community members – builders, community members, employees, friends and family, that have been devastated by UST depegging.
I am heartbroken about the pain my invention has brought on all of you.
— Do Kwon (@stablekwon) May 13, 2022
Following the Terra episode, the markets recovered through the summer, only to be dragged back down by the FTX debacle. While the FTX situation cannot be categorized entirely as a DeFi issue, as it was the result of alleged misconduct at a centralized exchange, some have noted the effect FTX and its associated firm, Alameda, had on the ecosystem.
This is fairly public knowledge at this point, but the large currency contraction that UST went through in Feb 2021 was started by Alameda, when they sold 500mm UST in minutes to drain its curve pools during the MIM crisis
— Do Kwon (@stablekwon) December 8, 2022
Despite the bloodshed, the DeFi industry has quietly kept building and innovating. 2022 was also marked by several institutional DeFi headlines that could yield benefits over the coming years.
The Bitcoin network is starting to see utility as the Lightning Network allows projects to build on top of it. Cash App integrated the Lightning Network for faster Bitcoin transactions. There are several other payment applications that could potentially change the “store of value” narrative for the apex asset.
The DeFi TVL on the Ethereum network before the previous bull run started was a few hundred million dollars. The DeFi TVLs on several layer-1 and layer-2 networks, namely Avalanche, Solana, Polygon and Arbitrum, are at a few hundred million dollars each. As the next Bitcoin halving comes around, all these ecosystems should see DeFi growth.
While market sentiment has not been positive, there have been a huge number of positive developments within DeFi, so what does 2023 hold for DeFi?
Security and DeFi
Hackers ran rampant in 2022, causing DeFi crypto investors to lose considerable amounts of money. As regulations ramp up and institutional adoption shows promise, there would have to be a few key developments in this space.
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The crypto industry has lost close to $3 billion across 125 hacks as of October 2022. This hurts the reputation of the space and is a huge hurdle in attracting institutional capital. In response, the DeFi ecosystem has already started creating applications that inform wallet holders of what a smart contract intends to do before the user signs it.
However, more needs to be done to address security vulnerabilities around oracles and cross-chain bridges. More decentralization of cross-chain bridges is a good step forward. Also, DeFi platforms will start considering insurance products more seriously to protect user funds. Firms like CertiK and Hacken offer specialized cybersecurity solutions to Web3 platforms.
DeFi and self-custody
The failure of several prominent centralized exchanges and platforms in 2022 has already helped shift volumes to DeFi platforms. However, DeFi is still largely reliant on centralized platforms to onboard new users and convert fiat to cryptocurrencies and vice versa. This trend is being challenged and could change in 2023.
As more users choose DeFi over centralized financial solutions, on-ramping infrastructure into the crypto world should improve. Wallets will have on-ramp plugins like MoonPay and Ramp that will connect to users’ credit cards, Apple Pay or bank accounts to convert fiat to cryptocurrencies and vice versa.
Another key on-ramp feature that has emerged is wallets that do not need users to manage private keys. As user experience starts taking center stage, DeFi solutions could see more first-time users.
2022 saw a number of gaming projects with DeFi integrations trying to find market share. In 2023, these projects will continue maturing and growing with DeFi as a strong pull factor.
Web3 gaming has found itself in a unique position in the entire ecosystem and could be the growth hack that Web3 has been looking for. While the games still struggle with playability, ecosystem-specific earning models, staking and farming will provide unique offerings and value propositions that traditional games lack.
Can regulators be far behind?
With catastrophic failures from marquee companies and loss of user funds, central banks and regulators will start having a greater say in DeFi.
While counter-intuitive to the ethos of what Web3 stands for, central banks will start creating regulations and legislation for consumer protection. If United States regulators crack the 90-year-old Howie Test whip and deem most cryptocurrencies as securities, that will most certainly affect this space in the short-to-medium term.
Until crypto platforms comply with time-tested securities laws, risks to investors will persist. It remains a priority of the SEC to use all of our available tools to bring the industry into compliance. https://t.co/m8oh0gTvc3
— Gary Gensler (@GaryGensler) December 22, 2022
However, some regulation has helped the space gain more credibility. Know Your Customer and Anti-Money Laundering (AML) controls, as well as conduct rules for labeling DeFi-related financial products could bring certainty to the space and encourage investors.
Institutional DeFi on the rise
Institutional interest in DeFi has picked up over the last year. Payments, custody and AML solutions have particularly seen interest from large banks and financial institutions.
Barclays bought a stake in Copper, an institutional crypto custody firm, while Standard Chartered’s innovation arm partnered with investment management firm Northern Trust to launch Zodia, a cryptocurrency custodian for institutional investors.
Bank of New York Mellon, the world’s largest custodian bank, partnered with Chainalysis to help track and analyze cryptocurrency products.
Financial services firms such as BlackRock and Citigroup invested over $1 billion each in DeFi platforms through 2022. As these firms see more institutional clients interested in the crypto asset class, they will be compelled to create offerings to support their clients.
With more central banks rolling out plans for their own digital currencies, banks will need to prepare themselves for the on-chain world.
On-chain banking would be the next phase of digital banking where transaction finality and reconciliation would be instantaneous, giving rise to new business models and financial products. 2023 would see key steps in this direction.
In summary, DeFi is poised to mature and stabilize through 2023. Any new technology has its ups and downs. Having seen a strong bullish phase and a grueling bearish slump, the time is ripe for stable growth based on wisdom gained through the experiences of 2022.
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