Liquidity has driven DeFi’s growth to date, so what’s the future outlook?

Published at: May 1, 2022

In mid-February 2020, the total value locked within decentralized finance (DeFi) applications first exceeded $1 billion. Fueled by the DeFi summer of 2020, it wouldn’t even take a year before it multiplied 20-fold to reach $20 billion and only another ten months to reach $200 billion. Given the pace of growth so far, it doesn’t seem outlandish to imagine the DeFi markets hitting a trillion dollars within another year or two.

We can attribute this monumental growth to one thing — liquidity. Looking back, DeFi’s expansion can be defined in three eras, each representing another significant development in removing barriers to liquidity and making the markets more attractive and efficient to participants.

DeFi 1.0 — Cracking the chicken and egg problem

DeFi protocols existed prior to 2020, but they suffered somewhat from a “chicken and egg” problem when it came to liquidity. Theoretically, someone could provide liquidity to a lending or swap pool. Still, there aren’t enough incentives for liquidity providers until there’s a critical mass of liquidity to attract traders or borrowers who will pay fees or interest.

Compound was the first to crack this problem in 2020 when it introduced the concept of farming protocol tokens. In addition to interest from borrowers, lenders on Compound could also earn COMP token rewards, providing an incentive from the second they deposited their funds.

It proved to be a starting pistol for the DeFi summer. SushiSwap’s “vampire attack” on Uniswap provided further inspiration for project founders, who began using their own tokens to incentivize on-chain liquidity, kicking off the yield farming craze in earnest.

DeFi 2.0 — Improving capital efficiency

So, that was DeFi 1.0, approximately the era that took us from $1 billion to $20 billion. DeFi 2.0, the period that saw further growth up to $200 billion, brought improvements in capital efficiency. It saw the growth of Curve, which honed Uniswap’s automated market makers (AMM) model for stable assets, offering more concentrated trading pairs with lower slippage.

Curve also introduced innovations like its vote-escrowed tokenomic model, which incentivizes liquidity providers to lock up funds for the long term to further increase the reliability of liquidity and reduce slippage.

Uniswap v3 also brought further improvements in capital efficiency with its customizable liquidity positions. Beyond Ethereum, the multichain DeFi ecosystem began to flourish on other platforms including BSC, Avalanche, Polygon and others.

So, what will propel DeFi through the next phases of growth to reach a trillion dollars and beyond? I believe there will be four key developments.

DEXs go hybrid

The AMM model that’s proven so successful in DeFi evolved out of necessity after it became evident that Ethereum’s slow speeds and high fees wouldn’t serve the order book model well enough for it to survive on-chain.

However, the existence of DeFi on high-speed low-cost blockchains means that we’re likely to see an uptick in the number of decentralized exchanges (DEXs) using an order book model. Fast settlement times reduce the risk of slippage, while low to negligible fees makes an order book exchange profitable for market makers.

There are several examples of decentralized exchanges using central limit order books emerging already — Serum, built on Solana, Dexalot on Avalanche and Polkadex on Polkadot, to give several examples. The existence of order book exchanges is likely to make it easier to onboard institutional and professional investors, as they allow limit orders, making for a more familiar trading experience.

Cross-chain composability

The proliferation of DeFi protocols on blockchains other than Ethereum has resulted in significant fragmentation of liquidity into different ecosystems. To some extent, developers have tried to overcome this with bridges between blockchains, but recent hacks such as Solana’s Wormhole bridge hack have created concerns.

Nevertheless, secure cross-chain composability is becoming necessary to unlock the fragmented liquidity in DeFi and attract further investment. There are some positive signs — for instance, Binance recently made a strategic investment into Symbiosis, a cross-chain liquidity protocol. Similarly, Thorchain, a cross-chain liquidity network, launched last year and has recently gained rapid ground in value locked, implying a clear appetite for cross-chain liquidity.

Blockchain and DeFi begin to merge with the financial markets

Now that crypto is becoming a recognized global financial asset, it’s only a matter of time before the boundaries begin to blur with blockchain and DeFi. This is likely to move in two directions. Firstly, by bringing the liquidity from the established global financial system on-chain, and secondly, by the adoption of crypto-related decentralized financial products by institutions.

Several crypto projects have now launched institutional-grade products, and more are in the pipeline. There’s already a MetaMask Institutional wallet, while Aave and Alkemi operate Know Your Customer (KYC) pools for institutions.

On the other side, Sam Bankman-Fried is flying the flag for bringing the financial system on-chain. In March, he spoke at the Futures Industry Association in Florida, proposing to U.S. regulators that risk management in financial markets could be automated using practices developed for the crypto markets. The tone of the FT piece covering the story is telling – far from the dismissive, even scornful attitude that the traditional financial press used to have toward crypto and blockchain, it’s now loaded with intrigue.

Quite when DeFi reaches the trillion-dollar milestone is anyone’s guess. But, those of us watching the current pace of growth, investment and innovation feel reasonably confident that we’ll get there sooner rather than later.

This article does not contain investment advice or recommendations. Every investment and trading move involves risk, and readers should conduct their own research when making a decision.

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.

Jimmy Yin is a co-founder of iZUMi Finance. Before entering the world of DeFi, he was a researcher at North American Blockchain Association and community member of World Economic Forum. His PhD was supervised by Max Shen at UC Berkeley and HK University. Jimmy pursues enhancement of liquidity in both crypto and spirit.