Liquidity has been driving DeFi’s growth so far, so what’s the outlook for the future?

In mid-February 2020, the total value locked in decentralized finance (DeFi) applications surpassed $1 billion for the first time. Fueled by the DeFi summer of 2020, it would take less than a year for it to double twentyfold and reach $20 billion and just another ten months to reach $200 billion. Given the pace of growth so far, it doesn’t seem far-fetched to envision DeFi markets hitting $1 trillion within a year or two.

We can attribute this monumental growth to one thing – liquidity. In retrospect, the expansion of DeFi can be defined in three eras, each representing another significant development in removing liquidity barriers and increasing the attractiveness and efficiency of the markets for participants.

DeFi 1.0 – Solving the chicken and egg problem

DeFi protocols existed before 2020, but they suffered somewhat from a “chicken and egg problem” when it came to liquidity. In theory, someone could provide liquidity to a loan or swap pool. Still, there are insufficient incentives for liquidity providers until there is a critical mass of liquidity to attract dealers or borrowers who pay fees or interest.

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Compound was the first company to solve this problem in 2020 when it introduced the concept of farming protocol tokens. In addition to earning interest from borrowers, lenders on Compound could also earn COMP token rewards that provide incentive from the second they deposit their funds.

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It proved to be the starting point for the DeFi summer. SushiSwap’s “vampire attack” on Uniswap was another inspiration for the creators, who began using their own tokens to incentivize on-chain liquidity, kickstarting the yield farming craze in earnest.

Related: Liquid mining is booming – will it last or will it burst?

DeFi 2.0 – Improving Capital Efficiency

So that was DeFi 1.0, roughly the era that took us from $1 billion to $20 billion. DeFi 2.0, the period that saw further growth up to $200 billion, brought improvements in capital efficiency. It saw the growth of Curve, which Uniswap’s automated market maker model (AMM) for stable assets offers refined and more concentrated trading pairs with less slippage.

Curve also introduced innovations such as its vote-guarded tokenomic model, which encourages liquidity providers to lock up funds for the long-term to further increase liquidity reliability and reduce slippage.

Uniswap v3 also brought further improvements in capital efficiency with its customizable liquidity positions. Beyond Ethereum, the multichain DeFi ecosystem started to thrive on other platforms like BSC, Avalanche, Polygon, and others.

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So what will propel DeFi through the next stages of growth to reach $1 trillion and beyond? I believe there will be four key developments.

DEXs are going hybrid

The AMM model that has proven so successful in DeFi evolved out of necessity after it became apparent that Ethereum’s slow speeds and high fees would not serve the order book model well enough to survive on-chain.

Related: Automated market makers are dead

However, the existence of DeFi on low-cost, high-speed blockchains means that we are likely to see an increase in the number of decentralized exchanges (DEXs) using an order book model. Fast settlement times reduce slippage risk, while low to negligible fees make an order book exchange profitable for market makers.

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There are already several examples of decentralized exchanges using central limit order books – Serum based on Solana, Dexalot on Avalanche and Polkadex on Polkadot to name a few. The existence of order book exchanges should make it easier to onboard institutional and professional investors as they allow for limit orders and provide a more familiar trading experience.

Cross-chain composability

The proliferation of DeFi protocols on blockchains other than Ethereum has led to significant fragmentation of liquidity into different ecosystems. To some extent, developers have tried to overcome this with bridges between blockchains, but recent hacks like Solana’s Wormhole Bridge hack have raised concerns.

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Still, secure cross-chain composability becomes necessary to unleash the fragmented liquidity in DeFi and attract further investment. There are some positive signs – for example, Binance recently made a strategic investment in Symbiosis, a cross-chain liquidity protocol. Similarly, Thorchain, a cross-chain liquidity network that launched last year and has been rapidly increasing in value recently, implying a clear appetite for cross-chain liquidity.

Blockchain and DeFi are beginning to merge with financial markets

Now that crypto is becoming a recognized global financial asset, it is only a matter of time before the lines with blockchain and DeFi start to blur. This is likely to go in two directions. First, by bringing liquidity on-chain from the established global financial system, and second, by institutions deploying crypto-related decentralized finance products.

Several crypto projects have now launched institutional-grade products, and more are in the pipeline. A MetaMask institutional wallet already exists, while Aave and Alkemi operate Know Your Customer (KYC) pools for institutions.

On the other hand, Sam Bankman-Fried is waving the flag to chain the financial system. In March, speaking at the Futures Industry Association in Florida, he proposed that US regulators automate risk management in financial markets using practices developed for crypto markets. The tone of the FT article covering the story is revealing — far from the dismissive, even contemptuous, attitude the traditional financial press used to have towards crypto and blockchain, it is now rife with intrigue.

When DeFi hits the trillion dollar milestone is unclear. But those of us who are watching the current pace of growth, investment and innovation are fairly confident that we will achieve that goal sooner rather than later.

This article does not contain any investment advice or recommendation. Every investment and trading move involves risk and readers should do their own research when making a decision.

The views, thoughts, and opinions expressed herein are solely those of the author and do not necessarily reflect or represent the views and opinions of Cointelegraph.

Jimmy Yin is co-founder of iZUMi Finance. Before entering the world of DeFi, he was a researcher at the North American Blockchain Association and a community member of the World Economic Forum. His PhD was supervised by Max Shen at UC Berkeley and HK University. Jimmy tracks improving liquidity in both crypto and Geist.