Messari: Amidst the market downturn, DeFi still sounds the horn of the "intangible revolution."

Author: Chase Devens, Messari

Original Title: 《DeFi's Invisible Revolution》

Compiled by: Hsilung, Chain Catcher

Abstract:

• Although the outlook seems bleak in the short term, the early successes of DeFi indicate that it will unleash the long-awaited disruptive potential of software in the world of finance.
• DeFi's "invisible revolution" will be characterized by several macro-industrial transformations, including socialized operating costs, embedded financial services, and market liquidity depth.
• The distributed nature of crypto will support users in limiting state power, while its real-time verifiability will provide the tools necessary for DeFi to comply with national regulatory policies.

Crypto has experienced a historic bull market over the past 24 months. Its beginning and end are marked by expectations for DeFi: to establish a global financial system accessible to anyone with the internet. In between, as market attention shifted to NFTs, Web3, and P2E, DeFi applications have been steadily growing. Despite market fluctuations, the supply of stablecoins has been growing in sync with the ratio of TVL. This ratio adjusts according to price and better represents the value of DeFi than TVL.

The recent Terra incident has brought DeFi back into the public eye: in just a few days, the network evaporated $28 billion. Just two years after the world discovered its programmable building blocks, DeFi found itself teetering on the brink, caught in a valley of disillusionment. The hopes for large-scale decentralized stablecoins were temporarily dashed. Scalability and interoperability solutions are still in early development stages and cannot support global crypto users. Additionally, regulations crafted by hawkish nation-states may soon be forthcoming.

Although the outlook seems bleak in the short term, it would be a mistake to think that expectations for DeFi will never be realized. In the brief and volatile history of crypto, its antifragility has made it stronger after each major adjustment. DeFi is no exception; the internet is destined to have a decentralized financial system that matches its distributed mode of dissemination.

Perceiving the "Invisible Revolution"

It has been nearly a decade since Marc Andreessen announced that software is eating the world. In a 2013 article, Andreessen pointed out that "there is still too much debate around financial valuations, rather than the potential value of the best new companies in Silicon Valley." Software is quietly transforming nearly every industry, but its full potential has yet to be appreciated by the masses.

The fintech frenzy of the 2000s and 2010s wrapped existing financial systems in a digital blanket, making glamorous improvements to the front end and attracting significant VC capital. Online banking and mobile payments became ubiquitous, while automated KYC processes gradually brought more people into the licensed value transfer track. However, 30 years after the software revolution, the back end of the financial industry remains a slow, bloated system characterized by days of settlement time, weekend downtime, high intermediary fees, and significant human intervention. These companies pretend that consumers' lives have been materially improved due to their "digital transformation" efforts. But this is merely an illusion aimed at prolonging their use of outdated technology stacks.

DeFi is an all-encompassing term that refers to the allocation of capital and value transfer on decentralized, cryptographically secure digital networks. It is a panacea that will unleash the long-awaited disruptive potential of software in global finance. The process of dismantling rotten infrastructure will be akin to replacing a car engine; its impact will not be visible to the naked eye and will not be appreciated by the world until the transformation is complete. To understand what will happen in the future, let us first explore the characteristics of DeFi's "invisible revolution."

Socialized Operating Costs

McKinsey estimates that the annual revenue of financial intermediaries (in 2019) was $5.5 trillion. From the perspective of an economy, this represents $5.5 trillion in operating costs. However, trustless blockchains do not concentrate all these cost sources in specialized financial service sectors; instead, they distribute the costs of creating and maintaining financial markets among network users.

Self-sovereign smart contracts are a killer innovation of DeFi, as they not only help redistribute these costs but also significantly reduce their impact on individuals and businesses. Protocols like Uniswap and Yearn demonstrate that complex financial behaviors can be simplified into straightforward automated processes, with costs amounting to only a fraction of the labor costs required by existing systems. Just as in manufacturing during the Industrial Revolution, humans cannot compete with machines (or code) on marginal costs.

Of course, this does not mean that the physical world will overnight migrate its infrastructure and business models to the permissionless track of crypto. However, when the fixed costs of implementing smart contracts (IT redesign, human capital, and time) and ongoing variable costs (fees, contract maintenance, and regulatory compliance) exceed the operating costs of continuously updating isolated IT systems, companies will gradually take action to adopt decentralized technology stacks in their choice chains.

Embedded Finance and D2C Financial Services

Matt Harris of Bain Capital describes fintech as the fourth platform shift of the internet. Specifically, he believes that financial services are no longer standalone businesses but products embedded within the business models they support. The open-source and composable nature of DeFi is the missing piece of the entire puzzle. It will support embedded finance to achieve global scale. Fintech companies will no longer focus on connecting isolated infrastructures—they will create reusable templates for businesses to access the native economy of the internet.

The shift to an embedded finance world will also change the relationship between every business and its customers. Just as the internet provided every company with a channel to communicate directly with its customers, DeFi will support companies in establishing D2C (direct-to-consumer) financial relationships on a large scale. Integrated payments, insurance, and lending will become hallmarks of the decentralized economy. NFTs will support receipts on-chain and serve as proof for discounts and cross-selling. As users build these on-chain histories, they will create the necessary foundation for open social graphs, which can be used for under-collateralized loans and credit networks. With conversion costs approaching zero, a thorough understanding of customers and proactive improvements will ultimately distinguish winners from losers.

DeFi Matrix

In the coming years, the number of on-chain assets will continue to grow exponentially. NFTs are positioned to "financialize all things digital," some countries may issue CBDCs in the next decade, and creators of Web 3 will begin to understand the power of social tokens.

The DeFi Matrix, created by Balaji Srinivasan, includes paired trades that exist across all crypto assets. In Srinivasan's words, billions of assets are traded against each other every second, providing varying amounts of liquidity for different order books and AMMs. Each cell in the matrix represents that asset's relationship to various available markets.

All financial markets can be simplified into submatrices that exist within the overall DeFi matrix. National stock markets could include tokenized stocks traded against government-backed CBDCs. The foreign exchange market will evolve into CBDC vs. CBDC, while the fiat/crypto market will continue to be crypto-native assets (BTC, ETH, etc.) vs. CBDCs or stablecoins.

The Sovereign Individual predicts that such a system based on a perpetually online market will renew commerce at its roots through barter. The liquidity of different assets will exist within a range and provide real-time information on the price stability of assets relative to one another. Furthermore, it will allow for effective capital allocation at a scale much smaller than the existing system. If this occurs, we may not need to solve the decentralized stablecoin problem, as complex hedging strategy matrices could be created in an almost infinite market. As the recent UST collapse has shown, liquidity is what matters to an economic system when the economy is in distress, not stability.

Zero-Knowledge (ZK) Privacy

Without considering privacy, enterprises will not use distributed ledger public ledgers. Zero-knowledge (ZK) technology will become a breakthrough feature that allows companies to use public ledgers while preserving sensitive data and information details. While general ZK rollups and ZK-based smart contract networks have been the focus of ZK development, work is progressing to connect existing enterprise backends directly to chains like Ethereum. In July 2021, EY open-sourced the code for Nightfall 3. By combining ZK proofs with optimistic rollups built on Polygon, Nightfall can support more complex business logic while protecting the privacy of transaction details. The development of ZK technology is still in its early stages, but as smart contract scalability, tokenization, and automated markets advance, it will soon become a key factor in merging our physical economy with the digital economy.

Regulatory Relationships

It is well known that nation-state regulations will govern the Wild West of cryptocurrency. While the timing and specifics of regulation remain unclear, we have already seen signs that the DeFi landscape will be divided into regulated whitelist markets and unlicensed black markets. Aave Arc was launched earlier this year to provide a permissioned pool where each user is verified and compliant with existing KYC and AML frameworks. As the crypto market matures, it is not surprising to see these permissioned instances integrated into leading protocols across various L1 ecosystems.

This will not lead to the disappearance of existing, trustless DeFi usage from the market. In the post-pandemic era, we understand the right to vote with our feet. As these financial tools become increasingly important in the coming years, if governments restrict users from utilizing these financial tools, both users and businesses may seek judicial freedom. Trustless DeFi is like a virus; governments around the world have proven unable to slow its spread. People will have the final say on whether to trade in a permissioned manner.

To prevent the world from descending into anarchy, some compromise is needed between regulation, oversight, and a completely free market. Fortunately, the openness and verifiability of crypto will provide individuals and businesses with the tools to facilitate that negotiation. Audits and risk assessments of DeFi will occur in real-time, while ZK proofs will enable businesses to demonstrate their compliance without disclosing information that gives them a competitive edge in the market.

The Call to Arms

As the crypto market is about to enter another short or long hibernation period, the community must keep in mind the long-term future we are building. The aforementioned predictions may take 10 or 20 years to fully realize. As the "invisible revolution" progresses, there will be many severe bumps along the road. However, Rome was not built in a day, and neither will DeFi be. When obstacles suddenly become insurmountable, giving up would be contrary to Satoshi's mission and our industry's goals.