Demand for decentralised finance (DeFi) exploded in 2021 before collapsing last year, as digital assets in general came under pressure. However, a number of positive factors are driving demand once more in 2023. There are sound reasons for believing this growth will continue over the longer term – a trend that prime brokers should welcome. They can help take DeFi into the mainstream of the financial services industry.
How DeFi will continue to move centre stage in 2023
DeFi to complement, rather than threaten, prime broker activities
DeFi provides a way of delivering financial services that cuts out traditional centralised intermediaries by relying on automated protocols. At first glance, it could be seen as a threat to the prime broker model. However, it appears more likely that the emergence of DeFi will simply reinforce the importance of using a prime broker to access this market. DeFi will also provide another source of revenue for the industry.
For example, the Bank for International Settlements (BIS), a forum for central banks, points out that while the main vision of DeFi’s proponents is intermediation without centralised entities, some form of centralisation is inevitable. It adds that ‘DeFi’s vulnerabilities are severe because of high leverage, liquidity mismatches, built-in interconnectedness and the lack of shock-absorbing capacity’. In BIS’s view, DeFi has the potential to complement, rather than replace, traditional financial activities. 1
Certainly, the volume of fraud and scandal stemming from the use of DeFi underlines the appeal of using prime brokers that can offer clients built-in risk management, from credit risks and liquidity risks to counterparty risks, and the assumption of clearing and intermediary risks.
DeFi back on the growth path
DeFi’s main growth began in 2021, according to a paper by the European Central Bank (ECB), which says the size of the market is generally measured by the sum of all digital assets deposited in DeFi protocols, known as ‘total value locked’ (TVL). This value increased from approximately €18 billion in January 2021 to over €240 billion by the end of December 2021. 2 The market slumped in 2022, along with the digital-asset market in general, but demand has picked up strongly in 2023.
Improving regulatory environment augurs well for growth prospects
There have already been a number of positive recent developments that should facilitate the further growth of the market in 2023 and beyond. In January, for example, the US Securities and Exchange Commission’s (SEC) decision to charge an alleged rogue trader was welcomed by the ratings agency Moody’s as a sign that DeFi is moving towards a ‘safer and more welcoming environment’. Moody’s added that the action should ‘improve oversight of the DeFi industry’, which has been difficult to regulate due to the lack of clarity regarding jurisdiction over open-source protocols, according to CoinTelegraph. 3
The collapse of the centralised exchange FTX has also helped drive growth in the DeFi sector. There had been fears that investors might abandon crypto altogether, rather than switch to decentralised exchanges (DEX). However, DEX trading volumes surged after FTX crashed in November 2022. Daily trading volume hit a high of $12.5 billion on 10 November 2022 and total trading volume for November 2022 reached $114 billion, compared with $66 billion in the previous month. 4
The collapse of the centralised exchange FTX confounded fears that investors might abandon crypto, prompting a surge in trading on decentralised exchanges
The peak and likely fall in interest rates in 2023 should prove a further positive influence for DeFi. DEX volumes nosedived in 2022, just as the US Federal Reserve (the Fed) started to hike rates to combat inflation, because:
- Higher interest rates lessen the appeal of DeFi, since investors can secure relatively high yields through less risky investment vehicles such as government bonds
- Rising interest rates also increase uncertainty and hence market volatility as investors speculate over the path of future rate hikes and their impact on the economy and financial markets. This prompts an increase in risk aversion, which reduces DEX trading volumes
While DeFi has largely been confined to digital assets, there’s increasing interest in applying real-world assets (RWA) to this sphere. Major participants in the DeFi lending market, for example, such as MakerDAO, have voted to invest in US Treasuries and corporate bonds, and they’ve formed partnerships with conventional banks to provide loans with RWAs serving as collateral. Many participants believe RWAs provide an opportunity to combine conventional institutions with DeFi liquidity, and it’s expected that using RWAs will become more widespread in 2023.
Over the next few years, we believe DeFi holds the potential to grow from a small niche within the financial industry to take centre stage. Increasing regulation and oversight should help this process by restoring confidence in a sector plagued by numerous frauds and scandals.
1 https://www.bis.org/publ/qtrpdf/r_qt2112b.pdf
2 https://www.ecb.europa.eu/pub/financial-stability/macroprudential-bulletin/focus/2022/html/ecb.mpbu202207_focus1.en.html
3 https://cointelegraph.com/news/regulatory-action-against-mango-markets-exploiter-is-a-win-for-defi-moody-s
4 https://macrohive.com/hive-exclusives/the-three-trends-that-matter-for-defi-in-2023/
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