‘The new frontier’: What are the true innovations in DeFi?

In the same way that AI is revolutionizing work and enhancing existing economic models, the $50 billion decentralized finance, or DeFi, industry democratizes financial products for internet users worldwide. However, the nascent nature of the DeFi space obscures the technology’s promise and the novelty it brings to the financial landscape. The path to mainstream adoption remains relatively uncharted as many DeFi primitives cater to crypto natives rather than solving the inherent problems that carry over from traditional finance.

By identifying the true innovations in DeFi and reflecting on significant milestones, this article presents a clearer picture of the industry’s progress. Readers will also learn what is required to unlock the future of DeFi and how protocols like DeVol deliver the features needed for the technology to reach its multitrillion-dollar potential.

The significance of blockchain technology for finance

Cumbersome processes and vulnerabilities have long plagued traditional financial institutions, which are operated solely by outdated infrastructure. International wire transfers through legacy banks still take two to five days, while standard securities transactions follow the conventional T-2 (trade date plus two days) settlement cycle. 

The advent of blockchain introduced the world to an efficient solution that significantly improves financial transactions. Blockchain networks provide a decentralized system connecting users worldwide to exchange value. Leveraging this system, institutions are exploring the tokenization of real-world assets such as private equity and real estate to make them instantly tradable for a global user base. For example, a new feeder fund offering tokenized exposure to a portion of a private credit fund from Hamilton Lane was recently launched on the Polygon blockchain, reducing the minimum investment from $2 million to $10,000. The World Economic Forum has estimated that 10% of global gross domestic product (GDP) will eventually be stored on blockchain technology by 2027. Beyond increased liquidity, such a globally-distributed network also delivers several new capabilities for the next generation of financial services.

First, blockchains utilize a single shared layer for storing transactional and ownership information. Bringing the network and record-keeping components on a single layer streamlines the process of trading and clearing financial products. DeFi protocols already tap into blockchain’s efficiency to offer atomic swaps – instant exchange of two assets on the condition that both are simultaneously transferred. This process lowers trading risks and decreases settlement times from days to seconds.

Another benefit enabled by blockchain-based financial applications is the disintermediation of middlemen. The adoption of smart contracts, which automatically execute even complex financial transactions when the predefined conditions are met, replaces intermediaries with middleware and gives greater control to the transacting parties.

The existing crop of DeFi protocols already leverages blockchain technology to enable permissionless finance for users. Several use cases have emerged across different verticals, providing viable alternatives to centralized financial products within and outside the crypto ecosystem.

What are the significant milestones in DeFi?

At the peak of the 2021 bull market, the total value locked (TVL) across the DeFi ecosystem totaled $170 billion based on data from DeFiLlama. The primary growth drivers included protocols serving nascent use cases, such as lending, prediction markets, and decentralized exchanges powered by automated market makers (AMMs).

The introduction of AMMs notably marked a turning point for DeFi adoption. First-generation protocols like Uniswap and Balancer delivered true innovation by replacing traditional market-making techniques with liquidity pools and deterministic pricing. Instead of a centralized market maker capturing bid and ask spreads, DeFi protocols rely on liquidity providers who earn a portion of trading fees.

The AMM-powered DeFi trading model provides other unique benefits. It supports the exchange of a broader spectrum of assets. Anyone can instantly create and provide liquidity for assets, removing the need to rely solely on centralized exchange listings. Users can also trade in a fully non-custodial fashion, instead of giving up ownership with a third-party exchange platform. 

Meanwhile, the inherently flawed nature of centralized finance (CeFi) institutions within and outside the crypto ecosystem further underlines the immense value that DeFi protocols bring to the table. While CeFi platforms are closed-source and expose users to huge counterparty risks, DeFi protocols function in a transparent and decentralized fashion. 

DeFi’s resilience amid the recent crypto winter instills public confidence in the emerging industry. More importantly, it provides a foundation for the industry to deliver the revolutionary features required to progress toward mainstream adoption.

The revolutionary features needed to unlock DeFi’s potential

Despite the significant strides made in the DeFi industry, several key niches remain relatively untapped. Options trading is one such area that, if unlocked, could vastly propel decentralized marketplaces and help DeFi reach its full potential.

Options trading enables investors to speculate on the future value of an asset by entering into a contract to buy or sell the asset at a specified price on a stated date. Options naturally provide leverage without liquidation risk and could provide remarkable stability to even inherently volatile assets like cryptocurrencies. 

Yet, the market for crypto options remains relatively under-tapped when compared with traditional markets such as equities. For instance, the average trading volume for crypto options is roughly at 2% of the overall spot trading volume based on data from DeVol.

Additionally, the digital asset options market is primarily dominated by centralized exchanges, even though spot-focused DEXes like Uniswap are already catching up with competitors such as Coinbase. The slow adoption of digital asset options comes from the complexities associated with derivatives products, and the limitations facing DeFi AMMs and option vaults.

The DeFi protocol DeVol (currently on Solana and bridging into Polygon) addresses the bottlenecks impeding the adoption of digital asset options by providing a comprehensive solution. DeVol leverages the benefits of liquidity pools with its innovative AMM model designed to provide best-in-class liquidity for traders and deep capital efficiency for liquidity providers. Liquidity takers are guaranteed a size for their trade, and pricing is deterministic. With a high number of strikes per expiration, all sharing liquidity from a single pool, liquidity is driven by the amount of capital in the pool rather than resting orders by market-making firms. Capital efficiency for liquidity providers (LPs) comes from the fact that unrealistic parts of the underlier price distribution are excluded.

The DeVol Protocol integrates fully on-chain price discovery for option contracts via a novel pricing methodology, eliminating the risks associated with off-chain settlement, and providing real-time price transparency based on supply and demand. The protocol’s unique AMM lowers the risk for LPs by addressing the negative selection and liquidity fragmentation issues that exist in prior generation digital asset options platforms. DeVol mutualizes risks and returns across LPs in a given pool, and they are protected via a sophisticated price impact function that reduces the risk of toxic flow from well-informed takers.  

Additionally, the DeVol protocol’s design takes a proactive approach to provide enhanced risk management with no trading counterparty risk. All option payoffs are fully collateralized and redeemable as long as the underlying smart contracts and blockchain operate as intended. 

Increased adoption of options trading across the DeFi ecosystem would significantly lower volatility and cascading liquidation scenarios for the cryptocurrency industry. DeVol is positioning itself to capture a sizable market share with its ecosystem of complete crypto options solutions that include advanced analytics, options trading, liquidity provisioning, and automated strategies. 

The future of DeFi 

The DeFi industry has witnessed significant growth in its first half-decade, buoyed by innovative solutions that address critical flaws in the legacy financial system. Nonetheless, the future remains promising, with higher gears yet to be found. 

The inevitable tokenization of real-world assets on the blockchain will drive increased institutional adoption. Further, improved regulatory clarity would legitimize the nascent space and facilitate the development of more financial products and services powered by blockchain-based protocols. 

At peak adoption, DeFi will deliver a globally integrated finance industry with interoperability across asset classes and aggregated liquidity. Digital asset options protocols like DeVol will help power such a future, and usher in more stable liquidity conditions, transparency, and efficiency within the DeFi economy.

This content is sponsored by DeVol.

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