History and Pre-context

The term DeFi, short for Decentralized Finance, was first coined in the summer of 2020, driven by the practical application of smart contracts to create decentralized financial services.

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The initial wave of DeFi applications originated from the 2017 ICO boom. These projects laid the groundwork for DeFi’s evolution, particularly in key sub-sectors:

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1. DEXs: Uniswap – Peer-to-peer cryptocurrency trading without the need for intermediaries.

2. Decentralized Lending/Borrowing: AAVE – A protocol enabling users to earn interest by lending and borrowing crypto assets.

3. Decentralized Stablecoins: Maker (now Sky) – A collateralized debt protocol for minting Stablecoins backed by crypto assets.

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The Rise of DeFi in  2020

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This influx of user-centric applications, combined with sudden interest rate cuts, favorable economic conditions during COVID-19, and a growing user base seeking yield-generating opportunities, converged to create a transformative shift within the crypto industry.

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In early 2020, DeFi protocols began adopting new strategies to attract users and liquidity. Many launched native tokens to encourage participation and enable decentralized governance. Compound led the way with COMP tokens, which kickstarted yield farming, allowing users to maximize returns by borrowing and lending assets.

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Other projects quickly followed. Yearn Finance optimized returns by switching between lending platforms, while SushiSwap drew liquidity from competitors through a “vampire attack,” incentivizing users with SUSHI tokens. A major milestone was Uniswap’s release of UNI tokens, distributed through a retrospective airdrop to reward and incentivize early users.

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DeFi’s growth was reflected in the Total Value Locked (TVL), which surged from $600 million to an astounding $20 billion by January 2021—a 30x growth in just 12 months, signaling the sector’s explosive expansion dubbed as DeFi Summer.

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Boom and Bust Cycle

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DeFi TVL dropped from $165 billion in early 2022 to under $40 billion by early 2023

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Throughout 2021 and into the first quarter of 2022, the DeFi sector experienced a surge in new projects, copycat platforms, and protocols offering astronomical yields (remember LUNA?). TVL peaked in December 2021 at around $178 billion, leading to an over-inflated market valuation, driven by unsustainable growth.

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However, as the macroeconomic environment shifted in early 2022 with rising interest rates and a “risk-off” sentiment, Bitcoin began to decline, and in hindsight, many overhyped projects fell even harder. The DeFi sector was no exception. The crypto bear market of 2022 saw asset prices drop sharply, TVL shrink significantly, and numerous projects fail as market conditions worsened.

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The End of DeFi? Not Even Close!

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Narratives often follow price movements and tend to overlook the foundational work and ongoing developments in the sector. It’s no surprise, given that DeFi has been driven by retail-based hype cycles. However, there are key indicators that reveal the true current state of DeFi. Let’s explore some of the fundamental factors that are shaping its progress:

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Let’s explore some of the fundamental factors that are shaping its progress:

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1. DeFi is still the top Consumer Application Sector of Blockchain Industry

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2. Evolving Use Cases: Expanding the DeFi Ecosystem

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The DeFi space continues to lead innovation, with the emergence of new categories that are transforming the landscape. The biggest difference between today’s DeFi scene and that of 2021 is the rise of entirely new application categories, such as:

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•CLOB DEXs and On Chain Derivatives : Decentralized exchanges using central limit order books for trading.

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•Liquid Restaking: Protocols that issue liquid tokens for Restaking.

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•RWAs (Real World Assets): Protocols involving the tokenization of real-world assets, like T-Bills.

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•Bridges: Protocols enabling tokens to move between different networks.

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•Basis Trading: Projects that profit from the price differences between spot and futures markets by simultaneously buying and selling crypto futures.

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Many other protocols , including the bluechips have upgraded their infrastructure to improve liquidity mechanics, enhance user experiences, and optimize performance.

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3. Widening the Scope: More Chains Embrace DeFi

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On the other hand, many new Layer 1 and Layer 2 solutions have shifted their focus to developing their own DeFi ecosystems. As of today, there are 315 blockchains, tracked by DeFiLlama, that host at least one DeFi-related application.

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Ethereum and its Layer 2 solutions continue to dominate the DeFi sector. However, other Layer 1 blockchains, such as Solana, have experienced significant growth in TVL (Total Value Locked) and dApps in the DeFi space from 2023 to the present.

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Alternative Layer 1s and Layer 2s have scaled significantly, providing DeFi with cheaper, faster, and more scalable block space. This is essential for transaction-heavy activities like Swapping, lending, and Derivatives trading, reducing fees and improving efficiency across the sector.

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4. Oracles and Bridges: Driving DeFi Interoperability

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Bridges facilitate the seamless transfer of assets between different blockchains, allowing users to engage with DeFi applications across various ecosystems more effectively. This cross-chain functionality not only boosts liquidity but also maximizes the utility of assets in DeFi.

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Oracles provide reliable, real-time price data across these chains, ensuring that decentralized applications (dApps) operate smoothly, even when dealing with assets from different networks. Accurate pricing is vital for maintaining stability in lending protocols, derivatives markets, and decentralized exchanges (DEXs).

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Greater interoperability in DeFi is leading to breaking down the barriers between blockchains, creating a more interconnected and efficient Decentralised financial system.

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5. Empowered Communities and Enhanced Governance

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Governance in DeFi has evolved with many platforms issuing tokens that grant holders voting rights, effectively decentralizing decision-making and fostering a sense of ownership within the ecosystem. This model underscores the sector’s shift toward user-centric protocols, where stakeholders play an active role in shaping the strategic direction of the platform.

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At the same time, Decentralized Autonomous Organizations (DAOs) have gained prominence as a governance framework, enabling transparent and decentralized control over protocol upgrades and key decisions. DAOs empower communities to directly influence project development, signaling a move toward more democratized governance in the DeFi space.

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Is DeFi Poised for a Major Comeback?

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Now, with a clear understanding of DeFi’s past trajectory and its current state, it’s time to explore why we can anticipate a resurgence in the sector in the mid-term. Despite the challenges DeFi has faced, such as market volatility, regulatory scrutiny, and shrinking TVL, the underlying infrastructure has matured significantly.

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1- Rate cycles:

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A potential catalyst for DeFi’s resurgence lies in the evolving U.S. monetary policy. We’ve recently crossed a critical economic inflection point, with the Federal Reserve initiating a 50 basis point rate cut during the September FOMC meeting, signaling the beginning of a new easing cycle. Historically, periods of monetary easing increase liquidity in financial markets, which is a key driver for asset inflows. As liquidity rises, more capital is likely to enter risk markets, including DeFi. Moreover, a reduction in the Fed funds rate will make DeFi’s yields more attractive in comparison to traditional, risk-free rates. As these conventional yields decrease, investors will naturally seek out alternative opportunities, potentially driving a market rotation towards DeFi, where Stablecoins and various yield-generating strategies now offer far more security and reliability than they did just a few years ago. This combination of increased liquidity and more appealing yields positions DeFi as a beneficiary of the current monetary environment.

2- Stablecoins is the Fuel of DeFi

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Stablecoins have become essential to the DeFi ecosystem, acting as both a store of value and a key source of liquidity. In recent years, stablecoin issuance has risen from $130 billion to nearly $180 billion, highlighting their growing importance. These stablecoin, are constantly seeking yield, and DeFi provides the ideal space for this.

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Various chains and platforms now compete by offering attractive yields to draw in Stablecoin holders. This not only generates returns for users but also boosts liquidity across DeFi. Stablecoins are especially important in trading, serving as a denominator asset in most crypto transactions on decentralized exchanges.

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3- Liquidity as a Lever in the DeFi Ecosystem

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Liquidity in DeFi acts as a powerful leverage mechanism. When Major assets are collateralized and used for lending, and as new users enter the ecosystem, on-chain lending increases. This drives lenders to seek more yield and incentives and borrowers to demand capital for building an exposure ( either for stablecoins or other Yield bearing assets ) which ultimately creating a positive feedback loop. As liquidity builds, it amplifies the leverage effect, impacting asset prices and market dynamics. A similar phenomenon occurred in 2021, where increased liquidity fueled rapid growth, influencing pricing across DeFi assets.

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On-Chain Trading: Catalysts for DeFi’s Next Growth Surge

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As the last point ,  key metric to watch is the DEX to CEX spot trade volume, which tracks the shift of trading activity from centralized exchanges (CEX) to decentralized exchanges (DEX). The long-term trend indicates that more volume is moving on-chain. This shift is driven by several factors: DEXs are becoming more capable, offering cheaper and faster swaps and trades, especially with the rise of Layer 2 solutions and alternative Layer 1s. Additionally, CLOB DEXes (Central Limit Order Book DEXes) are providing users with a centralized exchange-like experience, making them more user-friendly. Furthermore, many assets, particularly newer or more niche tokens like meme coins, are now being created and traded on-chain before making their way to centralized exchanges, underscoring the growing importance of DEXs in the ecosystem.

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‍FiCAS team is closely watching the evolving Web3 market and leverages expertise to identify the best investment opportunities at the right moments so you do not have to do that yourself.

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Disclaimer: This content is for educational and informational purposes only and does not constitute trading, legal, or investment advice. It is directed at our followers in Switzerland and may not represent the views of FiCAS. The author may hold assets mentioned in this article and assumes no obligation or responsibility for any actions taken based on the information provided.