The next phase of DeFi is here

The crypto market enters a new phase in 2024 with familiar optimism. After overcoming the turbulence of the past 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 particularly promising. With central banks signaling interest rate cuts, DeFi returns are becoming increasingly attractive as alternative forms of investment. Moreover, new ecosystems and a new generation of protocols introduce fresh financial primitives into the space.

However, to cross the chasm of widespread adoption, this phase of DeFi needs to be different from the previous one. What are the key pillars needed for the evolution of DeFi, and how do they manifest in this market? Let’s explore.

The first phase of the DeFi market was characterized by the introduction of highly incentivized ecosystems that created artificial, unsustainable returns across multiple ecosystems, but also laid the foundation for protocol innovations. The viability of incentive programs has often been challenged, but they have addressed the cold start problems in many ecosystems. Unfortunately, with changing market conditions, a significant portion of DeFi activity in these ecosystems declined, and returns fell to levels that were no longer attractive from a risk-return perspective.

Another notable aspect of DeFi v1 was the dominance of complex protocols that encompass a wide 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 function, and protocols like Aave include hundreds of risk parameters and enable very complex, monolithic functionalities. These large protocols often led to forks to enable similar functions in new ecosystems, leading to an explosion of protocol forks across Aave, Compound or Uniswap and various EVM ecosystems.

Meanwhile, security attacks have emerged as the main barrier to DeFi adoption. Most DeFi hacks are asymmetric events in which a large percentage of the TVL of protocols is lost. The combination of these hacks and the decline in native DeFi returns have contributed significantly to scaring off investors.

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

But can the next phase of DeFi match new market conditions and the technological innovation needed to achieve mainstream adoption?

For a second iteration of a technology trend to achieve a much greater level of adoption than its predecessor, either the market conditions must change, or the technology must evolve to captivate a new generation of customers. In the case of DeFi v2, we can break down 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. In a recent article I referred to this movement as “DeFi micro-primitives”. Protocols like Morpho Blue enable 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, which provide fresh canvases for new financial primitives in DeFi. Early innovators in these new ecosystems include protocols such as Renzo or EtherFi.

Institutional adoption in DeFi v1 was mainly driven by crypto companies. To develop this, DeFi v2 needs to supplement its key primitives with robust financial services that lower entry barriers for institutions. Risk management should likely become a native primitive in DeFi v2, enabling institutions to accurately model risk return in DeFi. This can 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 must be aggregated into higher-order structured protocols that provide the sophistication and robustness required by institutions. Services such as margin lending, insurance or credit are needed to unlock the next phase of DeFi for institutions. A DeFi vault offering returns 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 almost impossible without institutional primitives such as risk management and insurance. In their absence, brute force regulation may be the only option. From this perspective, building institutional-grade capabilities in DeFi v2 is not only about increasing adoption, but also about mitigating existential risks to the space.

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

The known secret in DeFi is that improved user experience is essential for user adoption. However, if we consider 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 needed to increase retail adoption.

Moreover, retail investors’ interactions with DeFi protocols should be abstracted by simpler primitives that do not require them to be DeFi experts. Imagine that, instead of interacting with a protocol like Aave or Compound, you could 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 requires 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 mainly driven by artificial financial incentives, DeFi v2 needs to be more utility-driven, organic and simpler to confirm its viability as a parallel financial system to traditional finance.