Liquidity drove DeFi growth — what’s next?
The DeFi Summer 2020 was driven by on-chain liquidity. Earlier that year, in February, the total value locked (TVL) in decentralize finance (DeFi) exceeded $1 billion for the first time, and in less than 22 months it had grown to exceed $200 billion.
The prime reason for this stellar growth was liquidity. A DeFi liquidity pool is a smart contract that locks tokens to ensure liquidity for those tokens on a decentralized exchange. Users who provide tokens to the smart contract are called liquidity providers.
DeFi has gone through three different periods of development, each representing another significant development in removing barriers to liquidity and making the markets more attractive and efficient to participants.
In the era of DeFi 1.0, someone could provide liquidity to a lending pool, but there weren’t enough incentives for liquidity providers. Liquidity needed to reach a critical mass to attract traders or borrowers who will pay fees or interest. Compound was the first protocol to solve this issue with its concept of farming protocol tokens. In addition to interest from borrowers, lenders on Compound could also earn COMP token rewards, and that was the incentive needed to give DeFi a big push in Summer 2020.
DeFi 2.0 brought improvements in capital efficiency, and the rise of Curve and Uniswap. Uniswap v3 also brought further improvements in capital efficiency with its customizable liquidity positions, and we also saw the emergence of multichain DeFi ecosystem that used other platforms besides Ethereum, such as Avalanche and Polygon.
What developments will take us into DeFi 3.0? Analysts expect the TVL to be in the trillions, and have pinpointed four key developments that will take it there. The first is an uptick in the number of decentralized exchanges (DEXs) using an order book model. Low fees and fast settlement times will propel this forward. Serum, built on Solana, Dexalot on Avalanche and Polkadex on Polkadot are three examples.
As DeFi liquidity has become fragmented across chains, the next step is to introduce secure cross-chain composability. Another element is the merger of blockchain and DeFi with financial markets. This could happen by bringing the liquidity from the established global financial system on-chain, and/or through the adoption of crypto-related decentralized financial products by institutions.
It’s uncertain when DeFi will reach the trillion-dollar milestone, but the current pace of growth, investment and innovation suggests it will be sooner rather than later.
