Decentralized finance, better known as DeFi, is a shadow of its former $178 billion self, with about $45 billion in total locked value (TLV) today. But after pruning a handful of deceptive projects – like Terra, whose founder is being sued by the SEC for fraud – the remaining $45 billion market looks considerably more mature and sustainable.
Let’s look at what’s next for the DeFi market and why you may want to count it down but definitely not out – in fact, its future may be brighter than ever.
#1. Real Yield Replaces APY
Most crypto traders have encountered DeFi platforms offering astronomical 100% or even 1,000% yields. Naturally, you might question whether these yields are too good to be true. (If not, consider reading our article on avoiding scams.) While some early projects offer temporarily high yields, others operate something closer to a Ponzi scheme.
Many scams involve projects distributing APY in a way that depletes its treasury – known as “dilutionary emissions.” The value of the project’s tokens diminishes thanks to the reduction in its treasury value. Therefore, while they may offer an attractive APY, it’s often not sustainable over the long term. And ultimately, someone will be left holding the bag.
You can think of this in terms of stock dividends:
Suppose a company has 1,000 outstanding shares valued at $100,000 or $100 per share. It currently pays a $5 annual cash dividend, resulting in a 5% dividend yield. This dividend costs the company $5,000 per year. If the company reinvests in growth initiatives and loses $1,000 a year, it must pay the $5,000 out of its treasury. And if these growth initiatives don’t pay off, then the stock will be worth at least $5,000 less, and future dividend cuts are likely.
“Real yield” can help determine if a project’s yield is sustainable. By comparing income to distributions, you can decide if a project’s APY is “real” and sustainable over the long run.
For example, suppose that an automated market maker (AMM) generates $10,000 in liquidity pool transaction fees. According to the project’s tokenomics, $7,500 goes to stakers in the reward pools, leaving a surplus of $2,500 for the treasury – creating a positive real yield.
After being burned by countless scams, DeFi investors increasingly seek real yields – even if they’re lower than the most hyped opportunities. Real yields may also be the key to attracting mainstream conventional investors.
#2. DeFi Buys Real-World Assets
Terra’s spectacular collapse has reduced the appetite for algorithmic stablecoins. Instead, many investors turn to stablecoins backed by real-world assets, such as Treasury bonds or other low-risk securities, rather than tokenomics.
The quality of these real-world assets has also been a hot issue. For example, until recently, Tether held most of its reserves in commercial paper – a notoriously illiquid market. If investors attempted to redeem a lot of Tether at once, it would have been tough to provide liquidity without selling commercial paper at fire sale prices and potentially going under. But after intense scrutiny, the project shifted the bulk of its reserves into Treasuries.
Similarly, MakerDAO made headlines in October 2022 with the purchase of $500 million worth of Treasury bonds – which it added $700 million to in June 2023, bringing its holdings to $1.2 billion. With Treasury yields on the rise, the move is designed to take advantage of the current yield environment and put its assets to work in a liquid and low-cost way.
High-quality, real-world assets can help stablecoins live up to their promise of stability – and, in today’s environment – increase yield for the platforms behind stablecoins (the yields typically get passed on to the stablecoin’s backers). Moreover, institutional investors may find these proven assets more palatable than algorithmic stablecoins, where it can be difficult to quantify risk.
In addition to higher quality real-world assets, DeFi protocols are proving their ownership of these assets through a combination of audits and proof-of-reserves mechanisms. While USDC leverages monthly audits to reassure investors, Coinbase recently awarded a proof-of-reserves grant to help develop a decentralized solution to reserves.
Ultimately, stablecoins capable of proving their ownership of real-world assets in real-time will likely become the bellwethers underlying the DeFi ecosystem until algorithmic stablecoins can prove they have an ultra-low-risk way to back their value.
#3. Institutions Begin to Take Notice
The $45 billion DeFi market is a minuscule portion of the $28 trillion global financial services market and the $109 trillion global stock market. While it operates on the cutting-edge of innovation, the world’s financial institutions are far better known for being risk-averse (most use software written in the 1960s) than cutting-edge.
That said, financial institutions are aware of what’s at stake.
The meteoric rise of startups like Stripe puts pressure on these institutions to innovate and provide a modern, streamlined, and user-friendly service to consumers and developers. And DeFi is widely seen as the next digital-native iteration of these financial services.
At the same time, institutional investors are interested in the DeFi ecosystem for a different reason. The relative inefficiency of the markets creates attractive yields and arbitrage opportunities that are difficult to come across in conventional financial markets. And many mainstream investors want to own yield-generating DeFi assets.
Several companies and projects aim to bring these institutions into the fold.
PrimeVault, a Y Combinator-backed startup, recently launched next-gen custody, trading, and risk infrastructure for institutional CeDeFi and enterprise digital asset operations. As an all-in-one asset management platform for managing digital tokens and assets across different chains, the platform could jumpstart institutional adoption by simplifying workflows.
Other startups help simplify institutional investments. For instance, Figment makes it easier for large investors to stake at scale with data, liquid options, developer tools, and other offerings. In fact, they account for about 5% of all staked ETH. It also provides insurance that offers protection against slashing incidents, helping reduce risk for institutional investors.
Ultimately, the rise of institutional investment and involvement in the DeFi space could help bring stability and mainstream investors and consumers into the fold.
Countertrends to Watch
The meteoric rise of DeFi in late 2021 prompted a swift regulatory backlash that continues to impact the industry to date.
At the market’s height in November 2021, the SEC issued a statement on DeFi risks, regulations, and opportunities, taking issue with the industry’s lack of transparency and pseudonymity. And more recently, the agency’s crypto chief warned that more charges were coming to crypto exchanges and DeFi protocols following actions against Coinbase and other crypto exchanges.
Meanwhile, the IRS could also impact the industry. Regulators have proposed several bills requiring DeFi projects to adhere to Anti Money Laundering (AML) and Know Your Customer (KYC) requirements. These include reporting suspicious transactions and even furnishing 1099s to customers and the IRS. The solutions to these problems could change the DeFi industry as we know it today.
The Bottom Line
DeFi remains a $45 billion market despite the high-profile failures of many popular projects, like Terra. But as we move into 2024, the DeFi market is showing more signs of maturity, which could help attract mainstream investors and institutions. In particular, safer yields, reliable stablecoins, and institutional investors could usher in a new era of stability.
If you engage in DeFi transactions, ZenLedger can help you organize everything for tax time. Our platform automatically aggregates transactions across wallets and exchanges, computes your capital gain or loss, and generates the tax forms you must file yearly.
This material has been prepared for informational purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.