The next phase of DeFi is here

The cryptocurrency market is entering a new phase in 2024 with renowned optimism. Having overcome the turmoil of the past 18 months and supported by recent regulatory approvals, monetary policy changes and new Web3 innovations are paving the way for a new wave of crypto innovation.

Developments in decentralized finance (DeFi) are particularly promising. As central banks signal rate cuts, DeFi yields are becoming increasingly attractive as alternative forms of investment. Additionally, new ecosystems and a new generation of protocols are introducing new financial primitives into the space.

However, to cross the chasm to widespread adoption, this phase of DeFi must differ from the last. What are the key pillars necessary for the evolution of DeFi and how are they manifesting in this market? Let’s explore.

The first phase of the DeFi market was characterized by the launch of highly incentivized ecosystems that created artificial and unsustainable returns in various ecosystems, but also laid the foundation for protocol innovations. The viability of incentive programs has often been questioned, but they have solved cold start problems in many ecosystems. Unfortunately, as market conditions changed, a significant portion of DeFi activity in these ecosystems declined and returns fell to levels that were no longer attractive from a risk-return perspective.

Another notable aspect of DeFi v1 was the dominance of complex protocols encompassing a wide range of functionality, leading to questions about whether they should be called financial primitives. After all, a primitive is an atomic functionality, and protocols like Aave include hundreds of risk parameters and enable very complex monolithic functionality. These large protocols have often led to forks to enable similar functionality in new ecosystems, resulting in an explosion of protocol forks in Aave, Compound or Uniswap and various EVM ecosystems.

Meanwhile, security attacks have emerged as the biggest barrier to DeFi adoption. Most DeFi hacks are asymmetric events in which a significant percentage of the protocols’ TVL is lost. The combination of these hacks and the decline in native DeFi yields has largely contributed to deterring investors.

Despite these challenges, DeFi v1 has been a huge success. The ecosystem has managed to withstand incredibly hostile market conditions, maintaining strong adoption levels and vibrant communities.

But can the next phase of DeFi align with new market conditions and the technological innovation needed to achieve widespread adoption?

For a second iteration of a technology trend to reach a much higher level of adoption than its predecessor, either market conditions must change or the technology must evolve to captivate a new generation of customers. In the case of DeFi v2, we can describe its adoption stages in three categories:

1. Developers creating new DeFi protocols and applications

2. Retail Investors Access DeFi from Wallets and Exchanges

3. Institutional investors are using DeFi for more sophisticated use cases and scale.

For developers, this new phase of DeFi is governed by impactful trends. Protocols are moving from monolithic structures to smaller, more granular primitives. I called this movement “DeFi micro-primitives” in a recent article. Protocols like Morpho Blue allow atomic ready primitives that can be combined into sophisticated functionalities.

Additionally, DeFi v2 developers will benefit from the emergence of new and distinct ecosystems such as EigenLayer or Celestia/Manta, providing new canvases for new financial primitives in DeFi. Early innovators in these new ecosystems include protocols like Renzo or EtherFi.

Institutional adoption of DeFi v1 has been primarily driven by crypto companies. For this to scale, DeFi v2 must complement its key primitives with robust financial services that lower the barriers to entry for institutions. Risk management is arguably expected to become a native primitive in DeFi v2, allowing institutions to accurately model risk-returns in DeFi. This could lead to more sophisticated risk management services.

The increasing granularity of DeFi v2’s architecture also means greater adoption challenges for institutions. To solve this problem, micro-primitives must be merged into higher-order structured protocols that provide the sophistication and robustness required by institutions. Services such as margin lending, insurance or credit are necessary to unlock the next phase of DeFi for institutions. A DeFi vault offering returns on different protocols combined with risk management and lending or insurance mechanisms is an example of a structured product suitable for institutional settings.

Regulation remains the X factor in institutional adoption of DeFi. However, a thoughtful regulatory framework is almost impossible without primitive institutional principles like risk management and insurance. In their absence, regulation by force may be the only option. From this perspective, developing institutional-grade capabilities in DeFi v2 is not only about increasing adoption, but also about mitigating existential risks for the space.

Retail investors have been the demographic most affected by the turmoil in the DeFi markets. However, the emergence of new ecosystems is increasingly attracting individual investors. Despite this trend, DeFi remains a crypto-to-crypto market. Using DeFi protocols remains a foreign concept for most retail investors, and the granularity of DeFi primitives makes it even more difficult.

The well-known secret of DeFi is that an improved user experience is essential for user adoption. However, when it comes to user experience, we can be more ambitious than just simplifying interactions with DeFi protocols. The portfolio experience has remained largely unchanged over the past five to six years. A wallet experience integrating DeFi as a core component is necessary to increase retail adoption.

Additionally, retail investors’ interactions with DeFi protocols should be summarized through simpler primitives that do not require them to be DeFi experts. Imagine, instead of interacting with a protocol like Aave or Compound, being able to request a loan with the appropriate level of collateral and protection mechanisms with just one click. User experience in DeFi is an obvious issue but one that requires immediate attention.

Macroeconomic conditions and the current state of the crypto market are converging to enable a new phase in DeFi. DeFi v2 is expected to combine more granular and composable financial primitives allowing developers to create new protocols with the emergence of robust financial services for institutions and a better user experience that removes adoption barriers for retail investors. While the first phase of DeFi was primarily driven by artificial financial incentives, DeFi v2 is expected to be more utility-driven, organic, and simpler to validate its viability as a financial system parallel to traditional finance.

Edited by Benjamin Schiller.

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