The DeFi evolution: top 5 protocols to illustrate the space and spot future leaders

Decentralized Finance, or DeFi in short, is one of the most promising sectors in the crypto economy with currently $39 billion of total value locked (TVL). It is a steep decline since an all-time high of $180 billion, but nonetheless a considerable achievement, showing the young industry’s resilience.

Ever since the first decentralized exchange (DEX) appeared in 2016, the DeFi sector faced the bear markets of 2018 and 2022, plenty of scams, as well as some sensational crashes. Among the main reasons DeFi still exists is a growing demand for non-custodial and independent financial services, but also its capacity to adapt its practices on the go.

DeFi’s four main pillars – DEXes, decentralized stablecoins, staking, and lending-borrowing apps – have each evolved in their own way, and the current top 5 protocols can illustrate the space well.

 

Lido, leader in liquid staking

Staking cryptoassets on Proof-of-Stake blockchains gives the possibility to not only participate in their activity, such as transaction validation and block creation, but also to earn reward. The main evolution in this sector was the creation of liquid staking protocols, which took away the trouble of running a blockchain node (and complying with any additional requirements) and kept the essential: users stake their crypto and earn a passive revenue. What’s more, such protocols issue and give users a sort of IOU token that can also be used in the DeFi ecosystem.

Liquid staking got big after Ethereum launched its PoS chain in the end of 2020 and grew rapidly after Ethereum fully transitioned to the PoS consensus last autumn.

This week, a liquid staking app Lido became the biggest DeFi service with over $6.15 billion of TVL, flipping one of the oldest DeFi protocols MakerDAO (data: DeFiLlama). Lido’s governance token $LDO has gained 44% in just three days.

 

MakerDAO, a decentralized stablecoin that works

Since the end of 2017, MakerDAO has been issuing a decentralized stablecoin DAI, which maintains its value of approximately $1 by over-collateralization: users are required to spend more than $1 worth of ETH to be able to mint 1 DAI. This practice, together with the diversification of the underlying asset portfolio, allows to maintain the DAI stable.

MakerDAO now registers a TVL of almost $6 billion, and DAI’s market cap is of $5 billion.

Over-collateralization is not an ideal scheme from the business point of view though, and the next stage for decentralized stablecoins is expected to be an algorithmic stablecoin. However, its most prominent example – TerraUSD – has failed spectacularly, and the market is still waiting for a decentralized algorithmic stablecoin that will work.

 

Aave, the lending-borrowing specialist

Launched in 2020, the lending-borrowing service Aave is now the third biggest DeFi protocol, with $3.8 billion of TVL.

A user can deposit their crypto into the protocol’s liquidity pool and borrow another crypto (often a stablecoin) that other users have loaned. The former pay interest, the latter – earn interest, and the volatility issue is tackled by overcollateralizing the loan.

This sector has evolved significantly since the first days of DeFi, notably by introducing the pooling mechanism (pool-to-peer instead of peer-to-peer) and improving user experience.  

 

Curve and Uniswap, the biggest decentralized exchanges

Just like centralized exchanges, the first DEXes were using an orderbook to match buyers and sellers. However, this traditional method proved inadequate due to the risk of frontrunning and insufficient liquidity. Replacing orderbooks with AMMs, or automatic market makers, has allowed the DEXes to flourish, and as of today, Curve ($3.7 billion TVL) and Uniswap ($3.4 billion TVL) are the two biggest ones.

An AMM relies on a math formula to price an asset according to the available liquidity pools, where professionals and individuals deposit crypto to earn LP tokens. It has its downsides too: the problem of impermanent loss (when the price ratio of deposited tokens changes abruptly) and the impossibility of placing limit orders.

These two issues remain unsolved (although Balancer has claimed to tackle the impermanent loss), and a future DEX leader may be the one that solves them.

Beyond specific issues, the DeFi space in general needs a better user experience, and a protocol that will make it easier to navigate it will have big chances to succeed. DEX aggregators like 1Inch, wallet integrations like MetaMask swaps, and yield optimisation services like Yearn might be on their way already.

Another part of DeFi with an under-exploited potential is insurance, and despite the existence of services like Nexus, it is still awaiting a breakthrough.

Written by D.Center