Will DeFi Come Out of Crypto Winter Stronger?

We have all heard of hibernation, when animals in the wild conserve energy during periods of unfavorable weather conditions and food shortages. Bears, for example, reduce their metabolic state in winter to save energy, only to later emerge in spring leaner and stronger. The past few months in crypto have shown that decentralized finance (DeFi) is no stranger to a chilly winter – or bears, for that matter.

The total value of decentralized finance has fallen to around $50 million, around a third of its previous high-water mark in May 2022. Although the question of DeFi’s potential to evolve into a disintermediated and immutable financial system remains, there has been some meaningful progress.

Chelsea Virga is vice president of Galaxy Digital’s strategic opportunities team.

In the wake of FTX’s collapse, billions of dollars poured into decentralized exchanges (DEX) from centralized entities, doubling trading volumes in November alone. Even amid crypto’s market turmoil, decentralized exchanges and lending platforms have performed smoothly compared to some of their centralized peers. DeFi’s core features—such as smart contracts that have settlement instructions built into code and security features, including over-collateralized lending standards—explain how Maker, Aave, and Compound successfully raised $400 million from a financially compromised borrower, the Celsius Network. Meanwhile, the centralized borrower has since declared bankruptcy and still has over $1 billion in outstanding debt to repay.

To unlock its potential, DeFi needs a narrative overhaul. For too long, many protocols attracted users by dangling unsustainable returns—for example, during the hot days of “DeFi Summer,” which was fueled in part by a welcoming macro backdrop. Since then, interest rates have risen, inflation has risen and the “risk-free” yield on six-month T-bills breached 5%, pulling interest (no pun intended) away from the blockchain.

A changing macroeconomic environment has had knock-on effects. A few months ago, after Coinbase increased its USDC rewards to 2.36%, DeFi giant MakerDAO voted to increase its DAI savings rate tenfold to 1% to remain competitive. Ondo Finance, an on-chain project focused on the tokenization of US Treasuries and corporate bonds, launched a couple of months back with the intention of offering “equity class” tokens useful on other DeFi platforms as on-chain security.

DeFi’s future success lies in the creation of a financial offering that can improve centralized financial products (CeFi). We have already turned a peak on inventive concepts such as distributed ledger technology (DLT) clearing and settlement, liquid stakes, on-chain underwriting and zero-knowledge (ZK) privacy technology. These are all ideas that can drive efficiency in DeFi’s offerings and insurance systems.

Much of this activity is as dependent on regulators as smart contract engineers. Germany’s financial watchdog, BaFin, has acted proactively to regulate blockchain by issuing legislation on aspects such as initial coin offerings, security token offerings and decentralized apps (dapps). The approach can provide financial stability while promoting innovation.

This is an area where the US is still gaining clarity. Securities and Exchange Commissioner Hester Peirce has stated that she believes regulation requires a nuanced approach where investor protection is prioritized without stifling technological progress. Peirce noted in January that “regulation should foster an environment in which good things flourish and bad things perish, not the other way around.” A unified framework must be implemented before many institutions will consider taking the leap. Meanwhile, DeFi continues to build.

Historically, CeFi has been the dominant liquidity provider for crypto financial instruments, such as cash-settled perpetual futures and other derivatives, primarily because they are more cost-effective for leverage seekers from a security perspective. However, this is rapidly changing due to distrust of centralized exchanges. On the back of the FTX exchange collapse, permissionless spot and swap exchange GMX more than doubled its protocol revenue in November to $16.7 million. Decentralized exchange dYdX gained 16,000 users between September 2022 and the turn of the year.

Another trend in DeFi has been floating stakes, which allow users to earn dividends from stakes while still participating in DeFi activities. Ethereum-based staking platform Lido’s utility token has seen an impressive price increase since the beginning of this year, with over $9.4 billion staked on the platform. Platforms like Lido take in assets, use them as collateral and provide alternative tokens for users to spend on their platform – a process that has a CeFi parallel in “repo transactions.”

Enabling a larger complex of on-chain assets will be key to attracting more activity and new entrants to the DeFi market. Value creation will come from the tokenization of real assets such as money markets, mortgages, trade finance and infrastructure loans, among others. With distributed ledger technology, DeFi has the potential to offer cheaper financing options through fractionation and reduce entry costs for investors. Blockchain can drive a wider range of assets available to investors, ultimately building portfolio diversification.

There is a domino effect here. Last year, MakerDAO, the largest DeFi protocol with $8.6 billion in total value locked, jumped further into traditional capital funding, with five traditional funding vehicles and a $30 million DAI loan using bond tokens to a subsidiary of the French the financial lawyer Société Générale. Then, a few months ago, private equity giant KKR tokenized its $4 billion healthcare exposure on Avalanche. Then, in November, Apollo announced plans to offer an upcoming fund on a public blockchain through Figur. Just last month, the Hong Kong government issued its first tokenized green bond worth around $100 million through Goldman Sachs’ tokenization protocol GS DAP.

These innovations show how traditional finance and decentralized finance continue to intertwine, or at least how many existing financial products can be replicated on public blockchains.

DeFi’s fire was initially ignited by automated market maker (AMM) technology, such as Uniswap, where algorithms would facilitate token trading through a mathematical formula to determine asset prices. Today, DEXs like dYdX are increasingly implementing central limit order books (CLOBs) similar to traditional exchanges where a database matches buy and sell orders for a particular asset. In some cases, market makers may be added through integration with a request for quotation (RFQ) to further supplement liquidity. Linking AMMs with professional market makers strengthens liquidity and price execution.

An important consideration for all decentralized financial operations is how to optimize the loan guarantee and ensure that the security requirements are secure. DeFi lenders often require additional collateral for lending. In other words, they require traders to pledge assets worth more than their loans.

Composable DeFi platforms provide innovative ways of collateralization. For example, cross-margining, the process of cumulatively calculating a trader’s margin through calculating their unrealized profit statement (often abbreviated to “PnL”), is a valuable advance we’ve seen over the last cycle.

The Aave and Compound lending protocols enable users to leverage based on loan-to-value (LTV) and curate a single health factor that takes into account all their positions. DEXs like dYdX similarly allow users to offset their trading losses with gains, and some even offer partial liquidation protection (so if it comes to that, only the worst-performing part of a portfolio is liquidated). While traditional prime brokerage offerings for funds are still more robust, this development is a step in the right direction.

Smart contracts for flash loans have been another interesting mechanism to reduce borrower defaults. For example, suppose a user wants to finance a profitable arbitrage trade by borrowing capital unsecured. Smart contracts can consolidate the entire transaction from loan to repayment in one immediate transaction, and will not be fully executed if repayment does not occur.

Blockchain’s transparency can also be an advantage for risk management. Its immutable ledger allows users to verify the ownership and movement of assets. Several projects are working along these lines, trying to use chain data to provide indications of creditworthiness and validation of real-time financial positions. This information can be used in conjunction with off-chain financial information to develop credit scores.

Zk-SNARKs (zero-knowledge succinct non-interactive argument of knowledge) will be an additional DeFi catalyst. In a nutshell, ZK technology will help parties investigate whether a specific claim is true or not, without revealing any additional information beyond the claim itself. This can enable organizations to secure transactions with others while preserving confidential financial information.

To reach mainstream adoption, user interfaces need to be improved. Wallets and decentralized applications (dapp) should be intuitive enough for all users – especially those new to crypto. Developers must take a similar approach to the development of personal computers in the early 1990s, which focused on accessibility.

An easy-to-use concept gaining traction among people interested in DeFi security is “account abstraction,” or a tailored approach to wallet recovery. This is an alternative to simply telling merchants to look after their keys – “not your keys, not your coins.” Trading platforms like Argent.xyz allow selected users or devices to act as guardians to help restore a wallet on a new phone. These social recovery features can make on-chain transactions safer.

Centralized exchanges in the last cycle were able to draw users from an expanded variety of layer 1 blockchain ecosystems. In contrast, DeFi projects are often limited by the chain they are deployed on. For ether (ETH) to end up on, it must pass via a bridge; a cumbersome experience will limit mainstream growth.

This is already changing. DeFi projects like Osmosis, born in the interoperable Cosmos ecosystem, use underlying cross-chain infrastructure providers, like Axelar, to bring in users from any chain. Axelar enables Osmosis to create one-time deposit addresses for users similar to a centralized exchange. Osmosis is based on Cosmos, but it can accept tokens from Ethereum Virtual Machine (EVM) chains and beyond. (Axelar is a portfolio company of Galaxy.)

While Ethereum has been the dominant player for DeFi, network congestion and significant gas fees remain a potential obstacle. At this point in the blockchain’s evolution, DeFi is increasingly populated with alternative layer 1 and layer 2 high-capacity systems, which scale transactions count at a fraction of the price.

With the expansion of product offerings, improvements in pricing and availability, upgrades to user experience, and improvements in cross-chain capabilities, DeFi may emerge from crypto winter a stronger animal. These major changes will require a collaborative effort consisting of innovation from developers, clarity from regulators and continuous feedback from users.

Vincent Van Gogh compared convention to “a paved road: It is pleasant to walk on, but no flowers grow on it.” DeFi has an opportunity to revolutionize traditional financial markets in the next cryptocurrency boom broadly – ​​but only if we use the current crypto winter to rebuild the infrastructure that will allow new things to flourish.