DeFi: from inception to 2021 and beyond

An explainer by Finematics tracing the history of decentralized finance from the earliest experiments on Ethereum through the explosive DeFi Summer of 2020, covering key protocols, milestones, market events, and where DeFi is headed in 2021 and beyond.

This transcript is an accessible copy of the original video transcript (opens in a new tab) published by Finematics. It has been lightly edited for readability.

The origins of DeFi (0:00)

What's the story behind decentralized finance? How did all of this start? What happened in DeFi in 2020? And where are we going in the future?

The origin of DeFi goes back to 2009. Although you may not think of Bitcoin as the first DeFi protocol, it was in fact the inception of the whole industry. Bitcoin for the first time allowed people to actually own and fully control a digital asset — sending value across the globe without a need for any financial intermediary. This laid the foundation for the whole DeFi ecosystem.

On the Ethereum side, one of the first crucial events for DeFi was the Ethereum ICO. On the 22nd of July 2014, the Ethereum token sale was announced by none other than Vitalik Buterin. It raised about 18 million dollars in 42 days, making it one of the first successful crowdfunding campaigns powered by cryptocurrency. This was an important moment that enabled the further development of the Ethereum network and paved the way for smart contracts and decentralized applications.

MakerDAO and the birth of DeFi lending (1:28)

The next important milestone: MakerDAO was launched in December 2017. This was one of the protocols that started what we'd now call the DeFi ecosystem. At its core, MakerDAO allowed users to lock ETH as collateral and generate DAI — a USD-pegged stablecoin — against it. This created one of the first decentralized lending and borrowing protocols, and DAI became a cornerstone of the DeFi ecosystem.

Also important was the creation of the ERC-20 token standard. This allowed anyone to create fungible tokens on Ethereum. ERC-20 tokens became the standard for most DeFi protocol governance tokens, stablecoins, and other digital assets. They also enabled a wave of innovation, as new protocols could issue their own tokens and easily integrate with the broader ecosystem.

The ICO era and early exchanges (2:42)

The year 2017 also saw the emergence of EtherDelta, one of the first decentralized exchanges on Ethereum. Built on the concept of an order book, EtherDelta's user experience was far from ideal — it was slow, buggy, and not user-friendly. Despite that, EtherDelta was one of the most popular exchanges for trading ERC-20 tokens, especially during the ICO era.

Unfortunately, the exchange was hacked at the end of 2017. The hacker gained access to EtherDelta's frontend and proxied the traffic to a phishing site, scamming users out of around eight hundred thousand dollars. On top of this, the founder of EtherDelta was charged by the SEC for running an unregulated securities exchange in 2018, which was pretty much a nail in the coffin.

During 2017, one of the first big use cases for Ethereum — ICOs — became prevalent. New projects, instead of raising money using traditional methods, started offering their own tokens in exchange for it. Although the idea of decentralized fundraising was not bad in theory, it resulted in multiple overhyped projects raising way too much money without anything to show besides a few pages of a white paper.

In the plethora of ICOs, there were also projects that we would today classify as DeFi. Some of the most notable DeFi projects from the ICO era were:

• Aave — lending and borrowing
• Synthetix (previously known as Havven) — a liquidity protocol for derivatives
• Ren (previously Republic Protocol) — a protocol for providing access to inter-blockchain liquidity
• Kyber Network — an onchain liquidity protocol
• 0x — an open protocol for peer-to-peer exchange of assets
• Bancor — another onchain liquidity protocol

Despite the bad reputation of 2017 ICO mania, some of the projects that emerged back then are now considered top protocols in DeFi.

The user-to-contract model (4:52)

One of the main breakthroughs at that time was the idea of users interacting with smart contracts containing pooled funds from multiple users, rather than interacting directly with other users. This basically created a new user-to-contract model that was more suitable for decentralized applications, as it didn't require as many interactions with the underlying blockchain as the user-to-user model.

The quiet period and Uniswap (5:20)

After the ICO mania was over and the bear market kicked in, DeFi experienced a relatively quiet period — at least from the outside. In reality, behind the scenes, major DeFi protocols were being built. I usually call this period "before COMP" — we'll learn later why Compound's COMP token liquidity mining was a major breakthrough in DeFi.

On the 2nd of November 2018, the initial version of Uniswap was published to the Ethereum mainnet. This was the culmination of over a year's worth of work by its creator Hayden Adams. Uniswap is clearly one of the most important projects in DeFi. In contrast to EtherDelta, Uniswap was built on the concept of liquidity pools and automated market makers, leveraging the user-to-contract model. The first version of Uniswap was entirely funded by a grant from the Ethereum Foundation.

In July 2019, another important event happened: Synthetix launched the first liquidity incentive program — a mechanism that later became one of the key catalysts for the DeFi Summer of 2020. Multiple other DeFi projects also launched their protocols on the Ethereum mainnet between 2018 and 2019, including Compound, Ren, Kyber, and 0x.

Black Thursday (8:07)

On the 12th of March 2020, the price of ETH sharply dropped by more than 30 percent in less than 24 hours as a result of fears over the global pandemic. This was one of the biggest stress tests for the still-nascent DeFi industry.

The Ethereum gas fees raced dramatically to over 200 gwei, which was really high at that time, as a result of multiple users trying to increase their collateral in various loans and trying to trade between different assets.

One of the most affected protocols was Maker. The wave of liquidations caused by users' ETH collateral losing value resulted in the keeper bots — external players responsible for liquidations — being able to bid zero DAI for the auctioned ETH collateral. This led to a shortfall of around four million dollars worth of ETH that was later accommodated by creating and auctioning additional MakerDAO's MKR tokens.

In the end, even though events like Black Thursday can be quite severe, they usually result in the strengthening of the whole DeFi ecosystem, making it more and more antifragile.

DeFi Summer (9:37)

This brings us to the major period of DeFi growth, also called the DeFi Summer. The main catalyst was the liquidity mining program of COMP tokens launched by Compound. In May 2020, DeFi users started being rewarded for lending and borrowing on Compound. The extra incentives in the form of COMP tokens resulted in supply and borrow APYs for different tokens going up dramatically. This also enabled the development of yield farming, as users were incentivized to keep switching between borrowing and lending different tokens to achieve the best yield possible.

This event initiated a wave of other protocols distributing their tokens via liquidity mining and creating more and more yield farming opportunities. It also created Compound governance, where users with COMP tokens could vote on different proposed changes to the protocol. Compound's governance model was later reused by multiple other DeFi projects.

Yearn Finance and YFI (10:48)

This brings us to another major DeFi innovation. Yearn, developed by Andre Cronje in early 2020, is a yield optimizer that focuses on maximizing DeFi capabilities by automatically switching between different lending protocols. To further decentralize Yearn, Andre decided to distribute a governance token — YFI — to the Yearn community in July 2020. The token was fully distributed via liquidity mining: no VCs, no founder rewards, no dev rewards.

This model attracted a lot of support from the DeFi community, with money flowing into the incentivized liquidity pools, topping 600 million dollars in locked value. The token price itself started its parabolic run from around six dollars when it was first listed on Uniswap, to over thirty thousand dollars per token less than two months later.

Like with pretty much all groundbreaking projects in DeFi, Yearn's success was quickly followed by multiple other teams launching similar projects with a few minor alterations.

The food DeFi era (11:44)

Another project that started gaining traction thanks to its unique elastic supply model was Ampleforth. This model was quickly borrowed and reiterated on by another DeFi protocol: Yam. After only 10 days of development, Yam was launched on the 11th of August 2020.

Yam tokens were distributed in the spirit of YFI, and the protocol quickly started attracting a lot of liquidity. It aimed at building interest in strong DeFi communities by rewarding holders of COMP, LEND, LINK, MKR, SNX, and YFI for staking their tokens on the Yam platform.

Just one day after launch, with half a billion dollars of total value locked in the protocol, a critical bug in the rebase mechanism was found. The bug affected only a portion of liquidity providers, but this was enough for people to lose interest in Yam, despite later attempts to relaunch the protocol.

Then comes SushiSwap, launched at the end of August 2020 by an anonymous team. The protocol introduced a new concept of a vampire attack that aimed at siphoning liquidity out of Uniswap by incentivizing Uniswap's liquidity providers with SUSHI tokens. SushiSwap was able to attract as much as one billion dollars worth of liquidity. After some drama with the main SushiSwap developer, Chef Nomi, selling his entire stake of SUSHI tokens, the protocol was eventually able to migrate a lot of Uniswap's liquidity onto their new platform.

During the DeFi Summer, there were a lot of other projects of varying quality being launched — most of them just iterations of existing open-source projects trying to benefit from the over-exuberance. Following Yam and SushiSwap, there was a bunch of projects named after different kinds of foods — Pasta, Spaghetti, Kimchi, HotDog, and others — collectively named "food DeFi" or "food finals." Pretty much all of them failed after a day or two of interest.

The Uniswap token and key metrics (14:16)

One of the last major events of DeFi Summer was the launch of the Uniswap token, UNI. All the previous users and liquidity providers of Uniswap were rewarded with a retrospective airdrop worth well over one thousand dollars. On top of that, Uniswap started its liquidity mining program across four different liquidity pools and attracted more than two billion dollars in liquidity, most of which was taken back from SushiSwap.

During DeFi Summer, all of the key metrics improved dramatically:

• Uniswap's monthly volume went from 169 million dollars in April 2020 to over 15 billion dollars in September 2020 — a massive increase of almost 100x
• Total value locked in DeFi went from 800 million dollars in April to 10 billion dollars in September — over a 10x increase
• The amount of Bitcoin moved to Ethereum went from 20,000 in April to almost 60,000 in September — a 3x increase

DeFi winter and recovery (15:30)

DeFi's parabolic ascent was of course not sustainable long-term. The market sentiment quickly changed at the beginning of September 2020. Major DeFi tokens started sharply losing their value. The yields from liquidity mining, derived from the value of the distributed tokens, also became lower and lower. The DeFi winter had come.

The negative sentiment lasted throughout September and October, despite the DeFi ecosystem still being very active with developers continuing to build new protocols. The DeFi market finally found its bottom in early November, with some of the top DeFi protocols trading 70 to 90 percent lower than their all-time highs just a couple of months earlier.

After a quick rebound of more than 50 percent, the DeFi market started trending up again. Interestingly, during the DeFi winter, the Uniswap volume still remained much higher than it was in early 2020. Also, the total value locked in DeFi kept trending upwards, topping 15 billion dollars at the end of the year. This was all despite multiple hacks that haunted the DeFi industry throughout 2020: bZx, Harvest, Acropolis, Pickle, and Cover, to name just a few.

At the end of 2020, with Bitcoin breaking its previous 2017 all-time high, it looked like DeFi was preparing for another parabolic run.

Looking ahead to 2021 and beyond (16:56)

Looking further into 2021 and beyond, the future of DeFi is bright. DeFi developers keep building new innovative projects. Much-needed scaling is also coming in the form of Ethereum 2.0, layer 2 solutions, and even other blockchains. This will allow for a new set of users to start participating in DeFi. It will also help with discovering new use cases that were previously not possible due to high network fees.

Bringing new, more traditional assets into DeFi — by either tokenizing them or creating their synthetic versions — will also open up completely new opportunities. Competition between DeFi on layer 2, DeFi on Ethereum 2.0, DeFi on Bitcoin, and DeFi on other chains will also play a big role. Interoperability protocols and cross-chain liquidity may become really important.

Other areas such as credit delegation, under-collateralized, or non-collateralized loans are also being explored. This will all become clear in 2021 and beyond.