Decentralized finance (DeFi) has quickly evolved from a niche concept to a booming industry with the potential to disrupt the global financial landscape. We’ve seen firsthand how DeFi is revolutionizing financial systems, particularly when it comes to real rates of return—a critical factor for institutional investors and high-net-worth individuals looking to preserve and grow their wealth in today’s challenging economic environment. Below, we’ll highlight DeFi’s previous growth phase, its dual nature of appeal in both risk-on and risk-off phases of the economic cycle, and its current place in the broader financial system.
Fundamental Concepts of DeFi and Its Disruptive Potential
At its core, DeFi leverages blockchain technology to create open, permissionless, and transparent financial ecosystems that are impossible on traditional rails that rely on centralized intermediaries. DeFi uses smart contracts and decentralized applications running on blockchains to facilitate a wide range of financial services. This paradigm shift not only eliminates intermediaries, reducing costs while increasing efficiency, but also democratizes access to sophisticated financial tools worldwide. Its disruptive potential is based on a set of important primitives1 which promote 24/7 market operations, rapid innovation loops, global accessibility, capital efficiency and reduction of counterparty risk in the traditional sense, allowing no one to change the system:
- Programmable money: Smart contracts allow complex financial operations to be executed automatically and without trust.
- Composability: DeFi protocols can be combined like “monetary Legos” to create new financial products that are composed of each other.
- Permissionless innovation: Anyone can build and deploy DeFi applications without gatekeepers.
- Transparency: All transactions and protocol operations are visible and easily traceable on-chain.
- Non-custodial operations: Users can maintain full control of their assets throughout financial transactions.
DeFi’s core principles of transparency, accessibility, and financial inclusion have attracted a growing number of investors and participants to the ecosystem. From a nascent idea with less than $1 billion in capital held within DeFi in early 2020, the total value locked (TVL) has surged to around $100 billion at the time of writing. Including leveraged strategies such as Liquid Staking, Pool 2 assets, and borrowing, the TVL jumps to $150 billion. While the market has experienced some volatility, the underlying trend remains robust, driven by continued innovation and growing adoption.
Wealth Creation Strategies on the Edge of an Easing Cycle
The appeal of DeFi lies at its core in its ability to offer attractive yield opportunities across different phases of economic cycles as well as previously unattainable real rate opportunities with superior yields. This remarkable duality positions DeFi as a versatile tool in wealth creation strategies, capable of generating value in both restrictive and expansionary monetary policy environments. It also creates a compelling case for institutional involvement in DeFi across all market conditions and offers a potential hedge against traditional market cycles while providing alpha generation opportunities that are increasingly rare in traditional finance.
In times of tight monetary policy, tokenizing real assets such as US Treasuries offers a new source of sustainable yield for blockchain citizens. In times of expansion, which markets are anticipating for Q4 2024, yield opportunities on blockchain historically outpace traditional opportunities, which in turn attracts institutional interest as opportunities dry up on the traditional front. Here, the composability of DeFi protocols enables the creation of intelligent yield strategies that can capitalize on expansionary conditions. In previous expansionary conditions, we observed increased liquidity in DeFi protocols that enabled larger institutional positions without significant slippage. At the same time, capital inflows during these periods fueled rapid innovation, in turn creating new yield-generating strategies and products. We expect these catalysts to materialize during the next easing cycle as well.
As the next round of monetary easing draws closer, traditional financial instruments have a reputation for failing to generate positive real returns, especially in the all-too-common zero interest rate environment we’ve seen over the past decade. In this context, DeFi has proven to offer attractive yield opportunities and has emerged as an attractive option for investors looking for alternative sources of yield.
Decentralized exchanges have also revolutionized asset trading, providing liquidity and price discovery without the need for centralized order books. Lending and borrowing protocols have created efficient markets for traditional cryptocurrencies and tokenized assets, often generating yields far in excess of those available in traditional financial markets. Meanwhile, peer-to-peer lending models also have the potential to increase financial inclusion by providing access to credit to underserved populations.
Some of the key DeFi strategies include:
- Lending and Borrowing: DeFi lending protocols allow users to earn interest by lending their assets or borrowing against their cryptocurrency holdings.
- Yield farming: This involves strategically moving assets between different protocols to maximize yields. Yield farmers often receive additional token rewards on top of interest, which significantly increases overall yields. Advanced users can amplify yields by leveraging assets to increase their yield farming positions.
- Liquidity provision: By providing liquidity to decentralized exchanges (DEXs), investors earn a share of trading fees. This can be especially lucrative for popular trading pairs.
- Staking: Participants can lock tokens to support network operations and earn staking rewards.
- Automated Yield Optimization: Protocols that automatically move user funds between different strategies to maximize returns.
- Automated Delta Hedging Trading Operations: Emerging protocols such as Superstate or Ethena offer market-neutral and structured “cash & carry” financial products that can be embedded in a stablecoin, a tokenized and dollar-pegged equivalent. These solutions are driving the fastest-growing DeFi sectors alongside tokenized Treasuries.
These strategies have historically offered attractive annual percentage yields (APYs), often ranging from 5% to 20% or more. Even accounting for the higher volatility and risk profile of the underlying strategies, these rates can translate into substantial real returns that can exceed those of traditional finance. As always, higher potential returns typically come with increased relative risk, while at the same time, these relatively nascent DeFi strategies currently tend to be less efficient than their mature traditional counterparts, resulting in high returns. While DeFi presents unprecedented opportunities for wealth creation, it is critical that high-net-worth individuals understand both the potential rewards and associated risks as they move from traditional risks such as counterparty risk to a new set of risks such as smart contract risk.
For seasoned market participants eager to explore the economic duality of DeFi, cycle-adaptive portfolio strategies that dynamically adjust to changing monetary conditions appear very attractive. Strategic approaches may further include cross-chain diversification, yield optimization, tokenization of proprietary assets, and sound on-chain risk management.
Tokenization Crosses the Chasm
As previously noted, the current tight monetary conditions have greatly accelerated the tokenization of off-chain assets due to increased on-chain demand. Tokenized assets can be used in DeFi protocols to create yield-bearing instruments that are particularly valuable during times of economic contraction. For example, tokenized U.S. Treasuries have gone from
Final thoughts
An overlooked aspect of DeFi: It has been battle-tested through many years of high volatility and includes the most profitable protocols in terms of fees. Aave never stopped facilitating lending, Uniswap never stopped trading during spikes in volatility, MakerDAO never stopped minting Dai, and Curve never stopped providing low slippage on stablecoins. The DeFi space recently handled $350 million in drawdown liquidations without blinking an eye.
It is increasingly evident that DeFi is not only a disruptive force relative to its financial peers, but a catalyst for wealth creation that offers attractive returns in varying economic conditions. As the DeFi sector matures, we anticipate increased institutional adoption, driven by greater regulatory clarity and the development of more sophisticated infrastructure. The lines between DeFi and traditional finance are set to blur further with the increased tokenization of real-world assets and the emergence of hybrid financial products that combine the best of both worlds. We expect DeFi strategies to play an increasingly important role in positioning more advanced investors.
Note
1 Primitives are new building blocks or fundamental concepts that can be used to build more complex and disruptive systems.
