Bitcoin was created to form a decentralized and purely digital alternative to traditional money. Money, however, is only the simplest instrument within the modern financial armamentarium.
Crypto has had futures and options for some time, but only recently has it started developing its own versions of some of the more sophisticated structures in the traditional financial ecosystem. The decentralized finance (DeFi) sector has seen astounding growth recently. In early 2019, there was only $275 million of crypto collateral locked in the DeFi economy. By February 2020, it was $1 billion, and it eventually hit $4 billion by late July before reaching $14 billion today.
The majority of DeFi applications currently run on the Ethereum blockchain; this has greatly negatively impacted the cost and speed of Ethereum transactions, but these problems have, in turn, stimulated a flurry of creative development regarding “layer 2” efficiency-oriented tools running on top of Ethereum, as well as alternative faster, cheaper, more scalable blockchains.
The ethos of the crypto and DeFi world has also recently leaked into the conventional finance arena, with the saga involving GameStop and WallStreetBets.
By this point, the question isn’t whether DeFi will become a major factor in the global economy, but rather how creatively it will be developed and to what extent it will emerge as a force for broad benefit.
One of the keys to guiding DeFi in a beneficial direction will be integrating advanced decentralized AI. So far, few DeFi projects have leveraged AI, but we may well see AI woven into the next burst of DeFi activity in 2021 — and maybe even in a way that enables DeFi to push startup decentralized tech projects forward much faster.
The first substantial DeFi project, MakerDAO, enables decentralized borrowing and lending of major cryptocurrencies. As of this writing, it currently holds 2% of all Ether inside its smart contracts and has issued over $77 million in debt.
Another more recent DeFi contender is Compound Finance, a more flexible staking and lending scheme, powered by an Andreessen-Horowitz-led $25 million funding round. The core mechanism behind Compound and many other current DeFi projects is “yield farming” — incentivizing token-holders for staking (locking up) their tokens in a way that allows tokens to be lent out via rewarding them with a special yield token.
2020 also saw the emergence of “Weird DeFi” in the form of food-themed “memecoins” like SushiSwap, BurgerSwap, BakerySwap, YAM and more. Of course, traditional finance has also seen its share of dubious schemes, though generally with less creative names.
One of the revolutionary aspects behind the scenes of modern DeFi is its “noncustodial” nature. Noncustodial smart contracts eliminate the intermediary from complex multiparty transactions, using code that temporarily locks certain tokens until certain conditions are met — without the tokens needing to move from their owner’s crypto wallet to somebody else’s. These contracts frequently rely on decentralized, noncustodial crypto exchanges like UniSwap, which are relatively new but steadily grabbing market share from centralized exchanges such as Binance, OkEx, Bittrex and so forth.
The fully automated nature of DeFi protocols enables financial instruments not seen in the traditional, centralized financial sector. According to a Rapid Protocol blog post: “One such example is ‘flash loans,’ a unique form of loan that must be taken out and paid back within a single transaction. These loans allow a user to borrow funds, convert or trade them across different platforms using algorithms of their choice, and then pay back the amount borrowed, all in moments.”
DeFi’s noncustodial aspect provides partial insulation from traditional financial regulations. But the European Commission plans to launch a comprehensive DeFi regulation scheme in 2022, which may provide some valuable legitimation to the sector while reducing the prevalence of pyramid schemes and such.
What, though, is the real importance of all this DeFi activity? Is it just about technical cool value, new toys for speculators to play with, and the provision of more sophisticated financial tools for those who prefer to keep their wealth outside the control of centralized authorities?
I think DeFi has the potential to be much more than this, but the key for it to achieve truly profound influence will be the extension of DeFi beyond Bitcoin and Ethereum to the broader scope of lower-liquidity cryptocurrencies (a.k.a. “altcoins”).
A significant percentage of the altcoins currently traded on crypto exchanges are utility tokens serving functions within innovative blockchain technology projects, across the gamut of vertical application domains. The market for these altcoins has risen and fallen a few times, but generally, it lacks the liquidity and sophistication of the markets for the top cryptocurrencies.
DeFi on lower-liquidity altcoins could provide the altcoin market with massively greater liquidity, decreasing the volatility and increasing the financing options for the associated technology projects. A healthier altcoin ecosystem would make the decentralized sphere far more attractive to early stage tech entrepreneurs, potentially shifting the global tech world away from centralized control and toward participatory democratic public-blockchain-based dynamics.
But lending, trading, prediction and market-making on lower liquidity altcoins is harder than doing these things for BTC and ETH, which is where AI must come to the rescue.
The SingularityDAO project, spinning off from the SingularityNET AI/blockchain platform I lead, aims to use DeFi tools together with neural-symbolic AI to foster liquidity, increase value and decrease volatility for lower-liquidity altcoins. SingularityDAO’s AI-DeFi mechanisms make it more beneficial and less risky to hold portfolios of utility tokens that individually have only modest liquidity.
Complementarily, Autonio, Loopring and others are using DeFi mechanisms to democratize market-making across the alt coin spectrum by allowing organizations running token-based projects to offer token rewards to market makers who provide liquidity for their tokens. Autonio is developing reinforcement learning-based market-making agents suitable for gradually increasing liquidity in lower-ranked tokens.
With just a little luck, 2021 may be the year DeFi begins shifting from food memecoins to AI-fueled systems designed to radically empower decentralized tech startups and those who hold their tokens.