The Next Phase of DeFi Is Here

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

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

However,
to
cross
the
chasm
of
widespread
adoption,
this
phase
of
DeFi
needs
to
differ
from
the
previous
one.
What
are
the
key
pillars
required
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,
unsustainable
yields
across
various
ecosystems,
but
also
laid
the
foundation
for
protocol
innovations.
The
viability
of
incentive
programs
was
often
challenged,
yet
they
addressed
the
cold
start
problems
in
many
ecosystems.
Regrettably,
with
changing
market
conditions,
a
significant
portion
of
DeFi
activity
in
these
ecosystems
dwindled,
and
the
yields
decayed
to
levels
that
were
no
longer
attractive
from
a
risk-return
perspective.

Read
more:



What
Is
DeFi?

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

Meanwhile,
security
attacks
emerged
as
the
main
barrier
to
DeFi
adoption.
Most
DeFi
hacks
are
asymmetrical
events
in
which
a
large
percentage
of
the
TVL
of
protocols
is
lost.
The
combination
of
these

hacks
and
the
decline
in
native
DeFi
yields
significantly
contributed
to
deterring
investors.

Despite
these
challenges,
DeFi
v1
was
a
tremendous
success.
The
ecosystem
managed
to
endure
incredibly
hostile
market
conditions,
maintaining
strong
levels
of
adoption
and
vibrant
communities.

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

For
a
second
iteration
of
a
technology
trend
to
achieve
a
much
larger
level
of
adoption
than
its
predecessor,
either
the
market
conditions
need
to
change,
or
the
technology
must
evolve
to
captivate
a
new
generation
of
customers.
In
the
case
of
DeFi
v2,
we
can
outline
its
adoption
milestones
into
three
buckets:

For
developers,
this
new
phase
of
DeFi
is
governed
by
impactful
trends.
Protocols
are
transitioning
from
monolithic
structures
to
smaller,
more
granular
primitives.
I
referred
to
this
movement
as
“DeFi
micro-primitives”
in
a

recent
article.
Protocols
like
Morpho
Blue
are
enabling

atomic
primitives
for
lending
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,
offering
fresh
canvases
for
new
financial
primitives
in
DeFi.
Early
innovators
in
these
new
ecosystems
include
protocols
like
Renzo
or
EtherFi.

Institutional
adoption
in
DeFi
v1
was
primarily
driven
by
crypto
companies.
For
this
to
evolve,
DeFi
v2
must
supplement
its
key
primitives
with
robust
financial
services
that
lower
entry
barriers
for
institutions.
Risk
management
should
arguably
become
a
native
primitive
in
DeFi
v2,
enabling
institutions
to
model
risk-returns
in
DeFi
accurately.
This
could
lead
to
more
sophisticated
risk
management
services.

The
increasing
granularity
of
DeFi
v2’s
architecture
also
implies
greater
adoption
challenges
for
institutions.
To
address
this,
micro-primitives
need
to
be
amalgamated
into
higher-order
structured
protocols
that
offer
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
yields
across
different
protocols
combined
with
risk
management
and
lending
or
insurance
mechanisms
is
an
example
of
a
structured
product
suitable
for
institutional
frameworks.

Regulation
remains
the
X
factor
in
institutional
DeFi
adoption.
However,
a
thoughtful
regulatory
framework
is
nearly
impossible
without
institutional
primitives
like
risk
management
and
insurance.
In
their
absence,
brute
force
regulation
might
be
the
only
option.
From
this
perspective,
building
institutional-grade
capabilities
in
DeFi
v2
is
not
just
about
increasing
adoption
but
also
about
mitigating
existential
risks
to
the
space.

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

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

Additionally,
retail
investors’
interactions
with
DeFi
protocols
should
be
abstracted
through
simpler
primitives
that
don’t
require
them
to
be
DeFi
experts.
Imagine,
instead
of
interacting
with
a
protocol
such
as
Aave
or
Compound,
being
able
to
request
a
loan
with
the
appropriate
level
of
collateral
and
protection
mechanisms
in
a
single
click.
User
experience
in
DeFi
is
an
obvious
problem
but
one
that
needs
immediate
attention.

Macroeconomic
conditions
and
the
current
state
of
the
crypto
market
are
converging
to
enable
a
new
phase
in
DeFi.
DeFi
v2
should
combine
more
granular
and
composable
financial
primitives
for
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
should
be
more
utility-driven,
organic,
and
simpler
to
validate
its
viability
as
a
parallel
financial
system
to
traditional
finance.