Why DeFi will bring about a huge paradigm shift?
Editor's Note: This article comes fromUnitimes（ID：Uni-times）Editor's Note: This article comes from
, by Jonathan Joseph (JJ), Founder of Smart Money, published with permission.
One of the joys of being in DeFi is feeling like you're inside a really big secret.
Venture capitalist Peter Thiel is always on the lookout for billion-dollar ideas hiding under his nose, and DeFi is just such a trillion-dollar idea, maybe even hundreds of trillions, depending on how you measure it .
DeFi (Decentralized Financial Services on Ethereum) is a programmable financial technology platform. The combination of Ethereum smart contract functions and token standards makes it possible to build a set of extremely powerful open development tools for building new financial technologies.
But DeFi is not the same as "cryptocurrency". It may or may not involve cryptocurrencies at all, which is part of the reason for much confusion. As a result, DeFi has been almost completely ignored by the traditional fintech industry and venture capitalists (VCs) investing in companies in the industry.
How to explain this paradox?
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A Paradigm Shift & A Brief History of Venture Capital
The risky asset class arose out of early-stage venture businesses that did not have reliable cash flows to access funding through traditional banking. This has created a new highly specialized form of financing understood more as an art than a science. This new form of financing essentially funds the research and development of new technologies, and its investors expect outsized returns.
The earliest venture capital company - American Research and Development Corporation (American Research and Development Corporation), has R&D (research and development) in its company name. It is by taking on this level of risk that this 10-year closed-end, illiquid investment vehicle is justified.
The key to understanding investors' quest for outsized returns is understanding early-stage technology markets and the timing and cycles of technology platforms. In this regard, Carlota Perez's study of "cycles of technological waves" [1] is of great significance.
But is this what we actually see?
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Blockchain lacks early venture capital
Those who understand early technology also know that history doesn't repeat itself, but it does have a rhythm. The parallels between the dot-com bubble of 2001 and the ICO bubble of 2017 are not hard to spot.
Like dot-com startups after the dot-com bust, crypto startups generally find themselves in the throes of the trough of disillusionment three years after the ICO bust — a well-known tech cycle.
Even before the COVID-19 pandemic, deal volume and investment in early-stage blockchain venture capital had plummeted. The following figure comes from a recent analysis by Joel John, an analyst at the blockchain investment company Outlier Ventures [2]:
“To put it simply, the average (all VC firms) are only putting in about $50 million per month for companies that are currently pre-Series B.”
“In fact, if fewer seed companies get backed, then 18 to 24 months from now, we won’t have a healthy crop of companies. The rules of the game are, we need to have enough companies in the early stages, In this way, the later stage can continue to optimize.”
The funding levels above include all “blockchain” funding. DeFi is an area within the blockchain/cryptocurrency industry, and it’s one that some blockchain hype capitalists (by investing in so-called “Ethereum killers”) are aggressively shorting.
According to a recent estimate by Brooke Pollack, founder of blockchain venture capital fund Hutt Capital[3], the current “dry powder” (the total amount of money available for investment) of blockchain/cryptocurrency venture capitalists is 10 billion to US$1.5 billion, accounting for only about 0.5% of the “dry powder” of global venture capital.
Note: "dry powder" is a common term used in venture capital and entrepreneurship circles to refer to cash reserves (or highly liquid assets) held by companies or venture capital funds.
Disruptive technology will look like a "toy" at the beginning and will not be taken seriously (Editor's Note: When new technologies are first introduced, they are often not taken seriously because they do not meet user needs well or are not understood. The starting point of this theory Yes, technology often advances faster than user demand grows), and DeFi takes this adage to a new extreme.
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SWIFT, Stripe and Plaid: platformizing the existing fintech stack
What is even more curious is that the current low level of VC funding in the crypto space coincides with the fintech funding boom, although the latter may have peaked in 2018. One of the biggest drivers of the fintech funding boom cycle is the dynamics of leveraging development tools to enable similar platforms.
All assumptions about fintech today assume that SWIFT will continue to act as the world's main financial "router". Not only is it the current global standard for international banking messaging, it is also the standard for imposing sanctions by denying access to the SWIFT network.
Technically, SWIFT is a protocol. But considering SWIFT was born in 1973, the protocol is not very useful for modern times. SWIFT assigns codes to member banks and transactions and uses these codes to send messages between member banks.
The key flaw of SWIFT is that it is only a messaging standard and does not actually transfer value. Because of these fundamental technical constraints, everything built on top of the existing fintech stack is subject to these design constraints and is flawed from the start.
This also explains why payments companies like Stripe and Plaid have been so successful. Their development tools make it easier to build fintech products, highlighting the value of reducing the technical debt associated with developing products on the SWIFT architecture.
But on the whole, these technologies are incremental improvements that are irrevocably hamstrung by underlying technical debt.
We’ve seen that in fintech, simply removing much of the friction of accepting payments and obtaining financial data is enough to create massive enterprise value and a continued wave of fintech innovation. But this innovation remains fundamentally and structurally limited to the financial application layer.
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DeFi is a programmable fintech platform
DeFi is an open-source fintech platform without traditional technical debt, built on transparent, sound economic and monetary policies. In the DeFi economy, the Ethereum blockchain is the global settlement layer, and ETH is the base layer currency, also known as "M0". Unlike the existing SWIFT architecture, every layer of the DeFi stack is programmable, including the base currency itself.
Programmability aside, DeFi’s secret sauce is its standardization and composability. Its impact will be far-reaching.
As Dmitriy Berenzon, research partner at blockchain investment firm Bollinger Investment Group, pointed out in his recent article on Constant Function Market Makers [5], DeFi finds Created its own "from 0 to 1" innovation!
This major innovation in liquidity removes the friction (middlemen, relationships, and paperwork) that hinders current capital markets, enabling the frictionless flow of liquidity that modern global financial markets demand.
“Earnings don’t affect the market as a whole; the Fed … looks at the central bank, looks at the flow of liquidity … most people in the market are looking for the earnings and the regular indicators. It’s the liquidity that moves the market.”
--Stanley Druckenmiller (Wall Street hedge fund manager)
On top of the constant innovation of trading and market making via smart contracts, DeFi protocols, smart contracts, and code libraries are emerging for every type of financial instrument (some even previously impossible). Because DeFi is both standardized and composable, the design space for finance and financial services will expand exponentially. With DeFi, any type of robust transaction or financial instrument is accessible to anyone in the world with an internet connection.
Among those still “unaware” of this trend are traditional fintech incumbents and the VCs who fund them. Overall, they still believe the existing tech stack is solid and don't see DeFi as a viable threat.
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How can DeFi break the existing paradigm?
In his analysis of Visa's acquisition of Plaid [6], analyst Ben Thompson examines the network effects that appear to be entrenched in traditional financial stacks. In it, he explains that Visa sits at the center of a powerful multifaceted network between banks, merchants and consumers (see image below).
“Once a job is done — and credit cards do a great job of doing their job — it would take a 10x improvement to move users to another solution. And in one (by banks, merchants In a three-sided network consisting of consumers and consumers), this would require a 10^3 improvement, not just a 10x improvement.”
But ironically, in explaining entrenched network effects, this ultimately highlights why DeFi can be so disruptive.
In the DeFi economy, Ethereum addresses replace SWIFT codes and bank accounts. DeFi redistributes value that has traditionally flowed to the Visa network and banks to merchants and consumers.
This is a 1000x improvement that breaks down seemingly entrenched network effects.
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DeFi infrastructure adoption is happening
No group has spoken out louder than the world's central banks about the limitations of SWIFT's architecture, although they are not usually champions of innovation. Someday in the future, central banks will compete with this liquidity by digitally issuing money.
But the market is not waiting for the central bank to act. Since the market correction brought on by the COVID-19 outbreak in March, USD-denominated stablecoin issuance on Ethereum has grown by more than 100% (see chart below), an important but early sign of DeFi’s product-market fit.
What confuses many people about DeFi is that adopting DeFi means adopting a cryptocurrency or other novel currency as a medium of exchange (MoE), but in fact DeFi means using *any* currency as a medium of exchange. The most popular medium of exchange in the current DeFi economy is the U.S. dollar (in the form of a U.S. dollar stablecoin), reflecting the global dominance of the U.S. dollar.
Decentralized trading infrastructures (decentralized exchanges, DEXs) have also shown a similar growth pattern to stablecoins.
The issuance of stablecoins and the adoption of DEX infrastructure are important precursors to the user-facing products currently being built by DeFi startups.
The adoption of DeFi infrastructure has now begun, but it is clear that DeFi platforms are still in the gestation phase of what Perez proposed as a "technology wave cycle". You don't need to go through Forbes' top VC list (the Midas List [7]) to figure out what's going to happen next.
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The Maturity and Funding Cycle of DeFi
So when will institutional capital appear in DeFi?We introduce another macro-cycle perspective from a16z, which anticipates the current low tide in what it calls the “price-innovation cycle” in the crypto space. Will institutional capital return to the industry when the price of ETH rises again? [Related Reading:"》]
Top VCs a16z: Crypto Prices - The Innovation Cycle
Many crypto venture capitalists think so.
In a market with negative yields already in the trillions and the stock market so drunk that "bankrupt" companies are the hottest area of the week, anything is possible.
While the above points to many similarities between the post-dotcom crash and the post-ICO crash, it's worth noting that some of the best years in venture capital history have come after the dot-com crash. By then most institutional capital had left the space in a similar fashion.
What needs to happen in traditional fintech for VCs to see the value of programmable finance?
Regardless, DeFi adoption is coming. But by that time, many previous earning opportunities may have disappeared through the value accumulation model in DeFi. VCs have to learn to adapt again to the risks associated with real early-stage investing in order to achieve these rare returns they spend their entire lives searching for.
Ironically, the same VCs who scoffed at the general public during the ICO bubble for underestimating the difficulty of early-stage investing were also the same VCs who missed out on the resulting emerging platform opportunity.
[1]:https://avc.com/2015/02/the-carlota-perez-framework/
[2]:https://www.decentralised.co/open-for-business/
[6]:https://stratechery.com/2020/visa-plaid-networks-and-jobs/
