Vitalik: Low-risk DeFi is already supporting the Ethereum economy

Original title: Low-risk DeFi is to Ethereum as search is to Google

Author: Vitalik, founder of Ethereum; Translated by: Golden Finance

For a long time, an important contradiction in the Ethereum community has been: (i) Can applications bring in enough revenue to maintain the economics of the ecosystem, whether that means maintaining the value of ETH or supporting individual projects; (ii) Can applications meet the fundamental goal of attracting people to join Ethereum?

Historically, the two categories have been very disconnected: the former is some combination of NFTs, Meme coins, and a kind of DeFi supported by temporary or recursive forces: people chase the incentives provided by the protocol through lending, or form a circular argument: "ETH is valuable because people use the Ethereum chain to buy and sell ETH and conduct leveraged transactions." Meanwhile, non-financial and semi-financial applications (e.g., Lens, Farcaster, ENS, Polymarket, Seer, privacy protocols) existed and were fascinating, but either saw very low usage or generated too little in fees (or other forms of economic activity) to sustain a $500 billion economy. This disconnect created significant disharmony in the community, which was largely driven by the theoretical hope that some application would satisfy both conditions. In this post, I will argue that as of this year, Ethereum already has such an application: “low-risk DeFi,” which is to Ethereum what search is to Google. Low-risk DeFi, with the goal of democratizing global access to payments and savings in valuable asset classes (e.g., major currencies, stocks, bonds with competitive interest rates).

Deposit rates for major stablecoins on Aave

Low-risk DeFi is to Ethereum as search is to Google. Google has made many interesting and valuable contributions to the world: the Chromium browser series, the Pixel phone, its AI work, including the open-source Gemini model, the Go language, and so on. But in terms of revenue generation, these are negligible, even negative. Instead, the largest revenue streams come from search and advertising. Low-risk DeFi can play a similar role for Ethereum. Other applications, including non-financial and more experimental ones, are crucial to Ethereum's place in the world and its culture, but they don't have to be seen as revenue generators. In fact, I hope Ethereum can do better than Google. Google is often criticized for losing its way and becoming like the antisocial, profit-driven companies it seeks to replace. Ethereum embeds decentralization at a deeper technical and social level, and I believe low-risk DeFi use cases create a great deal of alignment between "doing well" and "doing good" that isn't present in advertising.

Why Low-Risk DeFi?

What I mean by "low-risk DeFi" includes both basic functionality for payments and savings, as well as well-understood instruments like synthetic assets and fully collateralized loans, and the ability to exchange these assets with each other.

The reason for focusing on these applications has two core components:

1. These applications provide irreplaceable value to Ethereum and its users.

2. These applications are culturally aligned with the goals of the Ethereum community, both for the application layer and for the technical attributes of L1.

Why is DeFi valuable now?

Historically, I have been skeptical of DeFi because it did not seem to offer (1); instead, the main “selling point” seemed to be making money trading highly speculative tokens (the highest single-day fee on Ethereum came from a poorly designed digital monkey sale) or earning 10-30% returns from liquidity mining incentives.

One reason for this is regulatory barriers. Gary Gensler et al. should be roundly condemned for creating a regulatory environment where the less useful your application, the safer you are; the more transparent your actions and the clearer the assurances you provide to investors, the more likely you are to be considered a “security”.

Another reason is that in the early stages, the risks (protocol code bug risk, oracle risk, general unknown-unknown risk—risks that are completely unforeseeable and beyond the scope of current knowledge or experience) are too high to allow for more sustainable use cases to materialize. If the risk is high, then the only applications worth investing in are those with higher returns, which can only come from unsustainable subsidies or speculation.

But over time, protocols have become more secure and the risk has decreased.

Ethereum Layer1 DeFi Losses. Source: AI Research

DeFi hacks and losses still exist. But they are gradually being pushed to the edges of the ecosystem, where users are more experimental and speculative. A stable core of applications is emerging and proving remarkably robust. Unavoidable tail risks remain, but these also exist in traditional finance (TradFi)—and given rising global political instability, for many people around the world, they now pose a greater risk than DeFi. In the long run, the transparency and automated execution of a mature DeFi ecosystem will make it more stable than traditional finance. Who are the "non-Ouroboros" users who find all this meaningful? Essentially, individuals and businesses who want access to global markets to buy, hold, and trade mainstream assets but lack reliable traditional financial channels to do so. Cryptocurrency doesn't have a magic formula for consistently generating higher returns. But it does have a magic formula for making existing economic opportunities globally accessible without permission. Why is low-risk DeFi culturally aligned with the goals of the Ethereum community?

Low-risk DeFi has several advantages that make it an ideal choice:

• It contributes economically to Ethereum and ETH by using large amounts of ETH as collateral and paying high transaction fees

• It serves a clear, valuable, and honorable purpose: enabling global permissionless access to the well-known positive-sum mechanisms of economic interaction and wealth accumulation

• It does not create perverse incentives for Ethereum L1 (e.g., excessive centralization in pursuit of HFT-friendly efficiencies, which is better suited to L2)

That’s a very good set of properties!

Going back to the Google analogy, a major flaw in its incentive structure is that advertising revenue incentivizes the company to extract as much data from users as possible and keep that data private. This goes against the open source and positive-sum spirit of its more idealistic efforts historically. This inconsistency is even more costly for Ethereum because, as a decentralized ecosystem, any activity on Ethereum cannot be the work of a few behind the scenes; it must be a viable cultural rallying point. A revenue source doesn't have to be Ethereum's most revolutionary or exciting application. But it must at least be something unethical or embarrassing. If the largest single application in the Ethereum ecosystem were a political meme coin, you couldn't honestly say you were excited about it. People should be excited about something that is positively changing the world. Low-risk DeFi aims to enable global, permissionless payments and optimal savings opportunities. It is a form of finance that is positively changing the world, as many people in impoverished areas of the world can attest. What can low-risk DeFi evolve into? Another important characteristic of low-risk DeFi is that it naturally synergizes with, or can evolve into, many more interesting future applications. Here are a few examples: Once we have a mature ecosystem of on-chain financial and non-financial activity (see: Balaji's ledger concept), it will make sense to explore reputation-based, low-collateralized lending, which has the potential to become an even more powerful engine for financial inclusion. The low-risk DeFi we're building today, as well as the non-financial magic we're building today (such as zero-knowledge proofs), will help achieve this goal. If prediction markets become more mature, we may start to see them used for hedging. If you own stocks and you believe a global event is likely to cause the stock price to rise on average, and the prediction market for that event is liquid and efficient, then betting on that event is a reasonable statistical hedging strategy. Having prediction markets and "traditional" decentralized finance (DeFi) running on the same platform will make such strategies easier to implement. Today, low-risk DeFi is often about easier access to USD. But most of us didn't enter the cryptocurrency space to promote USD adoption. Therefore, over time, we can begin to push the ecosystem toward other stable forms of value: basket currencies, "flatcoins" directly based on the consumer price index, personal tokens, and so on. The low-risk DeFi we're building today, as well as more experimental projects like Circles and various "flatcoin" projects, are all designed to make this outcome more likely. In summary, I believe that a greater focus on low-risk DeFi, compared to Google Search and Ads, allows us to better economically sustain the ecosystem while maintaining cultural and values ​​alignment. Low-risk DeFi is already underpinning the Ethereum economy, making the world a better place even today, and has synergies with the many experimental applications being built on Ethereum. This is a project we can all be proud of.