One Billion, Two Billion, Three Billion, Four? DeFi's Knocking on TradFi's Door

The Takeaway:

"In May 2018, Dharma hosted a meetup at the Polychain offices in San Francisco, called the 'Decentralized Finance Meetup,'" Dharma co-founder Brendan Forster told CoinDesk this month.

It included all the early companies – the Maker Foundation, Compound Labs, 0x, dYdX, Wyre – and he said roughly 150 people showed. Forster credited the gathering with a dawning realization at the time that DeFi startups were a distinct "cohort" within the industry.

Now in 2020, that cadre of DeFi upstarts has become the best justification for the persistence of the world's second-largest blockchain.

The name from that meetup – "decentralized finance" – stuck, because "decentralized" was more specific (and perhaps aspirational) than prior terms like "open finance" or "crypto-finance."

Its shorthand, "DeFi," had that double entendre with "defy." Disruptors gonna disrupt.

And so, that small group of startups would build through the last Crypto Winter, making DeFi the narrative driver of Vitalik Buterin's Ethereum protocol as it turns five years old.

From that Spring 2018 soiree, assets committed to DeFi broke $1 billion in February 2020, $2 billion on July 1 and $3 billion just 20 days later. At this pace, $4 billion is likely before August passes.

DeFi is an overnight success years in the making. 

"Bitcoin is the first DeFi, in my opinion," Kosala Hemachandra, CEO of MyEtherWallet (one of the very earliest wallet companies for Ethereum), told CoinDesk.

But Ash Egan of the venture firm Accomplice thinks it takes more features than Bitcoin has to get to DeFi. "I define DeFi as programmable, permissionless, transparent, trustless," he told CoinDesk in an interview.

Even then, Preston Byrne, an attorney who was an early entrepreneur in the sector and skeptical about some of its tentpole projects, also traces this history to a project that predates Ethereum. Dan Larimer's BitShares stablecoin, BITUSD, Byrne said, "It's the same thing" as what MakerDAO made to mint dai.

Indeed, when we spoke last year, Rune Christensen, the founder of MakerDAO, told CoinDesk that BitShares "in a way it was the first blockchain 2.0, Bitcoin 2.0," he said, a project that had "evolutionary potential." (Byrne saw it differently.)

Christensen was one of several key pioneers who actually started making his DeFi product prior to Ethereum's launch.

In fact, Buterin himself would pitch these coders on using Ethereum for their ideas.

That was the case with Joey Krug, the creator of the Augur betting app. He had been trying to make it work using Bitcoin scripts, but Buterin, who he met on a Skype chat, suggested he give Ethereum a try.

It took a masochist to build on early blockchains," Krug said, and yet "what we'd built on Bitcoin in six weeks took us about 36 hours on Ethereum."

And that's in part because Ethereum had been built with what we now categorize as DeFi applications in mind. 

In his original white paper, Buterin describes three categories of applications: financial, semi-financial and non-financial. He envisioned much of what we see playing out now: lending, derivatives and prediction markets, each of which represents several startups currently building on Ethereum.

Another prediction app, Gnosis, also began work on Bitcoin pre-Ethereum, but the founders met Ethereum co-founder Joe Lubin and became some of the first staff at his ConsenSys venture studio. To its credit, Gnosis ran the first bets on Ethereum a week after launch, a prediction market to guess what Augur's REP token would sell for.

By a few months after Ethereum's launch, there were already a lot of decentralized applications (dapps) that had "launched," many of them financial. There were projects like KYC Chain, already anticipating the problem of identity, and Otonomous, for chartering companies on a blockchain.

There were also companies in the less-reputable financial class, such as lotteries (Ethereum Jackpot), gambling apps (ESports EBets) and pyramid schemes (EthStick, The Greed Pit, Last Is Me!).

Ethereum actually made pyramids more trustworthy, Hemachandra said. Sure, they were all doomed to run out of new contributors, but one could also prove no one had absconded with contributions (which is how pyramids usually end). Perhaps that's why this kind of product has persisted.

Some ideas were good. Some were bad. Some were art. And some had potential if only they could find others to help them realize it. 

For Ryan Tate, a ConsenSys alum and current candidate for U.S. Congress in Washington state, Ethereum looked like a way to finance small businesses. For him, it started with a brewery.

He'd been living in Mexico and making beer in his garage, an English variety that was hard to find there. His brews were popular at garage scale, so he wanted to expand and open a real brewery. He even found a landlord who would take startup equity for rent, but he couldn't get the rest of his financing in place.

"I wanted something different, something for small businesses," Tate told CoinDesk in an interview. "Traditional bank lenders don't want to capitalize small businesses." Ethereum could.

He let go of the brewery and ended up in Seattle, but he hadn't let go of the idea of a different way of financing modest endeavors.

He didn't have computer-science training but he taught himself to code. In Ethereum he found something compelling. "Here's this smart-contracting language that's applicable to a lot more than what you can do with Bitcoin scripts," he said.

He built a prototype exchange on it, and that earned him an early berth at ConsenSys. But then The DAO would come along, promising to fund enterprises outside of the traditional banking and venture capital infrastructure.

"I was never a fan of The DAO. I didn't think it made any actual sense," Krug, now a chief investment officer at San Francisco-based Pantera Captial, said. "But the fact that you could do it was interesting."

The DAO was a complex thing that most people only remember now as a legal delusion. 

In short: It was a fund that people could contribute ETH to (ultimately, $150 million) and get back tokens. The idea had been that eventually developers would make proposals for funding for The DAO; token holders would vote on which to fund; and smart contracts would make sure the investors got paid back if their investments paid off. Probably it was going to do something with the Internet of Things.

But The DAO had security gaps, so cyber-criminals made off with $60 million of its ETH reserves in June 2016. This ultimately led to a hard fork that returned the stolen funds, one that forever laid to rest the notion that transactions on a blockchain are completely immutable.

On the world computer Vitalik said "fork" and the ETH-fam said, "How many tines?" 

Ethereum Classic persists as the unamended, and largely unloved, ledger.

The fork was too much for Tate.

"I actually decided to leave ConsenSys because I disagreed with their notion of reverting the blockchain. It seemed like this false narrative," Tate said.

But for MyEtherWallet's Hemachandra, The DAO ended an era of cavalier attitudes about smart contract security.

Dharma's Forster arrived on the scene shortly after the fork. "It sucks that what went down went down," he lamented. "It was basically venture capital but for everybody."

In that way, the token craze of 2017 was The DAO reborn, except hodlers just voted with their ETH, buying whatever token represented whichever initiative they liked (until the stock cops showed up). 

In a letter to Jamie Dimon on the Chain blog in October 2017, founder Adam Ludwin wrote, "Crypto assets are a new asset class that enable decentralized applications."

Ludwin's letter used Filecoin as his main example, though, because crypto-finance didn't really have mindshare then. "I think the Web3 narrative was just as popular if not more popular than financial-oriented tokens," said Accomplice's Egan, who spent that era within ConsenSys, which is now playing catchup on DeFi.

"Ethereum really did strike me as the next step of crypto. Bitcoin gave us money, but Ethereum gave us finance," Forster said.

In December 2017, as bitcoin hit all-time high after all-time high, MakerDAO debuted dai. In the middle of the craziest runup in crypto so far, it released a so-called "stablecoin," designed to roughly hold a peg with the U.S. dollar. People were skeptical.

This was key to DeFi becoming a thing. Anyone who goes down the crypto rabbit hole will quickly encounter the uses of money, one of which is "unit of account," that is, how does one measure what anything is worth?

"There are maybe 100 people in the world who use bitcoin or ether as the unit of account," Forster said. "The vast majority of people, and – still – crypto people, think in dollar terms."

The main use of crypto was and still is speculation. During the token boom, people wanted to trade to take advantage of swings in prices, but they also needed to lock in gains or staunch losses. A stablecoin was the most seamless solution. It would also prove to make lending and borrowing a lot more easily comprehensible.

Of course, at dai's debut tether (USDT) already existed, but people were wary. Dai suggested alternatives could work – alternatives that didn't rely on dubiously provable fiat reserves. When ETH prices fell but MakerDAO didn't fall apart, that was even more bullish. A new boom emerged from the ICO ashes: the stablecoin bonanza.

In late 2018, new stablecoins were debuting almost weekly. 

Amidst that rush, CoinDesk spoke to Jason Fang of Sora Ventures, who said, "The reason why we're seeing a lot more stablecoins is because our market went down 85% this year and having a widely used and trusted stablecoin would have saved us a lot of money."

But there was more than that. If some asset could be made to resist volatility with software alone, that was very seductive. 

"Once you have an asset that's got a stable value, then you can connect the real world," Compound founder Robert Leshner told CoinDesk in 2018. "You can program financial assets."

Byrne, a prominent crypto lawyer now, was one of the most vocal critics at the time, posting that "stablecoins are doomed to fail" in 2017.

There are arguably three kinds of stablecoins: algorithmic, collateralized and fiat-backed. Of the first, the presumptive Maserati, Basecoin (then Basis) just gave up without launching in December 2018.

Byrne thinks Basis just realized its plan had faulty assumptions. But he said, "They didn't give us the courtesy of explaining why they decided to shut down their scheme."

Terra arguably remains in this class, and just expanded its capacity. Ampleforth (née Fragments) remain as well.

MakerDAO's dai is collateralized, created via ETH-backed debt (with other assets like basic attention token (BAT) added later). Byrne said that dai "works really well when the price of everything is going up. It works very poorly when everything starts to go down."

Finally, fiat-backed: tokens that could be redeemed one-for-one for government notes. Tether pioneered this category but was tottering under the weight of demand in October 2018, as Circle, Gemini and Paxos debuted their alternatives.

"The fiat-based stablecoins I think are really the only ones worthy of the name, but they aren't really 'stablecoins.' They are 'dollar coins,'" Byrne said. Collateralized stablecoins make intuitive sense, but so did the gold standard.

For now, the market seems to have settled on USDC, the lovechild of Circle and Coinbase, for reliability; USDT for convenience; and MakerDAO's dai for decentralization. They all serve as a blockchain-antacid to cryptocurrency volatility, but as product guy Tony Sheng wrote in September 2018: "Their dreams are bigger: to compete with fiat currencies."

While everyone else was watching to see which stablecoin would unseat tether (none did), Leshner debuted Compound, the lending dapp.

He described it in September 2018 as a way to short tokens, that is, to make money as any of them lost value. That isn't the only use case, though, but few people thought of crypto as a place for borrowing and lending then. Despite the fact that MakerDAO minted dai with debt, few understood this at the time.

Compound's announcement came only a few months after the Dharma meetup in San Francisco. A similar meetup would take place at Devcon in Prague, and twice as many people would show, Forster said. Even competitors saw value in coming together to carve out this new way of thinking about crypto for everyone else.

Krug's betting protocol, Augur, had launched in July, and, with nothing but a $100,000 grant, the automated market maker (AMM) Uniswap would go live November 2018. In only months it would rival Bancor and its $153 million ICO.

The URL for DeFi Pulse was registered in December 2018 and the first Wayback Machine capture shows MakerDAO, Compound and Uniswap as the top three applications, with almost 90% of all the collateral locked on MakerDAO. Combined, they held a mere $317 million.

The market leader would experience sharp growing pains in 2019, with serious stress on the system. It would ultimately adjust, however, righting the ship and expanding its offerings. By year's end, it seemed to have found the opportunity in the chaos.

DeFi would grow as a steady drumbeat through 2019. Less morally dubious gaming would appear, such as a lottery in which players could only win (a little). Forster's Dharma would pivot to become an app that made saving easy.

"In terms of Gnosis, we continued to develop prediction markets," co-founder Stefan George told CoinDesk, "We also tried to go down the more regulated route. … This took a long time, so until today we still don't have a license."

In February of this year, DeFi Pulse, suddenly an indispensable data repository, would count $1 billion in collateralized assets on the various DeFi platforms.

"Number go up" etc., but these were still small stakes in a niche game.

The mononymous Vishakh is a co-founder of a consultancy and development shop called Cryptonomic, which helps corporations get on Ethereum.

Trained in computers, Vishakh found a career in hard finance. He was at Bear Stearns the day it all fell apart, so he saw no ambiguity in the message Satoshi hashed into Bitcoin's first block. 

Vishakh wanted a better, more transparent system, but he also wanted a path to challenge traditional finance (TradFi). There, he said, "You can have an accumulation of thousands and millions of peer-to-peer trades."

Vishakh and his partner tried to build something that could lead to mass scale, starting with one of the first ConsenSys hackathons in 2015, but in doing so he saw that Ethereum wasn't ready for hard finance. 

He and his partner wrote a post-mortem of their efforts in 2016, which he reviewed before we spoke this month and found his conclusions still hold: the software tooling is bad, and Ethereum lacks key features he thinks that it should have added by now, such as non-integer mathematics.

Krug made similar critiques, though on a smaller scale, and they both talked about Ethereum's throughput limitations. Even early on, Krug said, "People knew it would be slower than traditional finance, but I don't think anyone really foresaw it would be $10 to do a transaction."

(Transaction fees on Ethereum have recently soared. A victim of its own success, according to whom you ask.)

Technology, like art, might flourish under constraints. Founders had discovered in DeFi the low-transaction-count applications that could take advantage of Ethereum's network effects.

"There's money in it. It's not a failed experiment, but is it going to rival our financial frameworks? No," Tate said. 

He expects it will drive change at the Visas and Mastercards and commercial banks of the world, but, he said, "I don't really see Ethereum, whether its version 1 or version 2, I don't see it as the end-all."

The thesis that Ethereum is fundamentally limited seemed to be confirmed on March 12, 2020, Black Thursday, when the ETH price plummeted and many loans on MakerDAO went into default. Clever operators managed to scoop up more than $8 million in ETH for free. For the first time, MakerDAO had to consider triggering an emergency shutdown.

Once again, out of the chaos MakerDAO would come through and also expand the number of crypto markets in which it was a factor, but users of DeFi products were nevertheless shaken.

But crypto moves fast. 

Compound had already been teasing its decentralization process, and it would cook up the recipe that would pull this cohort out of its doldrums, one that had already been taste-tested when Synthetix debuted liquidity mining the prior summer, rewarding people for feeding its pool on Uniswap.

Compound, we would learn, planned to give users a token empowered with votes to change its rules, a "governance token," called COMP. Distribution began on June 15, engendering a boom now called "yield farming." Now $4 billion in total value locked (TVL) is within reach.

"It's really been the last like, in the last 18 months, things have come to fruition," Egan said.

Even DAOs are back.

And as base-layer rivals arise, the upstart blockchains all pitch their tech as a better host for this massive market than Ethereum's. That is, Ethereum's challengers are left to hope the sector doesn't grow too fast to leave. 

From the launch of dai in December 2017, it took 26 months for DeFi to lock up a billion dollars. The next billion took four months. It broke three billion on July 21 – six weeks.

"We are still at a very early stage and it can only grow from here," Hemachandra said, "Now we should talk about mass adoption."