DeFi, or decentralized finance, was one of the key narratives of the previous market cycle. 

The total value locked (TVL) in DeFi protocols rose from $1 billion in May 2020 to $260 billion by the end of 2021, before falling to the new base level of $60 billion during the ensuing bear market. This metric started to rise along with the new growth cycle, now hitting $156 billion (source: DeFiLlama).

However, this cycle differs from the previous one in many aspects, from the nature of the biggest protocols to the blockchains on which they are built. Understanding these changes can provide valuable insights into the current risks and opportunities within the DeFi sector. But first, what exactly do we mean by DeFi?

DeFi protocols and their evolution

One of the first DeFi use cases was lending-borrowing, with protocols such as Aave or Compound Finance allowing users to lend/borrow crypto through a decentralized platform.

DEXes (decentralized exchanges) like Uniswap and bridges like WBTC were developed to help users exchange or transfer cryptocurrencies from one blockchain to another.

Decentralized stablecoins such as DAI (issued by Maker DAO) were created as a decentralized alternative to coins like Tether or USDC.

These three use cases used to be the biggest ones in the previous market cycle, gathering 30%, 32%, and 13% of TVL  respectively (TVL in bridges not counted). The rest of TVL was shared by derivatives, payments, and insurance protocols, together with the nascent category of liquid staking that would soon eclipse them all.

Indeed, with Ethereum changing its consensus from Proof-of-Work to Proof-of-Stake in September 2022, liquid staking became the leading DeFi protocol. Liquid staking allow users to stake their coins within a PoS blockchain, while getting an IOU token in return, which they can use in other DeFi protocols (for example, as collateral), effectively making their money work twice. Lido, which offers liquid staking on Ethereum and Polygon, has become the biggest in this category, now counting over $27 billion of staked tokens.

As the new market cycle unfolds, the DeFi sector grows together with the broader crypto space. However, this sector’s composition is now totally different from 2020.

Liquid staking together with the newly emerged restaking (offering yet another way of using the already staked coins, like EigenLayer) now accounts for 38% of the total TVL. Lending-borrowing DApps command 26% of TVL, DEXes 14%, and decentralized stablecoins 6%.

Why does the composition matter? One could argue that the value proposition that liquid staking and restaking protocols bring to the space is lesser than those offered by the first “wave” of DeFi DApps. Not to mention “liquid restaking” and other complex constructions on top of the already circulating coins. This situation could suggest a certain stagnation within the sector, especially considering that a lot of new TVL comes from similar protocols built on new blockchains.

DeFi blockchains

In 2020, a staggering 96% of the TVL was registered solely on Ethereum. Today, Ethereum’s share is only 66% - which is still a lot but shows that other blockchains are coming forth.

Solana, BSC, and Tron now register over 5% of TVL each, actively developing their own DeFi ecosystems. What’s more, with the new layer-2 developments on Bitcoin, we may also see Bitcoin-based DeFi protocols emerge in the future.

The increasing diversity is generally a good thing, but in the case of DeFi, it shows the space reproducing the same ideas within different blockchains instead of innovating.

What perspectives for DeFi?

There are several avenues for innovators to explore, and probably the most obvious one is RWA, or tokenization of real-world assets. The basic assumption here is that absolutely any asset can be tokenized and traded without the hurdles imposed by traditional finance. That’s a huge market, which Citi estimated to reach $4 trillion by 2030 and which could boost DeFi in many ways.

However, the current TVL of decentralized RWA protocols is modestly hovering around $6 billion, with protocols mostly tokenizing US dollars, T-bills, and real estate. Such a mellow development could be attributed to significant gaps in regulation, particularly in the US. In the EU, the MiCA regulation does not directly cover DeFi either, keeping the DeFi sector in limbo.

Another problem is continuous exploits that still plague the sector, but this could be resolved with technological advances and DeFi insurance – yet another innovation avenue to explore.