One Billion, Two Billion, Three Billion, Four? DeFi’s Knocking on TradFi’s Door
Jul 28, 2020
Projects like MakerDAO, Compound, dYdX and Dharma realized in 2018 they were a distinct group with shared interests within the cryptocurrency industry.
Finance has been part of Ethereum from the beginning, but the first attempt to do finance on the "world computer" ended in disaster in 2016: The DAO.
A unit of account was key to make decentralized finance (DeFi) startups usable, so when dai launched during the bitcoin run-up of late-2017 and didn't crash when ether fell, it was a positive signal for the space.
Within a year of dai’s launch, a full stablecoin boom was underway.
The third big moment for DeFi came this summer when liquidity mining took off on Compound. Some $3.6 billion in crypto is currently touching the industry's DeFi platforms.
“In May 2018, Dharma hosted a meetup at the Polychain offices in San Francisco, called the ‘Decentralized Finance Meetup,'” Dharma co-founder Brendan Forster told CoinDesk this month.
It included all the early companies – the Maker Foundation, Compound Labs, 0x, dYdX, Wyre – and he said roughly 150 people showed. Forster credited the gathering with a dawning realization at the time that DeFi startups were a distinct “cohort” within the industry.
Now in 2020, that cadre of DeFi upstarts has become the best justification for the persistence of the world’s second-largest blockchain.
The name from that meetup – “decentralized finance” – stuck, because “decentralized” was more specific (and perhaps aspirational) than prior terms like “open finance” or “crypto-finance.”
Its shorthand, “DeFi,” had that double entendre with “defy.” Disruptors gonna disrupt.
And so, that small group of startups would buildthrough the last Crypto Winter, making DeFithe narrative driver of Vitalik Buterin’s Ethereum protocol as it turns five years old.
From that Spring 2018 soiree, assets committed to DeFi broke $1 billion in February 2020, $2 billion on July 1 and $3 billion just 20 days later. At this pace, $4 billion is likely before August passes.
A light in the Vitalik
DeFi is an overnight success years in the making.
“Bitcoin is the first DeFi, in my opinion,” Kosala Hemachandra, CEO of MyEtherWallet (one of the very earliest wallet companies for Ethereum), told CoinDesk.
But Ash Egan of the venture firm Accomplice thinks it takes more features than Bitcoin has to get to DeFi. “I define DeFi as programmable, permissionless, transparent, trustless,” he told CoinDesk in an interview.
Even then, Preston Byrne, an attorney who was an early entrepreneur in the sector and skeptical about some of its tentpole projects, also traces this history to a project that predates Ethereum. Dan Larimer’s BitShares stablecoin, BITUSD, Byrne said, “It’s the same thing” as what MakerDAO made to mint dai.
Indeed, whenwe spoke last year, Rune Christensen, the founder of MakerDAO, told CoinDesk that BitShares “in a way it was the first blockchain 2.0, Bitcoin 2.0,” he said, a project that had “evolutionary potential.” (Byrne saw it differently.)
Christensen was one of several key pioneers who actually started making his DeFi product prior to Ethereum’s launch.
In fact, Buterin himself would pitch these coders on using Ethereum for their ideas.
That was the case with Joey Krug, the creator of the Augur betting app. He had been trying to make it work using Bitcoin scripts, but Buterin, who he met on a Skype chat, suggested he give Ethereum a try.
It took a masochist to build on early blockchains,” Krug said, and yet “what we’d built on Bitcoin in six weeks took us about 36 hours on Ethereum.”
And that’s in part because Ethereum had been built with what we now categorize as DeFi applications in mind.
In his original white paper, Buterin describes three categories of applications: financial, semi-financial and non-financial. He envisioned much of what we see playing out now: lending, derivatives and prediction markets, each of which represents several startups currently building on Ethereum.
Ethereum really did strike me as the next step of crypto. Bitcoin gave us money, but Ethereum gave us finance.
Another prediction app, Gnosis, also began work on Bitcoin pre-Ethereum, but the founders met Ethereum co-founder Joe Lubin and became some of the first staff at his ConsenSys venture studio. To its credit, Gnosis ran the first bets on Ethereum a week after launch, a prediction market to guess what Augur’s REP token would sell for.
By a few months after Ethereum’s launch, there were already a lot of decentralized applications (dapps) that had “launched,” many of them financial. There were projects like KYC Chain, already anticipating the problem of identity, and Otonomous, for chartering companies on a blockchain.
There were also companies in the less-reputable financial class, such as lotteries (Ethereum Jackpot), gambling apps (ESports EBets) and pyramid schemes (EthStick, The Greed Pit, Last Is Me!).
Ethereum actually made pyramids more trustworthy, Hemachandra said. Sure, they were all doomed to run out of new contributors, but one could also prove no one had absconded with contributions (which is how pyramids usually end). Perhaps that’s whythis kind of product haspersisted.
When 'The DAO' breaks
Some ideas were good. Some were bad. Some were art. And some had potential if only they could find others to help them realize it.
For Ryan Tate, a ConsenSys alum and current candidate for U.S. Congress in Washington state, Ethereum looked like a way to finance small businesses. For him, it started with a brewery.
He’d been living in Mexico and making beer in his garage, an English variety that was hard to find there. His brews were popular at garage scale, so he wanted to expand and open a real brewery. He even found a landlord who would take startup equity for rent, but he couldn’t get the rest of his financing in place.
“I wanted something different, something for small businesses,” Tate told CoinDesk in an interview. “Traditional bank lenders don’t want to capitalize small businesses.” Ethereum could.
He let go of the brewery and ended up in Seattle, but he hadn’t let go of the idea of a different way of financing modest endeavors.
He didn’t have computer-science training but he taught himself to code. In Ethereum he found something compelling. “Here’s this smart-contracting language that’s applicable to a lot more than what you can do with Bitcoin scripts,” he said.
He built a prototype exchange on it, and that earned him an early berth at ConsenSys. But then The DAO would come along, promising to fund enterprises outside of the traditional banking and venture capital infrastructure.
“I was never a fan of The DAO. I didn’t think it made any actual sense,” Krug, now a chief investment officer at San Francisco-based Pantera Captial, said. “But the fact that you could do it was interesting.”
The DAO was a complex thing that most people only remember now asa legal delusion.
In short: It was a fund that people could contribute ETH to (ultimately, $150 million) and get back tokens. The idea had been that eventually developers would make proposals for funding for The DAO; token holders would vote on which to fund; and smart contracts would make sure the investors got paid back if their investments paid off. Probably it wasgoing to do something with the Internet of Things.
But The DAOhad security gaps, so cyber-criminals made off with $60 million of its ETH reserves in June 2016. This ultimatelyled to a hard fork that returned the stolen funds, one that forever laid to rest the notion that transactions on a blockchain are completely immutable.
On the world computer Vitalik said “fork” and the ETH-fam said, “How many tines?”
Ethereum Classic persists as the unamended, and largely unloved, ledger.
The fork was too much for Tate.
“I actually decided to leave ConsenSys because I disagreed with their notion of reverting the blockchain. It seemed like this false narrative,” Tate said.
But for MyEtherWallet’s Hemachandra, The DAO ended an era of cavalier attitudes about smart contract security.
Dharma’s Forster arrived on the scene shortly after the fork. “It sucks that what went down went down,” he lamented. “It was basically venture capital but for everybody.”
In that way,the token craze of 2017 was The DAO reborn, except hodlers just voted with their ETH, buying whatever token represented whichever initiative they liked (untilthe stock cops showed up).
In a letter to Jamie Dimon on the Chain blog in October 2017, founder Adam Ludwin wrote, “Crypto assets are a new asset class that enable decentralized applications.”
Ludwin’s letter usedFilecoin as his main example, though, because crypto-finance didn’t really have mindshare then. “I think the Web3 narrative was just as popular if not more popular than financial-oriented tokens,” said Accomplice’s Egan, who spent that era within ConsenSys, which is now playing catchup on DeFi.
“Ethereum really did strike me as the next step of crypto. Bitcoin gave us money, but Ethereum gave us finance,” Forster said.
Like a dai peg in the sky
In December 2017, as bitcoin hit all-time high after all-time high, MakerDAO debuted dai. In the middle of the craziest runup in crypto so far, it releaseda so-called “stablecoin,” designed to roughly hold a peg with the U.S. dollar. People were skeptical.
This was key to DeFi becoming a thing. Anyone who goes down the crypto rabbit hole will quickly encounter the uses of money, one of which is “unit of account,” that is, how does one measure what anything is worth?
“There are maybe 100 people in the world who use bitcoin or ether as the unit of account,” Forster said. “The vast majority of people, and – still – crypto people, think in dollar terms.”
The main use of crypto was and still is speculation. During the token boom, people wanted to trade to take advantage of swings in prices, but they also needed to lock in gains or staunch losses. A stablecoin was the most seamless solution. It would also prove to make lending and borrowing a lot more easily comprehensible.
Once you have an asset that's got a stable value, then you can connect the real world. You can program financial assets.
Of course, at dai’s debut tether (USDT) already existed, but people were wary. Dai suggested alternatives could work – alternatives that didn’t rely on dubiously provable fiat reserves. When ETH prices fell but MakerDAO didn’t fall apart, that was even more bullish. A new boom emerged from the ICO ashes: the stablecoin bonanza.
The cryptocurrency's new clothes
In late 2018, new stablecoins were debuting almost weekly.
Amidst that rush, CoinDesk spoke to Jason Fang of Sora Ventures, who said, “The reason why we’re seeing a lot more stablecoins is because our market went down 85% this year and having a widely used and trusted stablecoin would have saved us a lot of money.”
But there was more than that. If some asset could be made to resist volatility with software alone, that was very seductive.
“Once you have an asset that’s got a stable value, then you can connect the real world,” Compound founder Robert Leshner told CoinDesk in 2018. “You can program financial assets.”
There are arguably three kinds of stablecoins: algorithmic, collateralized and fiat-backed. Of the first, the presumptive Maserati,Basecoin (then Basis) justgave up without launching in December 2018.
Byrne thinks Basis just realized its plan had faulty assumptions. But he said, “They didn’t give us the courtesy of explaining why they decided to shut down their scheme.”
Terra arguably remains in this class, and just expandedits capacity. Ampleforth (née Fragments) remain as well.
MakerDAO’s dai is collateralized, created via ETH-backed debt (with other assets like basic attention token (BAT) added later). Byrne said that dai “works really well when the price of everything is going up. It works very poorly when everything starts to go down.”
Finally, fiat-backed: tokens that could be redeemed one-for-one for government notes. Tether pioneered this category but was