Liquidity has driven DeFi’s growth to date, so what’s the future outlook?

In mid-February 2020, the total value locked up in decentralized finance (DeFi) applications exceeded $1 billion for the first time. Fueled by the DeFi summer of 2020, it would not be a year before it would multiply by 20 to reach $20 billion and only another ten months to reach $200 billion. Given the pace of growth so far, it doesn’t seem far fetched to imagine DeFi markets reaching $1 trillion within a year or two.

We can attribute this monumental growth to one thing: liquidity. Looking back, the expansion of DeFi can be defined in three eras, each representing another significant development in removing barriers to liquidity and making markets more attractive and efficient for participants.

DeFi 1.0: solving the chicken and egg problem

DeFi protocols existed before 2020, but suffered from a chicken-and-egg problem when it came to liquidity. Theoretically, someone could provide liquidity to a lending pool or exchange. Still, there is not enough incentive for liquidity providers until there is a critical mass of liquidity to attract traders or borrowers who pay fees or interest.

Compound was the first to solve this problem in 2020 when it introduced the concept of agricultural protocol tokens. In addition to interest from borrowers, Compound lenders could also earn COMP token rewards, providing an incentive from the moment they deposit their funds.

It turned out to be a kick-off for the DeFi summer. SushiSwap’s “vampire attack” on Uniswap provided further inspiration to the project’s founders, who began using their own tokens to incentivize on-chain liquidity, kickstarting the yield farming craze in earnest.

Related: Liquidity mining is booming: will it last or go bust?

DeFi 2.0: Improving Capital Efficiency

So that was DeFi 1.0, roughly the era that took us from $1 billion to $20 billion. DeFi 2.0, the period that saw the most growth to $200 billion, brought improvements in capital efficiency. It saw the growth of Curve, which refined Uniswap’s automated market maker (AMM) model for stable assets, offering more concentrated trading pairs with less slippage.

Curve also introduced innovations such as its vote deposit toketomic model, which incentivizes liquidity providers to lock up funds long-term to further increase liquidity reliability and reduce slippage.

Uniswap v3 also brought further capital efficiency improvements with its customizable liquidity positions. Beyond Ethereum, the multi-chain DeFi ecosystem has started to flourish on other platforms, including BSC, Avalanche, Polygon, and others.

So what will propel DeFi through the next phases of growth to reach $1 trillion and beyond? I think there will be four key developments.

DEXes go hybrid

The AMM model that has proven so successful in DeFi evolved out of necessity after it became clear that Ethereum’s slow speeds and high fees would not serve the orderbook model well enough for it to survive on-chain.

Related: Automated market makers are dead

However, the existence 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 an order book model. Fast settlement times reduce the risk of slippage, while low or negligible fees make an order book exchange profitable for market makers.

There are already several examples of decentralized exchanges using central limit order books: Serum, built on Solana, Dexalot on Avalanche, and Polkadex on Polkadot, to give several examples. The existence of order book exchanges is likely to make it easier for institutional and professional investors to join, as they allow limit orders, making the trading experience more familiar.

Cross-chain composability

The proliferation of DeFi protocols on blockchains other than Ethereum has resulted in significant fragmentation of liquidity across different ecosystems. To some extent, developers have tried to overcome this with cross-blockchain bridging, but recent hacks, such as the Solana Wormhole Bridge hack, have raised concerns.

However, secure cross-chain composability is becoming necessary to unlock fragmented liquidity in DeFi and attract more 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 and has recently gained ground rapidly in locked value, implying a clear appetite for cross-chain liquidity.

Blockchain and DeFi begin to merge with financial markets

Now that cryptocurrencies are becoming a recognized global financial asset, it is only a matter of time before the boundaries begin to blur with blockchain and DeFi. This is likely to move in two directions. Firstly, by bringing liquidity from the established global financial system on-chain, and secondly, by institutions adopting crypto-related decentralized financial products.

Several crypto projects have now released institutional-grade products, with more in the pipeline. An institutional MetaMask wallet already exists, while Aave and Alkemi operate Know Your Customer (KYC) pools for institutions.

On the other hand, Sam Bankman-Fried flies the flag for putting the financial system on chain. In March, he spoke at the Futures Industry Association in Florida, proposing to US regulators that risk management in financial markets could be automated using practices developed for crypto markets. The tone of the FT article covering the story is revealing: far from the dismissive and even dismissive attitude that the traditional financial press used to have towards crypto and blockchain, it is now fraught with intrigue.

Anyone can guess when DeFi hits the trillion dollar milestone. But those of us watching the current pace of growth, investment, and innovation feel reasonably confident that we’ll get there sooner rather than later.

This article does not contain investment advice or recommendations. Every investment and trading move involves risk, and readers should do their own research when making a decision.

The views, thoughts, and opinions expressed here are those of the author alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.

jimmy yin is a co-founder of iZUMi Finance. Before entering the world of DeFi, he was a researcher at the North American Blockchain Association and a member of the World Economic Forum community. His Ph.D. was supervised by Max Shen at UC Berkeley and HK University. Jimmy pursues liquidity enhancement in both crypto and spirit.