The five DeFi categories to watch in 2022
“Software is eating the world. DeFi is the software that is starting to eat Wall Street,” reads a tweet from Tyler Winklevoss. Here is what type of decentralized finance applications you should keep an eye on.
Many of you will know Tyler Winklevoss as one of the two twins who fought Mark Zuckerberg in courtrooms over the idea for Facebook. What most people don’t know, is that the Winklevoss twins have been early bitcoin investors and founded the crypto-exchange Gemini. Today the brothers are among the wealthiest (they own about 7.2bn USD worth of crypto) and most powerful people in the crypto-sphere. Much of their success stems from DeFi, short for “decentralized finance.”
The Winklevoss were not alone in betting big on DeFi. The TVL (total value locked) in DeFi tokens stood at 189bn USD at the end of 2021. This marks a year-on-year increase of 767%. More than 60% of the value was locked on the Ether protocol. For more details on the split see DappRadar.
These impressive figures have to be taken with a grain of caution, though. First, because the TVL has been driven largely by Ether’s price surge. And second, in many papers and studies DeFi is equated with crypto, eventually considering every decentralized blockchain application as DeFi. It can be tricky indeed to tell those two apart, which is why I work with the definition of the The World Economic Forum. According to it, DeFi has four defining components:
Financial services or products: Real value, not just information, must be transferred through the protocol.
Trust-minimized operation and settlement: The blockchain must be permissionless (i.e. decentralized) and be equipped with smart contract capability.
Non-custodial design: The private keys are always with the account owner.
Programmable, open, and composable architecture: Each DeFi module must be open and interoperable with others.
Whether you are an investor or a finance professional on the lookout for the latest trends, telling DeFi apart from classic crypto applications is the first step to understand where the market is going. The second is knowing which type of applications to watch.
Before we get into the list, please note that I do not endorse any of the companies mentioned below. I describe them because they are prototypical of their categories and best illustrate the major characteristics of the application group. Many of them have been highly popular in 2020 and 2021, but this is no indicator for future success.
So here are the five application categories you should monitor in 2022:
1) Decentralized exchanges
Exchanges such as Coinbase or Gemini, where cryptocurrencies can be bought or sold, have been among the largest profiteers of the cryptocurrency age. They have reaped most rewards and enjoyed he highest corporate valuations. Coinbase even went public with a lot of fanfare. But those are all centralized institutions, run and managed by a team that is more or less liable for the company they own. In any case, people must lay their trust into them, which is exactly what crypto-enthusiasts have been fighting against since Bitcoin’s birth. Thanks to smart contracts and decentralized autonomous organizations (DAOs), automatic and non-custodial alternatives are possible. They are called decentralized exchanges, or short DEXs.
The most widely spread form of DEXs are automated market makers which get by without order books. Instead, asset holders dedicate assets for trading and thus earn yield from traders. An algorithm sets prices automatically according to supply and demand. Every time a token is bought, it gets removed from the liquidity pool, which triggers an automatic price adjustment. Hence, these matching engines replace traditional market makers. And brokers are cut altogether.
Uniswap is by far the best-known DEX. It is a typical automated market maker protocol built on Ethereum. The business model behind the protocol is that traders pay a fee which is then distributed to liquidity providers. Another prominent DEX is a fork of Uniswap called SushiSwap that allows larger participation of the community via a governance token.
2) Decentralized credit
Borrowing and lending is one of the first and still most important application modules of DeFi. In traditional lending the bank takes deposits from savers and lends them to credit seekers (while leveraging the ratio). The interest rates for savers are close to zero and in some countries even below that. On the other hand, unsecured lending borrowers pay up to twenty or thirty percent interest rates, in some countries even more. The difference is the bank’s margin. Thanks to DeFi credits, that margin goes directly to credit givers and seekers; the protocol operators take a comparably small fee. People are lending to each other without the need for a bank, either directly in a peer-to-peer fashion or by pooling the money.
A crucial DeFi innovation lies in the assessment of credit-worthiness. Banks check credit bureaus, income, past payment behavior, and a host of other variables to determine whether a customer is credit-worthy. They also determine the loan amount and the appropriate interest rate for the particular customer risk profile. Not so in DeFi. Most loans are over-collateralized and thus the risk-assessment becomes obsolete.
At Aave, one of the leaders of DeFi lending, customers don’t even have to go through a KYC (Know-Your-Customer) process in which they have to properly prove their identity. There is a KYC-enabled version (Aave Pro) but this will be primarily used when cooperating with financial institutions.
Though crypto-collateralized lending dominates this category, unsecured lending is also possible, especially thanks to a new financial instrument called flash loans. Assets are borrowed for interest and have to be paid back within the same block. If the borrower fails to do so, the transaction is automatically reversed.
3) Decentralized derivatives
Derivative DeFi applications step complexity up a notch. In its most basic form, a derivative is a token linked to another asset or group of assets. Those advanced financial instruments could be futures, options, or prediction markets. What links them, is that they all work with incentivized collateral pools. And just as with lending, DeFi derivatives are always over-collateralized to reduce the risk.
Highly interesting are DeFi applications that let users create synthetic assets. With Synthetix, for example, assets can be composed of crytpocurrencies, fiat currencies, stocks, or commodities. They are collateralized by tokens that are locked into smart contracts that also define the agreements and incentive mechanisms.
Prediction markets such as Augur are also increasing in popularity. With this DeFi application users can bet on economic events, sport matches, and things such as election results and the weather. Thanks to DeFi, you don’t need traders, clearing or futures commission merchants.
4) Decentralized insurance
Basically, every type of insurance can be operated on a decentralized network. Smart contracts enable the automatic and autonomous execution of insurance contracts. Yet DeFi insurance more narrowly has come to mean the protection of risks that are inherent in DeFi applications. Those might include a cover against software bugs, protocol hacks, or incentive system failures. Probably the most important covered risk is hacking. According to Rekt, the largest database on crypto hacks, 2021 saw 161 major attacks with almost two billion USD worth of assets stolen. For the five preceding years combined the figure stands at 700 million USD, showing the exploding relevance of DeFi insurance.
Technically speaking, insurance is also a form of a derivative as you are betting on a negative impact in the future. The difference is that the trigger for the insurance-payout depends on an oracle, which means some input from the off-chain world.
A prototypical DeFi insurer is Nexus Mutual. It enables you to buy cover against hacks from DeFi exchanges as well as smart contract bugs. The idea is that the insurer has a wide enough pool of premiums through which the insured risks can be spread.
5) Aggregator services
As I mentioned in the beginning, all DeFi applications share the key characteristic of interoperability. Like Lego bricks, DeFi modules can be combined with each other. This enables the rise of aggregation services. You can think of it as a kind of price comparison portal like Idealo that scans popular e-commerce retailers or flights to give you the best deals.
Most important in this category are DEX aggregators, as well as asset and yield management tools. DEX aggregators automatically and permanently scan all current DEXs to find the best exchange rates. Asset and yield management tools basically automatize what human asset managers do, namely build portfolios, keep a certain portfolio balance, invest your assets and so on. The consulting function of bankers and asset managers could be significantly threatened by DeFi algorithms. Popular DeFi aggregators are Zapper, Rotki, or Zerion.
Nobody can tell which particular DeFi application will come to dominate 2022. Nor whether the DeFi space will continue to hyperscale at its current pace. What is certain, is that we will see many hitherto unknown use cases. The five categories mentioned above will probably produce most of them, but it pays also to keep your eyes open to innovation that you can’t see at the horizon yet.