DeFi Guide
A map to find promising projects
Context
Decentralized Finance (DeFi) is a system of open-source financial legos. Problems just need to be solved once. With composability, smart developers build with the existing blocks. DeFi is about communities that work together. DAO to DAO partnerships is the way to grow.
It started with MakerDAO creating a stablecoin called DAI in 2017. In the second half of 2020, exponential growth took place and the sum of assets deposited in DeFi protocols (Total Value Locked -TVL) reached $100 billion in October 2021.
When compared with the hundreds of trillions from traditional finance (TradFi), it is easy to notice that this is just the beginning. DeFi’s potential goes beyond TradFi as it can be a tool for financial inclusion. There is latent demand from unbanked and consumers poorly served by current offerings.
In the figure below you can see the evolution of TVL and the time of launch of some important DeFi projects.
Source: elaborated by the author based on DeFi Pulse
It is worth noting that DeFi Protocols are already generating revenue. You can check the financial metrics from each protocol in Token Terminal.
Source: Messari
DeFi is the natural way for NFTs, Metaverses, DAOs, Gaming and the digital world. It is a matter of time to expand beyond that.
The revolution in finance comes with fintechs disrupting the frontend and DeFi the backend. This will make financial services cheaper, faster, more transparent and inclusive than TradFi.
With DeFi, you can trade tokens, save money, earn yield, grow your portfolio, borrow money, fund your ideas, buy insurance, manage your portfolio and use stablecoins.
DeFi Ecosystem Map
To explore this dynamic ecosystem, we need a map.
The idea of this map is not to cover all the DeFi protocols, but just to illustrate the different categories. Some protocols could fit in more than one category, but for the sake of simplicity, I considered the most relevant activity.
Source: elaborated by the author
Stablecoins: They provide the stability needed to access all the crypto financial services: exchanges, lending markets, derivatives, asset management and insurance. Check out my previous post on stablecoins here. DAI was launched in 2017 and it was the first decentralized stablecoin.
Trading: Decentralized exchanges enable the exchange of tokens without relying on centralized intermediaries. These platforms are non-custodial and open for anyone on the globe to use. Curve is specialized in stable assets and the others have a more general approach.
Lending: Users can lend their crypto assets or borrow against deposited collateral, without intermediaries. The first protocols, Compound and Aave, focused on variable interest rates, while a new generation of protocols such as Notional and Element are trying to develop fixed interest rates markets. Rari Capital is focusing on creating permissionless lending markets.
Derivatives: These platforms offer futures contracts, options, structured products, risk management products and other types of derivatives.
Insurance: These projects offer protection against smart contract vulnerabilities or price volatility.
Asset Management: Protocols enabling users to better manage their portfolios. Includes automated active strategies, yield aggregators and passive investing through indexes.
For the interface to interact with these projects, I like to use Zerion.
Promising Projects
In this section, I talk briefly about some projects that have promising prospects. To find rocket ships 🚀, I try to observe 3 key aspects:
🔥 Growth engine: the drivers that bring more users to the project and that create more value.
😍 People: code is essential, but people are the energy that keeps things moving. The core team and community are the pilots of this rocket ship.
🛡 Shields: the entry barriers that protect and differentiate the protocol from the competition. E.g. DAO2DAO partnerships, protocol reserves, risk management capability, substitution costs.
These aspects can change with time. Here are some projects that I believe have these properties:
Stablecoins - Fei Protocol:
Fei has the vision to be the stablecoin for DeFi and DAOs. It is the second most liquid decentralized stablecoin in Ethereum, just behind DAI. 1 FEI can always be redeemed by $1 because of the protocol-controlled value (PCV) that is worth more than $1 billion. Fei only holds decentralized assets, which increases its resilience and censorship resistance. With Fei Protocol v2, PCV will be managed more efficiently by using Balancer pools.
Growth engine: DeFi users looking for alternatives to centralized stablecoins (increasing regulatory pressure), DAOs treasuries wanting stablecoins for their operational expenses and DAOs wanting liquidity for their tokens (Liquidity-as-a-Service offering).
People: the core team was capable of attracting smart people to work for Fei Labs. Considering the recent hirings, we can expect an increased innovation and execution capacity in the following months.
Shields: With TRIBE buybacks and automated minting, TRIBE holders are the direct beneficiaries and risk bearers of PCV performance. A well-succeeded risk management mechanism builds trust and creates entry barriers. Also, a $1 billion PCV enables relevant partnerships and deep liquidity for FEI. Finally, integrations with other DeFi protocols, like Rari Capital and Ondo Finance, increase the value proposition of Fei for other DAOs.
Asset Management - Index Coop:
Index has the vision to be the Blackrock for crypto. The first product launched was DPI, an index that tracks the major DeFi protocols. Check out some interesting Index stats here.
Growth engine: new users to DeFi wanting a simple way to get crypto exposure, users wanting to leverage their positions in ETH and BTC, integration with fintechs and exchanges, DAOs treasuries diversifying their reserves, new products.
People: Index has one of the most vibrant communities. Its DAO is well structured around working groups and has shown the ability to innovate and continue to create successful products such as the ETH2x-FLI, to simplify access to ETH leverage, and the Metaverse Index.
Shields: The asset management business is based on trust and track record. Their products are well-known in the market. They have brand awareness and partnerships with relevant DeFi players such as DeFi Pulse.
Trading - Balancer:
A very flexible and innovative decentralized exchange with many types of pools available.
Growth engine: DAOs using the platform to manage reserves and build new products
People: It is a team with deep technical knowledge and is very innovative.
Shields: Partnerships with other projects like Aave, Element, Fei, Gyroscope, etc. This shows that Balancer is more than an exchange, it is an asset management platform that helps protocols and investors to manage their funds. The partnerships with DAOs tend to be more sustainable in the long term and the substitution costs for protocols are higher than typical users.
Lending - Rari Capital:
Fuse pools enable anyone to create their own lending market. It found a market fit with DAOs creating their pools where users can deposit their governance tokens and borrow money. In the future, it could also explore innovative ways to use NFT as collateral. NFTX already has its fuse pool for the governance token. Rari Capital also has yield aggregators that simplify the life of users just wanting to earn some yield.
Growth engine: DAOs creating pools, yield aggregators bringing more liquidity, new liquidity mining programs in fuse pools, new products.
People: A young and fast-moving team full of energy making a permissionless lending market
Shields: Partnerships with other DAOs, like Fei that help to bootstrap liquidity of Fuse pools. If your DAO creates a fuse pool and adds FEI on it, Fei Protocol can seed with FEI, helping to increase the liquidity of the pool. Yield aggregators can help to bring more liquidity to the pools and create entry barriers in this market.
Derivatives - Ondo Finance:
A starting project that offers vaults where part of the users can earn a fixed rate and the others a variable rate. The pooled funds for these 2 types of users are provided to decentralized exchanges and earn fees on that. After a specific duration, they withdraw this liquidity plus fees and pay the users. Together with Fei, they are offering a new way for protocols to bring liquidity to their tokens, doubling the liquidity provided. This is called Liquidity-as-a-Service (LaaS). Liquidity Mining attracts capital at a high cost, LaaS is a cheaper alternative. You can check out more info here.
Growth engine: DAOs hiring LaaS.
People: The team brings experience from the TradFi world.
Shields: They are already making interesting partnerships with other DAOs such as Fei.
As you can note from the examples above, I am very bullish on DAO partnerships, as it creates more sustainable advantages for the communities involved and offer a better service to users.
Future
I see four next steps for the growth of DeFi:
Use Layer-2s to reduce costs and enable financial inclusion, democratizing access to DeFi.
More integration with DAOs, NFTs, gaming, metaverses, crypto cities.
Partnership with Fintechs, like digital banks, Dharma, Venmo and others. They already have millions of users and the impact for DeFi can be exponential.
Better mobile experiences. If DeFi wants to reach the mainstream, it needs a pleasant UX for mobile. Mobile penetration is much higher than desktops.
I hope DeFi builders hold simplicity as a high value. Simpler products are easier to explain, maintain and compose with less risks.
I would love to know which DeFi projects you are bullish on.
P.S.: Thanks for the comments Sebastian Delgado and DioDionysos.
Please note that this letter is not intended as financial advice.