DeFi: What to Look Out For in the Second Half of 2021

Last week, one of Europe’s largest banks, Deutsche Bank, went against the Treasury Secretary Yellen’s depiction of higher-than-expected inflation rate. After the consumer price index achieved its highest yearly rate since 2008, at 4.2%, the former Fed chair called such a rate “transitory”, to return to normal after a few months. Moreover, just a few days ago, the Fed’s balance sheet reached an historic $8 trillion, as an accumulative effort to speed up the recovery.

While many have warned of the unseen and unpredictable consequences of such monetary milestones, Deutsche Bank is one of the world’s largest financial institutions to frame these policies as “sitting on a time bomb”. They should know, as the bank implemented negative interest rates following ECB’s -0.5% deposit rate. In a time where global fiat currencies are rapidly devaluing and banks even charge for deposits, it is fortunate that the DeFi space has exploded in such a timely manner.

Only one year ago, dApps within the decentralized finance ecosystem accounted for less than $1 billion in total value locked (TVL). Now, the digital assets sit around $59.5 billion, a 30% drop from May's ATH of $86.2 billion, mirroring the month’s crypto crash.

TVL locked in DeFi protocols from July 2020 to June 2021, source: defipulse.com

 As severe as that crash was, DeFi remains as one of the few investment paths available for those who view the stock market as a highly inflated bubble and wish to avoid record low near-zero or negative interest rates. Always brimming with innovation, here are some of the more important DeFi trends emerging for the latter half of 2021.

Cross-Blockchain Interoperability

As the first to offer smart contract capability, the Ethereum blockchain became a victim of its own success. An influx of new yield farmers have made the network congested right at the time of DeFi’s peak growth. While this is being gradually resolved with a transition toward ETH 2.0, which features a more scalable Proof-of-Stake (PoS) consensus mechanism, Binance Smart Chain (BSC) has been the biggest beneficiary thanks to its low transaction fees and fast throughput.

In order to escape Ethereum’s high fees and network congestion, many have turned to BSC as an alternative.

(source: twimg.com)

Although DeFi currently has 2.7 million users, this is still chump change compared to traditional finance. What the DeFi space really needs is seamlessness, but it’s still-early stage of development lacks such a feature. BSC already supports cross-chain asset transfers, but only for BEP20 tokens. Other smart contract-enabled blockchains offer more elegant interoperability:

Polkadot – Using its governance token DOT, Polkadot resolves congestion by distributing transactions across multiple parallel blockchains – parachains – making Polkadot theoretically able to handle up to million tps. Not only does its Substrate framework allow the development of custom-built blockchains, but all types of assets can be transferred across blockchains. Polkadot’s ecosystem currently has a market cap of $40.6 billion with its native DOT token priced at $21.7. After having launched Relay Chain last May, Polkadot is ready to launch multiple parachains in the second half of 2021.

Avalanche Network – Like Polkadot, Avalanche is a programmable blockchain for creating both dApps and blockchains. Its throughput is equally impressive, already capable of handling traffic equal to Visa’s, at about 4,500 tps. Its smart contracts are Ethereum-compatible, launching on blockchains dubbed as subnets, each one having its own validators. More notably, the Avalanche-Ethereum bridge makes it a true, next-gen blockchain, a network of networks. Accordingly, it allows assets to easily flow between the blockchains. For example, its most popular dApp – Pangolin (PNG) – with a market cap of $28 billion, can interface with Ethereum’s Uniswap (UNI). Pangolin launched in February and already surpassed $1 billion in trading volume in April, showing once again that the future of DeFi is in blockchain interoperability.

The upcoming launch of Polkadot parachains will mark its maturation into a more formidable competition to Ethereum.

Likewise, Moonbeam, as a bridge-building platform between Polkadot and Ethereum, is another project to track on your DeFi radar. Its Kusama’s version is Moonriver (MOVR), a bridge between Ethereum and Kusama parachain, seeking to tap into Ethereum’s massive liquidity, but offering negligible fees and ultra-fast transaction speeds.

The Birth of DeFi Derivatives Markets

Derivatives bets have earned a bad reputation since they caused the Financial Crisis of 2008 and subsequent banking bailouts. However, smart contracts are far removed from hedge funds speculating on mortgage credits. Derivatives only make about 7% of the DeFi space, at about $2.5 TVL. As you can see, the top 10 protocols dominating DeFi derivatives are a combination of insurance protocols and synthetic assets, which are simply tokenized derivatives with zero slippage.

Of course, Synthetix is at the top as the DeFi protocol that tokenizes real-world assets, like stocks or commodities via Chainlink oracles. Speaking of which, a solid competitor to Chainlink may soon emerge in the form of Kylin Network, another project worthy of your attention ahead of its upcoming testnet launch. Altogether, with the help of oracles, Synthethix is quite a revolutionary project because it allows people to trade stocks without suffering Robinhood-type conflicts of interest or outages.

DeFi derivatives ranking on June 14th, source:defipulse.com

Outside of stocks, increasingly popular derivatives are based on cryptocurrencies – Wrapped Bitcoin WBTC and RenBTC – both of which can be called Bitcoin stablecoins, as they are pegged to BTC. As ERC-20 tokens, they can be smoothly exchanged on the Ethereum network. Last week, WBTC supply achieved a milestone - it accounted for 1% of Bitcoin’s circulating supply (187,610 WBTC in total).

This is an important indicator that Bitcoin hodlers are not only interested in using BTC as a passive hedge against inflation (devaluation of fiat currency) but also as a source of passive income via yield farming. To this end, yield farmers can now take advantage of Wrapped Ethereum (WETH). Although this may seem redundant, keep in mind that the ERC-20 token standard emerged after the development of native ETH cryptocurrency.

A surge in derivatives demand is best illustrated by Hegic’s popularity. This options trading dApp relies on trustless, non-custodial hedge contracts. At the end of May, its total options trading volume exceeded $400 million.

Unlike both WBTC and WETH, renBTC is not a synth but relies on a direct BTC supply for its peg to Bitcoin. One should expect to see a big spike in its popularity because its generation/minting doesn’t require KYC or AML procedures, thus ensuring user privacy when taking part in DeFi yield farming.

Mitigating DeFi Risk

We are yet to see how Cardano will perform in terms of smart contract security when its Alonzo upgrade goes online in August. Perhaps, Hoskinson’s peer-reviewed, methodical approach to blockchain development will make Cardano the most secure smart contract blockchain. This would certainly give it a competitive edge, as all current programmable blockchains suffer from exploits and flash loan attacks. Despite being known exploits, they continue to erode trust in the DeFi ecosystem.

Until more devs audit their code, the only “guarantee” is to take advantage of decentralized insurance protocols like Nexus Mutual or Barn Bridge. As more investors move into the space fleeing high inflation rates, you can expect that those DeFi protocols that don’t offer deposit insurance will lose popularity.

Still in its initial stage, DeFi insurance has a massive room for growth. Bridge Mutual (BMI) seems to be one of the more comprehensive ones, not only covering smart contracts, but also stablecoins and exchanges. More importantly, they have announced cross-chain interoperability, starting with Polygon Contracts. Keep in mind that Bridge Mutual’s market cap is merely 11% of the biggest DeFi insurance protocol, Nexus Mutual. Yet if their upgrades come through as scheduled, Bridge Mutual could see significant growth.

Final Note

In conclusion, these are just some of the more notable DeFi slices of the expanding pie, opening the door to further exploration once you know the main players and unique value propositions they offer. The DeFi space remains in a very adolescent state. Despite this, it’s full of competition, due to its relatively low barrier to entry.

Of course, there are also regulatory concerns as well, especially for U.S.-based traders. While an increasing number of popular forex brokerages now offer cryptocurrency trading—to include eToro and, in the near future, Interactive Brokers—this largely does not include the bulk of DeFi-specific tokens. Many are waiting to see SEC Chairman Gensler’s take on the situation—which is another aspect to keep an eye on as we roll into the second half of 2021.