After an uncertain year, DeFi has high hopes for 2023

Decentralized finance (DeFi) is defined as any product or service offered by the Web3 world that helps users perform financial activities such as payments, borrowing, lending, investing, trading and betting.

Several Web3 use cases, including DeFi, GameFi, SocialFi and nonfungible tokens (NFT), emerged throughout the last bullish cycle. DeFi has been the largest market capitalization activity within Web3, with a peak total value locked (TVL) of over $175 billion at the peak of the 2021 bull market.

DeFi: The primary use case for blockchain?

Things haven’t been the same since the Bitcoin genesis block was created. Thanks to the rise of Ethereum that followed, DeFi has seen the product market adapt. Through the previous Bitcoin (BTC) bull market, DeFi TVL rose from $600 million in January 2020 to $180 billion in December 2021.

TVL in DeFi has held over $39 billion despite the market crisis in 2022. DeFi has democratized access to financial services, as it does not need a centralized organization to onboard users. Apart from democratization, DeFi has also opened up new models such as automated market creation.

All these innovative elements have catalyzed the growth of DeFi protocols and applications. This has also helped other adjacent use cases such as NFTs and GameFi to grow. For example, lending models with “NFTs as collateral” have had a good recovery. In addition, DeFi-based models and marketplaces for gaming NFTs have emerged for gaming guilds to tap into.

Despite these interesting developments, DeFi shrunk to just $39 billion in 2022. Let’s see what happened in 2022 and what to expect in 2023 for DeFi.

Fall out of favor

The year 2022 started with a broader market decline. Within the Web3 ecosystem, Solana’s Wormhole bridge was hacked, leading to $310 million worth of crypto assets being stolen. Thanks to a few projects on the Solana ecosystem, they managed to get out of this abyss.

In March, however, rumors about the credibility of the Terra ecosystem and its algorithmic stablecoin began to emerge. As the market took a further decline through April and May, the network collapsed, prompting a broader market selloff.

1/ I have spent the last few days on the phone calling Terra community members – builders, community members, staff, friends and family, who have been devastated by the UST depegging.

I am devastated by the pain my invention has caused you all.

— Do Kwon (@stablekwon) 13 May 2022

After the Terra episode, the markets recovered through the summer, only to be dragged down again by the FTX debacle. While the FTX situation cannot be fully categorized as a DeFi issue, as it was the result of alleged misconduct by a centralized exchange, some have noted the effect FTX and its affiliate, Alameda, had on the ecosystem.

This is pretty much public knowledge at this point, but the major currency contraction that UST went through in February 2021 was started by Alameda, when they sold 500mm of UST in minutes to drain their curve pools during the MIM crisis

— Do Kwon (@stablekwon) 8 December 2022

Despite the bloodshed, the DeFi industry has quietly continued to build and innovate. 2022 was also marked by several institutional DeFi headlines that could bring benefits in the coming years.

The Bitcoin network is starting to see utility as the Lightning Network allows projects to build on top of it. Cash App integrated Lightning Network for faster Bitcoin transactions. There are several other payment applications that could potentially change the “store of value” of the apex asset.

DeFi TVL on the Ethereum network before the previous bull run started was a few hundred million dollars. The DeFi TVLs on several Layer 1 and Layer 2 networks, namely Avalanche, Solana, Polygon and Arbitrum, cost a few hundred million dollars each. When the next Bitcoin halving arrives, all of these ecosystems should see DeFi growth.

Although market sentiment has not been positive, there have been a large number of positive developments in DeFi, so what does 2023 mean for DeFi?

Security and DeFi

Hackers were rampant in 2022, causing DeFi crypto investors to lose significant amounts of money. As regulations increase and institutional adoption shows promise, there must be some important developments in this area.

The crypto industry has lost close to $3 billion in 125 hacks as of October 2022. This damages the reputation of the space and is a major obstacle to attracting institutional capital. In response, the DeFi ecosystem has already started creating applications that inform wallet holders of what a smart contract intends to do before the user signs it.

However, more needs to be done to address security vulnerabilities around oracles and cross-chain bridges. More decentralization of chain bridges is a good step forward. Also, DeFi platforms will start to consider insurance products more seriously to protect user funds. Companies such as CertiK and Hacken offer specialized cyber security solutions for Web3 platforms.

DeFi and self-storage

The failure of several prominent centralized exchanges and platforms in 2022 has already helped shift volumes to DeFi platforms. However, DeFi still relies heavily on centralized platforms to onboard new users and convert fiat to cryptocurrencies and vice versa. This trend is being challenged and may change in 2023.

As more users choose DeFi over centralized financial solutions, embedding infrastructure into the crypto world should improve. Wallets will have on-ramp plugins like MoonPay and Ramp that will connect to users’ credit cards, Apple Pay or bank accounts to convert fiat to cryptocurrencies and vice versa.

Another important on-ramp feature that has emerged is wallets that do not require users to manage private keys. As user experience takes center stage, DeFi solutions may see more first-time adopters.

Web3 games

2022 saw a number of gaming projects with DeFi integrations trying to find market share. In 2023, these projects will continue to mature and grow with DeFi as a strong pull factor.

Web3 games have found themselves in a unique position in the entire ecosystem and could be the growth spurt that Web3 has been looking for. While the games still struggle with playability, ecosystem-specific revenue models, stakes and farming will provide unique offerings and value propositions that traditional games lack.

Can regulators be far behind?

With catastrophic failures by marquee companies and loss of user funds, central banks and regulators will start to have a bigger say in DeFi.

Although counterintuitive to the ethos of what Web3 stands for, central banks will begin to create regulations and legislation for consumer protection. If US regulators crack the 90-year-old Howie Test whip and consider most cryptocurrencies securities, it will certainly affect this area in the short to medium term.

Until crypto platforms comply with time-tested securities laws, the risk to investors will persist. It remains a priority for the SEC to use all of our available tools to bring the industry into compliance. https://t.co/m8oh0gTvc3

— Gary Gensler (@GaryGensler) 22 December 2022

However, some regulations have helped the room gain more credibility. Know your customer and Anti-Money Laundering (AML) controls, as well as codes of conduct for labeling DeFi-related financial products can bring security to the space and encourage investors.

Institutional DeFi on the rise

Institutional interest in DeFi has picked up over the past year. Payment, custody and AML solutions have particularly attracted interest from large banks and financial institutions.

Barclays bought a stake in Copper, an institutional crypto depository company, while Standard Chartered’s innovation arm teamed up with investment management firm Northern Trust to launch Zodia, a cryptocurrency depository for institutional investors.

Bank of New York Mellon, the world’s largest custodian bank, partnered with Chainalysis to help track and analyze cryptocurrency products.

Financial services firms such as BlackRock and Citigroup invested over $1 billion each in DeFi platforms through 2022. As these firms see more institutional clients interested in the crypto-asset class, they will be forced to make offerings to support their clients.

With several central banks rolling out plans for their own digital currencies, banks need to prepare for the on-chain world.

On-chain banking will be the next phase of digital banking where transaction completion and reconciliation will be instantaneous, giving rise to new business models and financial products. 2023 will see important steps in this direction.

In summary, DeFi is poised to mature and stabilize through 2023. Any new technology has its ups and downs. After seeing a strong bullish phase and a grueling bearish decline, the time is ripe for steady growth based on the wisdom gained through the experiences of 2022.