Decentralized finance (DeFi) has a problem. We wanted to build a financial alternative, driven by the shortcomings of opaque companies that often put their interests above those of their customers. The goal was a decentralized, self-governing economy that was transparent and largely independent of external influences.
Instead, today’s crypto markets are hanging on Fed Chairman Jerome Powell’s every word, running almost entirely on centralized stablecoins and introducing real bonds as collateral.
This article is part of ‘Staking Week’. Conor Ryder is head of research and data at Ethena Labs.
While I am fully aligned with a pragmatic approach – making short-term sacrifices that give us a better chance of achieving an end goal – the time has come to accept that DeFi as it stands now is not that decentralized. Blockchain finance might be a better term.
But crypto-native staking returns can help us return to DeFi.
How did we get to this point?
Stable coins
Many previous attempts at decentralized stablecoins have failed. In short, this is because they have either struggled to scale and compete with their centralized counterparts, or they have scaled too quickly based on fundamentally flawed designs.
Decentralized stablecoins are the holy grail, but since the collapse of Terra we have seen a lack of innovation in this area. New approaches are immediately rejected if they dare to suggest anything other than an approach that offers too much collateral. DeFi was left shaken and shaken after Terra, and since then there has been an emphasis on security at the expense of innovation.
Centralized stablecoins are the driving force behind DeFi today, with over 95% market share in on-chain volumes compared to their more decentralized counterparts. Web2 incumbents like PayPal entering the stablecoin space will only exacerbate this trend. Centralized stablecoins were built to get into as many hands as possible and as a result have quickly spread throughout DeFi. On the other hand, overloaded stablecoins, limited by their design, have lagged behind and have not achieved the same level of adoption.
While it is positive to see stablecoins being accepted regardless of who issues them, it is important that DeFi offers a competitive, decentralized stablecoin that can stand on its own two feet and put the “The” back into DeFi.
Yield
Second, the rise in US Treasury yields has shifted the real risk-free rate to 5%, leaving crypto collateral assets that generate little to no passive income with a competitive mountain to climb. If you have a struggling crypto protocol, where decentralization is not your first priority, it makes sense to move your collateral to a risk-free asset that yields a 5% return. However, these are not just the protocols that real-world assets (RWAs) have on board in search of higher returns. Some of DeFi’s largest blue chips have moved a large portion of their assets into RWAs. According to rwa.xyz, tokenized treasuries have increased from $100 million at the start of 2023 to more than $600 million today.
The rate and rapidity of adoption of US Treasuries and RWAs should make us question the industry’s commitment to decentralization. To be clear, it’s fine if we have other goals, such as moving financing on the blockchain à la PayPal USD or settling transactions via USDC on Solana via Visa. But let’s be honest about the current state of DeFi: it’s Blockchain Finance running on US Treasuries and centralized stablecoins. That can modernize the financial world and bring more users onto crypto rails, but we need to start building out solutions that serve as decentralizing forces in the space to provide viable options for holding money outside the banking system.
Where do we go from here?
Enter the returns from crypto stakes, or more specifically the returns from ‘post-Shapella’ stakes. Since the Shapella upgrade of the Ethereum network, users have been able to stake and unstake their ether (ETH) at their discretion, significantly reducing the risks of deploying ETH from a liquidity perspective. This is reflected in the discount on ether stakes, or sETH, to ETH, which has barely fallen past 30 basis points since Ethereum’s last major upgrade. Before Shapella’s upgrade, sETH was poor collateral due to its illiquidity and discount volatility. Now that sETH has been de-risked, we have seen it overtake ETH as the top collateral in DeFi.
Also see: Crypto Staking 101: What is Staking?
This means that DeFi now has yield-bearing collateral that is both native to crypto and decentralized. StETH delivers competitive bond yields of 4%-5% and gives protocols another option without the censorship risk profile of bonds. This will only help decentralize DeFi, as protocols and stablecoins can now build on top of sETH instead of RWAs and evolve independently of the traditional banking system.
An interesting addendum is that we are very likely at the top of an interest rate cycle for bond yields and interest rates, meaning that in a few years we could see ETH bond yields exceed bond yields. In that scenario, the decision to maintain RWAs for crypto protocols would be difficult to justify. At that point, we could see DeFi become truly self-sustaining, built on crypto-native, yield-bearing collateral.