Liquidity has driven the growth of DeFi so far, so what does the future hold?

In mid-February 2020, the total value locked in decentralized finance (DeFi) applications surpassed $1 billion for the first time. Driven by the 2020 DeFi Summer, this number has grown 20 times in less than a year, reaching $20 billion, and reaching another $200 billion in 10 months. Given the current rate of growth, it might not seem surprising to imagine the DeFi market reaching $1 trillion in the next year or two.

We can attribute this huge growth to -- liquidity. Looking back, the expansion of DeFi can be divided into three eras, each of which represented another major advance in removing liquidity barriers and making the market more attractive and efficient for participants.

DeFi 1.0 — Solving the Chicken and the Egg Problem

DeFi protocols existed before 2020, but they encountered a “chicken and egg” problem when it comes to liquidity. In theory, users could provide liquidity to lending or swap pools. However, liquidity providers do not have sufficient incentives until liquidity reaches a critical mass that can attract traders or borrowers willing to pay fees or interest.

Compound took the lead in solving this problem in 2020, and the solution was to introduce the concept of farming protocol tokens. In addition to interest on borrowers, Compound’s lenders are rewarded with COMP tokens, providing incentives from the moment they deposit funds.

As it turns out, this is the starting gun for DeFi Summer. SushiSwap’s “vampire attack” on Uniswap provided further inspiration for project founders, and they began to use their own tokens to incentivize on-chain liquidity, truly launching the yield farming boom.

DeFi 2.0 — Improving Capital Efficiency

This is the era of DeFi 1.0, we have come from a $1 billion DeFi market to a $20 billion DeFi market. In the era of DeFi 2.0, funds have further grown to 200 billion US dollars, improving capital efficiency. It has seen the growth of Curve — the company that has perfected Uniswap’s automated market maker (AMM) model to offer more concentrated, lower-slippage trading pairs for stable assets.

Curve also introduces innovations such as the voting escrow token economics model, which incentivizes liquidity providers to lock funds for a long time to further improve the reliability of liquidity and reduce slippage.

Uniswap v3 also further improves capital efficiency through its customizable liquidity positions. In addition to Ethereum, the multi-chain DeFi ecosystem began to flourish on other platforms, including BSC, Avalanche, Polygon, etc.

So, what will propel DeFi to $1 trillion and beyond in the next growth phase? I believe there are four key developments.

Decentralized exchanges go hybrid

The AMM model, which has proven so successful in DeFi, was developed after Ethereum’s slow speed and high fees clearly did not serve the order-book model well enough to survive on-chain.

However, the presence of DeFi on high-speed, low-cost blockchains means that we are likely to see an increase in the number of decentralized exchanges (DEXs) using the order book model. Fast settlement times reduce the risk of slippage, while negligible fees make trading orders profitable for market makers.

There are already multiple decentralized exchanges that use a central limit order book, such as Serum built on Solana, Dexalot built on Avalanche, and Polkadex built on Polkadot. The existence of order book exchanges may make it easier for institutional and professional investors to participate because they allow limit orders and provide a more familiar trading experience.

Cross-chain composability

In addition to Ethereum, the proliferation of DeFi protocols on the blockchain has resulted in severe fragmentation of liquidity into different ecosystems. To some extent, developers have tried to overcome this with bridges between blockchains, but recent hacks, such as Solana’s wormhole bridge hack, have raised concerns.

Secure cross-chain composability is becoming increasingly necessary to unlock decentralized liquidity in DeFi and attract further investment. There are some positive signs — for example, Binance recently made a strategic investment in Symbiosis, a cross-chain liquidity protocol. Similarly, Thorchain, a cross-chain liquidity network launched last year, has recently made rapid progress in value locking, which shows that there is a clear market demand for cross-chain liquidity.

Blockchain and DeFi begin to merge into financial markets

Now that cryptocurrencies are becoming a recognized global financial asset, it is only a matter of time before the lines between blockchain and DeFi start to blur. This could go in two directions. One, by bringing liquidity from the established global financial system on-chain, and two, by institutional adoption of crypto-related decentralized financial products.

Several crypto projects have already launched institutional-grade products, with many more in the pipeline. There is already an institutional wallet for MetaMask, while Aave and Alkemi operate know-your-customer (KYC) pools for institutions.

Sam Bankman-Fried, on the other hand, is calling for bringing the financial system on-chain. Speaking at the Futures Industry Association in Florida in March, he suggested to U.S. regulators that risk management in financial markets could be automated using practices developed for the cryptocurrency market. The tone in which the FT reported the story is telling — in contrast to the dismissive, even dismissive, attitude of traditional financial media to cryptocurrencies and blockchain in the past, it is now rife with intrigue.

No one can tell when DeFi will reach the trillion-dollar milestone. But those of us watching the current pace of growth, investment, and innovation have reason to believe that we will get there sooner or later.

Cointelegraph Chinese is a blockchain news information platform, and the information provided only represents the author's personal opinion, has nothing to do with the position of the Cointelegraph Chinese platform, and does not constitute any investment and financial advice. Readers are requested to establish correct currency concepts and investment concepts, and earnestly raise risk awareness.