The Leading DeFi Tokens: 2022
DeFi: Bye Bye Banks
Brick and Mortar Banks —> Blockchain Protocols
Imagine a giant M&A deal where every participating banks’ overhead goes to zero, and new users can be onboarded without setting up an account.
That’s what could happen with decentralized finance.
Another way to say it: imagine a world in which all brick and mortar financial institutions transition onto the blockchain.
Now imagine a new scenario with two people: a young female artist from Indonesia, and a young father from the Philippines. The artist sells digital art in the form of NFTs to make extra money. The father earns extra income from a play-to-earn blockchain game. Neither have a traditional bank account.
Both earn and save their money in crypto. They go online to Uniswap, convert their tokens into ETH, then they lend out their ETH on Aave protocol to earn a higher interest rate than depositing in a US bank account. Or maybe they want to take a little extra risk and stake their ETH in a Yearn vault to get 11% APY.
As the price of ETH rises, each of them pulls their money out of their DeFi pools and converts ETH to USDC using Uniswap to lock in profits. This is what someone with a bank account and brokerage account can currently do in the US.
DeFi offers an alternative to the traditional finance system. It actually works right now for anyone in the world, but we are in the very early stages. The market opportunity here is vastly bigger than might appear.
There are 7.7B people in the world and only about 300M own equities.
About 50-250M people in the world own or use crypto, according to estimates.
It’s easy to show which of these two numbers is growing faster. (see Kyle Samani in Sources)
DeFi is currently in the process of onboarding more people to finance than any other technology ever, and many people will use DeFi without ever using the traditional finance industry.
How does it work?
Here are a few of the main building blocks of DeFi.
AMMs
Automated Market Makers. Users come here to swap their tokens into other tokens. Uniswap is the first and the biggest. Uniswap just did the same amount of daily trading volume as Coinbase. They abandoned the concept of an order book and created smart contracts that determine price through the “constant product market maker model”. In the most basic form, users deposit their tokens in liquidity pools for traders to access when swapping tokens. When traders swap, those supplying liquidity get rewarded through a small fee. This is called liquidity farming.
DEX
Decentralized Exchanges. Users come here to swap tokens or trade derivatives. The most well known DEX is dYdX, which allows users to trade crypto derivatives. Decentralized exchanges are less decentralized than AMMs because they offer off-chain ordering that is settled on-chain.
Trading is permissionless (decentralized), routed by smart contracts (decentralized) to a centralized order book (centralized) matching buyers and sellers. dYdX is very popular, earning some of the largest fees in the DeFi space. They are also transitioning their chain to their own blockchain to make the process 100% decentralized. Other protocols, like Serum built on Solana, have created centralized order books on-chain in a decentralized way.
Over-Collateralized Lending
If you own crypto, you can borrow money against it. You can do this with tokens or with stablecoins, to remove price volatility. Since this is permissionless and anonymous borrowing, lenders need to protect themselves from loan default. Protections are done through creating an “overcollateralized” loan-to-value ratio.
For example, a borrower needs to post more dollars as collateral than the amount received. The leading lending platform is Aave, which just launched an institutional product. Currently, there is $9B locked in Aave smart contracts being lent out across seven networks and thirteen markets.
Under-Collateralized Lending
The real non-crypto economy accelerates through the use of credit. Crack open a finance textbook, and you’ll remember that credit is the instrument that lets consumers borrow now and pay later. For DeFi to mimic the traditional financial world, under-collateralized lending will need to flourish. Right now, only a few protocols are attempting this. Maple Finance is the biggest protocol that operates as a lender of credit to crypto institutions. Goldfinch is a similar protocol targeting international fintech companies.
Not everyone can pool their money into these protocols or borrow from these protocols, which makes them not fully decentralized. There is not yet a full-proof way for lenders to manage risk of default without KYC-ing borrowers. The current model works whereby lead lenders take on more risk for loans and subordinate lenders follow their lead. The lead lenders get rewarded through a bigger portion of the interest payments but get slashed more in the scenario of a loan default.
One solution that’s been proposed is assigning every crypto wallet a credit score, which could be done anonymously. Expect a lot of innovation to be focused in this sector as DeFi continues to thrive.
Yield Aggregators
There are many ways to earn yield in DeFi. It could come through lending, liquidity farming, or a combination of both. Because lending and borrowing are done through smart contracts, protocols have been developed that create strategies to earn the highest yields for different tokens. Users can lock their tokens in these vaults to earn yield and the protocol takes control of rebalancing their funds and chasing the best strategies.
Yearn Finance is the most well-known of these protocols and is one of the most transparent names in crypto. They operate as a DAO, publish how they spend their fees, and buy back their token on the open market to reward Yearn (YFI) token holders.
Liquid Staking
Liquid staking is a new flourishing area of DeFi. Layer 1 protocols that sell blockspace require staking to operate; however, most users don’t understand how to stake their crypto and many layer 1’s require lockups for staking. Liquid staking protocols like Lido give users liquidity on their staked assets to use in other areas of DeFi.
On Lido, users can stake their ethereum which currently has an indefinite lock up (it will likely be ~6-8 months). Lido issues these users stEth, which they can then turn around and lend on Aave or deposit into a Yearn vault. This allows for greater flexibility, liquidity, and innovation to use a new asset as collateral in DeFi. At any given time after the Ethereum Merge, a user can convert their stEth back to ETH on the Lido website.
DeFi Summary
Decentralized finance is being built. Lending protocols, decentralized exchanges, and under-collateralized crypto lending are new products; we are just beginning to see their real applications.
Some key stats:
There are 7.7B people in the world and only about 300M own equities
About 50-250M people in the world own or use crypto depending on your definition
There are 4M all time users of Uniswap
There are 368k all time users of Aave
There are 58k all time users of Yearn
Sources:
Uniswap just did the same amount of daily trading volume as Coinbase
Blockspace: An Intro with Chris Dixon
Kyle Samani, on Panic with Friends Podcast on March 10th, 2022
➡️ About FirstWatch Crypto ⬅️
FirstWatch Crypto was started by Dan McGlinn (@DigitalDanMcG) and John "Blaize" Hrabrick (@blaizebitcoin) who have been investing in the space for a combined 8 years. FirstWatch Crypto is on a mission to simplify the crypto investment landscape.
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