Media coverage of Web3 typically focuses on the latest round of eye-popping NFT sales and day-to-day cryptocurrency price fluctuations. This narrow focus obscures deeper conversations about the space, particularly the meteoric rise of decentralized finance, or DeFi, the fastest-growing blockchain category and a prominent pillar of Web3. Although DeFi has come a long way, the sector is still in its early stages, and developers are working hard to solve its unique challenges as it begins to scale to challenge centralized financial markets. DeFi newcomers must navigate the growing pains typical of a nascent industry while wading through news coverage dominated by market speculation rather than the real value the space provides.
These complex dynamics could cause those in the traditional finance and fintech industries to write off or ignore the growth of DeFi. Over the past year, however, there have been significant developments that signal a paradigm shift in what individuals want from financial services, with DeFi perfectly positioned to meet this demand.
For anyone looking to understand this new system and its potential, this article will demonstrate how DeFi is transforming finance, starting by highlighting traditional finance’s shortcomings before reviewing recent DeFi adoption milestones and laying out the space’s ongoing challenges and their potential solutions.
Traditional finance’s shortcomings are creating new opportunities for disruption
Put simply, DeFi is the reinvention of traditional financial products, including markets and trading exchanges, lending and borrowing, the opportunity to earn interest on savings, and more, using blockchains and oracles. Crucially, DeFi products provide access to cryptocurrency that traditional financial products, by and large, do not.
There are three major dynamics driving the rise of DeFi. First and foremost, mistrust in the traditional banking system has led to a growing interest, particularly among young people at the beginning of their financial journeys, in exploring non-traditional financial offerings. In 2020, 57% of customers reported not trusting banks to look after their long-term financial well-being, while in 2021, 51% of Gen Z and 49% of Millennials identified a fintech, rather than a bank, as their most-trusted financial brand. More broadly, this desire for more transparent, fairer relationships between individuals and platforms is fueling the growth of Web3, an Internet ecosystem defined by users’ ownership of their data, content, and finances.
The other driving factors center around access to new and alternative financial products. DeFi is currently one of the most popular ways to hold and use cryptocurrency, and provides an essential service to the ever-expanding pool of people interested in crypto. In comparison, banks have long expressed skepticism about cryptocurrency and only recently began to offer custody to high-net-worth clients.
Finally, DeFi offers access to financial products once reserved for advanced traders, industry professionals and institutions. These services, which include decentralized exchanges and peer-to-peer borrowing protocols, present transparent and potentially profitable financial opportunities. Decentralized lending protocols like Aave, for example, can offer lenders more than 5% returns on their deposits, compared to sub-1% interest rates on “high yield” mainstream online savings accounts.
Reaching new milestones in mainstream and institutional adoption
While DeFi’s current user base and funds represent only a fraction of the global financial system, DeFi is the fastest-growing segment, and the most significant opportunity, for blockchain technology today. In 2021, DeFi’s Total Value Locked (the total funds secured in DeFi protocols) grew from $18.7 billion to $252.46 billion, a 12x increase. This has been accompanied by a surge in users: the number of unique profiles in DeFi grew from 1.1 million to more than 4 million over the course of 2021.
Beyond application usage, both crypto-native firms and the institutions they seek to replace are rapidly hiring for Web3-focused positions, signaling growing mainstream interest and adoption. Notably, blockchain companies are also drawing in a wave of professionals from organizations like big tech companies and banks.
At a more systemic level, DeFi is increasingly positioned for rapid maturation. According to Coinshares, a digital asset investment strategy firm, as of November 2021 more than 100 “pure-play” crypto companies had raised more than $120 billion from venture capitalists. These companies have plenty of runway: A 2021 World Economic Forum report found that the key technologies underpinning blockchain and DeFi (distributed ledgers and smart contracts) are poised to disrupt $867 trillion in traditional markets. Corporate bonds, packaging blockchain-originated loans as securities, and on-chain private equity tokens are already live and will continue to expand as companies, new and old, dedicate additional resources to them.
Builders are focused on obstacles to adoption
As the potential of DeFi has yet to be fully realized, now is the time to engage and join the wave of innovation that will define the next generation of financial products. Here, we might look to the development of the Internet for a comparison. For instance, Pets.com, which pioneered the online delivery of pet products, made a huge initial splash before its ultimate, rapid demise. But today, we can clearly see that its concept was an early sign of a pivot to online ordering and product subscriptions, which are now commonplace and offer clear advantages over companies that don’t offer those options. In comparison to Web 2.0 companies like Pets.com, however, DeFi has spread further, with more institutional buy-in, and so is set up to mature much more quickly.
While there are some challenges to broad consumer adoption of DeFi, projects across the ecosystem are actively working to solve them. For instance, DeFi’s growth was contingent upon a solution to the oracle problem — the fact that blockchains cannot natively access the external data needed to develop complex applications. DeFi’s rapid adoption has closely corresponded with the launch of oracle networks like Chainlink, which aggregate and feed financial data from real-world sources onto blockchains. Once blockchain developers have access to data through oracle networks, they can build exciting new DeFi applications. These applications in turn drive adoption — newer blockchains like Avalanche have also seen adoption soar upon implementing oracle networks.
Another obstacle to adoption is an intuitive, accessible user experience (UX). Despite exponential growth, accessing DeFi products remains out of reach for many crypto non-natives. There is an urgent need for products that abstract away existing high knowledge barriers to entry, particularly for unbanked individuals (approximately 1.7 billion people), who perhaps stand to benefit the most from DeFi.
Additionally, enterprise organizations, a key piece of the blockchain adoption puzzle, have to contend with a lack of clarity around the potential primacy of individual blockchains. The most recently available data from 2019 estimated that there were over 800 unique chains. It could very well turn out that certain chains prove better suited for particular types of transactions or verticals — one could be better for DeFi, while others could offer superior performance for gaming or insurance applications. As Gartner argues, blockchain-agnostic middleware is likely the best bet for navigating a multichain future.
Early adopters will claim the advantage
While DeFi is still in the early-adopter phase, the space is evolving incredibly quickly, increasing the risk that latecomers will be left behind. DeFi is a key component of Web3, which represents a more comprehensive shift in how individuals interact with each other and with brands online, and as such has the capacity to grow exponentially. As it becomes easier and simpler for mainstream users to enter the space, firms will find themselves scrambling to keep up with demand. Fintechs such as Celsius, recognizing the opportunity DeFi can offer to their user base, have already begun the work of integrating with multiple projects and blockchains via oracle networks. Even more traditionally risk-averse financial services executives should begin to consider the potential for DeFi to disrupt their organization — and the value offered should they embrace it.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.