One of the fastest developing components of blockchain technologies is decentralized finance, or DeFi, which has grown into a major trend that will reshape and complement the traditional financial ecosystem. DeFi is, broadly, a set of applications and protocols that replicate and advance established financial instruments like loans or derivatives. In the way that electronification of trading and structured products made leaps forward for traditional banking infrastructure, DeFi is working to improve, innovate and ultimately perfect some segments of blockchain network use cases.
DeFi can be thought of as a composition of decentralized applications that are deployed on a blockchain network. These networks are growing in number to meet specific, nuanced network shortcomings. Because the network layer is the foundation of the application layer, it is important to consider the economics and security of the network and think critically about how the application layers interface with it.
What is DeFi and how does it relate to the network it lives on?
As noted, there is a relationship between networks and their native applications. We can consider lending as an example of how network properties affect applications.
In an Ethereum-based lending application, the lender provides liquidity in the form of stablecoins in return for ETH, BTC or other tokens as collateral. Important in this process is the collateralization ratio. For example, a collateralization ratio of 150% implies that for every 150 dollars of ETH that is lent on the protocol, 100 dollars of stablecoin is received.
This is a clear attempt to adjust collateral to market volatility which may be affected by fundamental network properties. If a lender believes a fundamental shake-up with Ethereum could cause the ETH price to go down, they may wish to pull their loan to avoid liquidation. Likewise, fundamental upgrades that strengthen the network, and increase the price, may make a lending platform a safe place to park capital. Either way, the end result is the same, the borrower gets access to more liquid capital.
The lifeblood of DeFi is smart contracts, which enable the system to work free of a central figure while keeping track of every single transaction on the blockchain. Smart contracts process these loans, for example. Fundamental network aspects like the cost of contract deployment and transactions create friction and influence the way applications work.
But what does a fully functioning network with DeFi applications look like? How can you evaluate the maturity of a network and its applications? We identify five “stages” that can help with an evaluation: (1) fundamental network health, (2) capital markets (sales, token issuance), (3) fully operational decentralized applications, (4) oracles and derivatives (insurance, execution and DApps), and finally, (5) interoperability.
- Fundamental network health
Fundamental network health is the first stage of any DeFi ecosystem because it is the network on which DeFi, as a series of applications, lives. In all cases when you are evaluating networks, you may want to assess a network’s energy usage, network use, developer contribution growth, how many tokens are deployed on the network, the number of wallets, the velocity of the tokens, and many other factors.
You may ask yourself: “How are tokens mined and how are transactions validated on the network? What is the cost of this process? What is the total value locked (TVL) in DeFi protocols on the network (basically how much money is trusted on this network)?” In reality there are countless ways to assess network health, including inflation rates, mining activity, the rates of change in stakers and hashpower. Entire businesses and investment theses are built here. These core metrics point to activity on the chain, the likelihood of potential growth and whether it has the potential to scale up effectively.
- Capital markets
The second layer of a network is a stable capital markets component. People do not spend money to build apps on top of Bitcoin, but they spend hundreds of millions if not billions to develop on other blockchain networks. Simply put, a robust capital market for a network demonstrates that investors are willing to commit capital to the advancement of the network’s goals and growth. A network with strong capital markets, whether funded via crypto or fiat, means larger pools of liquidity that allow for additional token issuance and application development.
Efficient capital markets allows for funding to create and build out new protocols that can expand the ecosystem and bring in new innovative applications for use. Intelligent analysts will look to see how new tokens and protocols, funded via these markets, complement existing native infrastructure and go beyond to applications that are not strictly for networks themselves.
- Decentralized applications, realization of capital markets
The next level of maturity for a network is the build-out of decentralized applications (DApps), which is also the realization of a strong capital market. For example, a decentralized non-fungible tokens (NFT) exchange, or a token exchange are good kinds of DApps that require relative network stability to function optimally and liquidity to operate.
Specific examples of functional DApps are Regen Network, which tokenizes carbon credits and democratizes them as an instrument used as collateral for loans or also diversification in a basket of crypto assets, and Akash, which provides cloud computing solutions. It’s significant to note that not every application built on a network is a DeFi application but that DApps often tie into decentralized finance and econometric systems.
The number of well-developed and used DApps is a good sign of success for a network, particularly with the defi components of a network.
- Oracles and conditional execution
Oracles are special DApps whose purpose it is to serve data. Particularly curious readers may have asked themselves how the 150% collateralization ratio mentioned before is enforced or how the synthetic assets on Mirror are priced. The answer is oracles. Oracles may be serving data that is on-chain (an example of this would be an oracle that looks to see how many tokens are in a wallet) and might also source data from off-chain, like a New York Times article about who won the world series. Oracles are a cornerstone for DeFi because they are used to determine pricing, like indices in traditional finance, and other conditional functions, and are how many different contracts talk to one another.
Now what is a conditional function and who does it benefit? Consider insurance: a good example of a DApp that uses oracles and lending infrastructure. Insurance DApps, following a mutual model, take in pools of capital from users (who are essentially lenders) who are willing to earn income in the form of premiums paid by insurance counterparties. Consider an example that the insurance contract is for Coinbase being hacked in the next three months — an oracle is what determines if that event occurred and the payouts are made accordingly. This framework is similar to everything from sports betting to derivative contracts like calls and puts: simple collateral, reference and condition.
Interoperability is the current frontier of frontiers in network development and communication. It is at the heart of a decentralized ecosystem that allows for rapid communication, lending, trading and execution of smart contracts with public access for anyone regardless of blockchain. Interoperability allows for immense information flow, scalability and user-friendliness that will broaden adoption without inducing high fees. Blockchains will no longer be islands.
In the simplest form, interoperability allows for separate blockchains with differing consensus mechanisms, speeds and other properties to communicate with each other and exchange information and assets. Notably, this will enable any crypto to be traded across any chain in the ecosystem creating immense liquidity options and the ability to complete cross-chain transactions that will lead to new breakthroughs in the DeFi space. One clear example of benefit for this would be using an interoperability tool like a “bridge” to pull liquidity, lending collateral, or rates from other networks.
Interoperability will allow for transfer of value of one token to another generating an endless list of use-cases for crypto. A network and DeFi ecosystem with interoperability enabled suggests the highest current maturity of the decentralized web.
Where are we now and where are we headed?
The future of the internet and finance will be sums of networks and applications that allow for smoother transaction flow, fast settlement, efficient lending, and trusted systems.
Combined, these core verticals listed should help readers understand the stages of networks and how they relate to DeFi or help them assess where certain technologies are in development.