Decentralized Finance: The Road Ahead

Feb 4, 2022

By Prof. Fabian Schär

Decentralized Finance (DeFi) is one of the hottest topics of 2021. DeFi refers to a blockchain-based ecosystem that employs smart contracts to create financial protocols in an open, transparent, composable and mostly non-custodial way (Schär 2021). The amount and speed of innovation in the DeFi space is exciting and the possibilities are seemingly limitless. Pretty much any metric that tracks DeFi growth has skyrocketed. DeFi has been the cover story of a recent issue of The Economist and as a result traditional financial intermediaries have started to pay attention.

However, this short article is not about the current state of DeFi, nor is it a general introduction. Instead, I will look ahead and try to anticipate what is yet to come, i.e., the DeFi-related topics that have a high probability of becoming important in the next year or and beyond. As an academic I feel obliged to add a disclaimer and state the obvious: This is not a scientific article. There is no sophisticated methodology underlying these statements and this is certainly not investment advice. The topics I am going to discuss reflect my observations and are based on my personal expectations

Regulation

DeFi regulation is something that is being fiercely debated in the blockchain community and reveals that the understanding of what DeFi actually is differs significantly, depending on who you ask. This leads to a situation, where the label “DeFi” is used in a somewhat liberal fashion, including projects that make use of heavily centralized aspects, have external dependencies and special privileges. I expect policy makers and regulators to step in and crack down on solutions that play “decentralization theater.”

Regulation will likely split the DeFi space in two separate categories. On the one hand, there will be protocols that are completely decentralized. These protocols neither can, nor should be regulated. On the other hand, there will be protocols that are somewhat centralized. For these protocols, I expect a move towards regulatory compliance. If they fail to do so, they will be shut down — something that can easily be done, if the protocol is not truly decentralized. As a result, any protocol that currently is in the grey area will most likely have to pick a side and act accordingly.

Institutional Interest

There are several examples of financial intermediaries which are trying to engage with DeFi protocols. What may seem counterintuitive at first does actually make perfect sense. DeFi offers consumers a choice. They can choose to engage with the protocols directly. This option is very positive. However, it would be naïve to assume that everyone would choose to exercise this option and decide to manage everything themselves. Many people would rather pay someone to do this for them. As such, there is a place for financial intermediaries, even if we assume that our base infrastructure will become completely decentralized.

Accordingly, I expect that financial intermediaries will start to explore how they can offer products and services on top of DeFi, and engage with some of these protocols. This exploration may be boosted by an increase in regulatory certainty around the topic, and the fact that some DeFi developers plan to create separate versions of their protocols, exclusively for financial intermediaries. Now, whether this is something that makes sense and if restricted protocols should still be called “DeFi” is up for debate, but putting any ideological discussions aside; from today’s perspective, it seems like something that has a relatively high probability of happening.

Governance

Most DeFi protocols (or more generally speaking any Decentralized Autonomous Organization — DAO) need some flexibility to remain upgradable or to change parameters in the contract. Governance systems define how these changes can be proposed, locked-in and executed. This is usually done through a voting mechanism.

DeFi protocols face the issue that they cannot rely on identities. Instead, voting is usually done through governance tokens. If the governance token allocation is relatively concentrated, this can be an issue. In Nadler and Schär (2021) we have proposed an algorithm that allows us to unwrap complex on-chain ownership structures and assign governance tokens to the beneficiary address. We have shown that the token distribution differs significantly across various protocols, but in some cases is highly concentrated.

DAO and DeFi governance will likely be an important topic in 2022. Regulatory pressure may accelerate discussions around this topic and we may see new proposals that are built on a mix of token voting, elected representatives and on-chain identities.

Maximal/Miner Extractable Value (MEV)

When people who are new to the space talk about DeFi, they usually worry about hacks. While hacks certainly are something one should keep an eye on, there is one topic that will likely become more important in 2022, i.e., Maximal Extractable Value or MEV.

The term refers to a relatively broad action set that allows the block proposing entity to extract rent, when successfully assembling a block. Attacks include but are not limited to the act of copying and swapping out profitable arbitrage transactions, sandwich attacks, and the provision of highly concentrated (just in time) liquidity on sophisticated constant function market makers with custom liquidity density functions.

I expect this topic to take center stage and hope that we will see proposals of how the network can respond to these issues.

Scalability and Layer 2

The race to Layer 2 will continue in 2022. Various scaling solutions will get more traction and we will see an increasing amount of transactions that are being executed through roll-ups.

The effect on transaction fees cannot be predicted. On the one hand, the increasing popularity of Layer 2 solutions may reduce the burden on the base layer. On the other hand, Layer 2 may further increase the overall popularity of the system and thereby even increase demand for space on the base layer.

What will be interesting to observe is, how centralized exchanges will respond to the Layer 2 trend. In particular, direct on- and off-ramps may not only foster the popularity of Layer 2, but also minimize the burden of these solutions on the base layer. Similarly, we will likely see further advancements on the Ethereum roadmap and with the various initiatives that try to increase cross-chain interoperability.

Conclusion

All of this being said, there will be many surprises along the way. What is true for most things in life also counts for the blockchain space: Expect the unexpected.

Yes, there are some DeFi topics that seem to be obvious candidates to enter center stage in 2022. But there will always be topics that seemingly came out of nowhere and will have a lasting impact on the space.

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