The Next Phase of DeFi Is Here

The crypto market is entering a new phase in 2024 with renowned optimism. Having overcome the turmoil of the last 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 especially promising. With central banks signaling rate cuts, DeFi yields are becoming increasingly attractive as alternative investment forms. Additionally, new ecosystems and a new generation of protocols are introducing fresh financial primitives into the space.

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

DeFi v1: incentives, yields, monoliths and hacks

The first phase of the DeFi market was characterized by the launch of highly incentivized ecosystems that created artificial, unsustainable yields across various ecosystems, but also laid the foundation for protocol innovations. The viability of incentive programs was often challenged, yet they addressed the cold start problems in many ecosystems. Regrettably, with changing market conditions, a significant portion of DeFi activity in these ecosystems dwindled, and the yields decayed to levels that were no longer attractive from a risk-return perspective.

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

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

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

But can the next phase of DeFi align with new market conditions and the technological innovation required to achieve mainstream adoption?

For a second iteration of a technology trend to achieve a much larger level of adoption than its predecessor, either the market conditions need to change, or the technology must evolve to captivate a new generation of customers. In the case of DeFi v2, we can outline its adoption milestones into three buckets:

1. Developers building new DeFi protocols and apps

2. Retail investors accessing DeFi from wallets and exchanges

3. Institutional investors using DeFi for more sophisticated use cases and scale.

DeFi v2 for developers: more granular and new primitives

For developers, this new phase of DeFi is governed by impactful trends. Protocols are transitioning from monolithic structures to smaller, more granular primitives. I referred to this movement as “DeFi micro-primitives” in a recent article. Protocols like Morpho Blue are enabling 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, offering fresh canvases for new financial primitives in DeFi. Early innovators in these new ecosystems include protocols like Renzo or EtherFi.

DeFi v2 for institutions: risk management, structured products

Institutional adoption in DeFi v1 was primarily driven by crypto companies. For this to evolve, DeFi v2 must supplement its key primitives with robust financial services that lower entry barriers for institutions. Risk management should arguably become a native primitive in DeFi v2, enabling institutions to model risk-returns in DeFi accurately. This could 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 need to be amalgamated into higher-order structured protocols that offer the sophistication and robustness required by institutions. Services such as margin lending, insurance, or credit are necessary to unlock the next phase of DeFi for institutions. A DeFi vault offering yields 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 nearly impossible without institutional primitives like risk management and insurance. In their absence, brute force regulation might be the only option. From this perspective, building institutional-grade capabilities in DeFi v2 is not just about increasing adoption but also about mitigating existential risks to the space.

DeFi v2 for retail: UX and simpler services

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

The well-known secret in DeFi is that improved user experience is essential for user adoption. However, when considering 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 necessary to increase retail adoption.

Additionally, retail investors’ interactions with DeFi protocols should be abstracted through simpler primitives that don’t require them to be DeFi experts. Imagine, instead of interacting with a protocol such as Aave or Compound, being able to 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 needs 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 primarily driven by artificial financial incentives, DeFi v2 should be more utility-driven, organic, and simpler to validate its viability as a parallel financial system to traditional finance.