Author: Jesus Rodriguez, Coindesk; Compiled by: Songxue, Golden Finance
The cryptocurrency market will enter a new stage in 2024, full of optimism. Having overcome the turbulence of the past 18 months, and supported by recent regulatory approvals, shifts in monetary policy and new Web3 innovations are paving the way for a new wave of crypto innovation.
The development of decentralized finance (DeFi) is particularly promising. As central banks signal interest rate cuts, DeFi yields are becoming increasingly attractive as an alternative form of investment. Additionally, new ecosystems and new generation protocols are bringing new financial primitives into the space.
However, in order to cross the mass adoption chasm, this phase of DeFi needs to be different from the previous phase. What are the key pillars needed for DeFi to grow? How do they manifest in this market? Let's explore it.
DeFi v1: Incentives, benefits, ensembles and hacks
The first phase of the DeFi market It is characterized by the launch of a highly incentivized ecosystem, which creates artificial and unsustainable benefits in each ecosystem, but also lays the foundation for protocol innovation. The viability of incentive programs is often challenged, but they solve the cold start problem in many ecosystems. Unfortunately, as market conditions change, a large portion of DeFi activity in these ecosystems decreases, with yields falling to levels that are no longer attractive from a risk-reward perspective.
Another noteworthy aspect of DeFi v1 is the dominance of complex protocols encompassing a wide range of functionality, leading to questions as to whether they should be called financial primitives. After all, a primitive is a function, and a protocol like Aave includes hundreds of risk parameters and supports a very complex overall functionality. These large protocols often result in forks to enable similar functionality in new ecosystems, leading to a proliferation of protocol forks in Aave, Compound, or Uniswap, as well as various EVM ecosystems.
At the same time,security attacks have become a major obstacle to DeFi adoption. Most DeFi hacks are asymmetric events where a large portion of a protocol’s TVL is lost. The combination of these hacks and the decline in native DeFi yields has greatly discouraged investors.
Despite these challenges, DeFi v1 has been a huge success. The ecosystem has successfully withstood extremely harsh market conditions, maintaining strong adoption levels and a vibrant community.
But can the next phase of DeFi adapt to new market conditions and the technological innovation needed to achieve mainstream adoption?
For the second iteration of a technology trend to achieve higher levels of adoption than its predecessor, either market conditions need to change or the technology must evolve to attract a new generation of customers. As far as DeFi v2 is concerned, we can divide its adoption milestones into three parts:
DeFi v2 for developers: More fine-grained and new primitives
For developers, this new phase of DeFi is influenced by Control of influential trends. Protocols are transitioning from monolithic structures to smaller, more fine-grained primitives. I called this movement “DeFi micro-primitives” in a recent article. Protocols like Morpho Blue enable loan atomic primitives to be composed into complex functionality.
In addition, DeFi v2 developers will benefit from the emergence of new unique ecosystems such as EigenLayer or Celestia/Manta, providing a new canvas for new financial primitives in DeFi. Early innovators in these new ecosystems include protocols such as Renzo or EtherFi.
DeFi v2 for institutions: risk management, structured products
The adoption of DeFi v1 by institutions is mainly Promoted by cryptocurrency companies. To achieve this, DeFi v2 must complement its key primitives with robust financial services to lower the barrier to entry for institutions. Arguably,risk management should become a native primitive of DeFi v2, allowing institutions to accurately model risk-return in DeFi. This may lead to more sophisticated risk management services.
The increasing granularity of DeFi v2 architecture also means greater challenges for institutional adoption. To solve this problem, micro-primitives need to be incorporated into higher-order structured protocols to provide the complexity and robustness required by institutions. Services such as margin lending, insurance, or credit are necessary for institutions to unlock the next phase of DeFi. DeFi vaults that offer yields across different protocols and combine risk management and lending or insurance mechanisms are an example of a structured product that fits an institutional framework.
Regulation remains the X factor for institutions adopting DeFi. However, without institutional primitives such as risk management and insurance, a thorough regulatory framework is almost impossible. Without them, strong regulation may be the only option. From this perspective, building institutional-grade capabilities in DeFi v2 is not only about increasing adoption, but also mitigating existential risks in the space.
DeFi v2 for retail investors: user experience and simpler services
Retail investors are influenced by DeFi Market turmoil affects those most severely. However, the emergence of new ecosystems has been steadily attracting retail investors back. Despite this trend, DeFi is still a cryptocurrency market. Working with DeFi protocols is still an unfamiliar concept to most retail investors, and the granularity of DeFi primitives makes it even more challenging.
The well-known secret in DeFi is that improving user experience is critical to user adoption. However, when thinking about user experience, we can be more ambitious than just simplifying interactions with DeFi protocols. The wallet experience has remained largely unchanged over the past five or six years. Wallet experiences that include DeFi as a core component are necessary to increase retail adoption.
Additionally, retail investors’ interactions with DeFi protocols should be abstracted through simpler primitives that do not require them to become DeFi experts. Imagine being able to request a loan with the appropriate level of collateral and protection mechanisms with just one click, without having to interact with protocols like Aave or Compound. User experience in DeFi is an obvious issue, but one that requires immediate attention.
Macroeconomic conditions and the current state of the cryptocurrency market are converging to propel DeFi into a new phase. DeFi v2 should incorporate more granular and composable financial primitives to allow developers to create new protocols that provide powerful financial services to institutions and provide a better user experience that removes barriers to adoption 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 financial system parallel to traditional finance.
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