Market Overview and Relevant Landscape
Since the beginning of internet-based trading, the markets around the globe have observed the ever increasing importance of the internet in everyday life. Not only that, but this colossal paradigm shift actually changed the whole methodical outlook of investors. This type of evolution of communications has created a basis for a vast amounts of research and forms of application stemming from it. The basic reason for this was and still is (defined by the Wharton School Center for Financial Institutions[^1]):
- Lower overall fees for the investors;
- Transparency - the ability for a much wider amount of investors to analyze information and come to conclusions themselves;
- Differential pricing, which means that the internet significantly lowered the costs that industry charges for financial transactions;
- Overall disintermediation - the constant shrinking of the intermediary broker function in between the trading transactions;
During the turn of the century, many communications and digital finance researchers were very hopeful for the potential the internet and its devised software would provide in the future. Already in 2000 one study gathered that the critical success of any digital trading will depend on the model of revenue flow[^2], which quite precisely predicted the nowadays plethora of technologies behind the distribution of financial gains in digital markets.
Moreover, around that turn of the century period, there were studies that predicted the digital market expanding and ensuring its longevity within the three main goals it needed to achieve[^3], and as we can look at it in hindsight - it has. Those three goals were defined as:
- The internet - free and open access to information for all individuals around the globe;
- Globalisation and regionalisation - markets widening their reach outside singular countries;
- Financial cryptography - the insurance of safe electronic passage of finances between the transaction parties;
Thus, all of these goals were achieved and implemented in various asset trading, such as cryptocurrency.
The end game for all virtual currencies always had to be the cryptocurrency technology. The increasing popularity of digital assets like Bitcoin is driving the market growth and will be doing so in the foreseeable future. The popularity of virtual currency as an exchange medium has led various central banks around the globe to participate in supporting the digital currency in various applications. Countries like the U.S., Uruguay, China and others have adopted the cryptocurrencies and had their central banks to support them in many exchange functions. Private ventures did not slack off on this trend, as for example, even Facebook has launched and offered a digital currency named Libra.
With having the best protected security in mind, multiple DEXes (Decentralized Exchanges) provide blockchain technology and peer-to-peer connection. Since centralized exchanges do not provide a recorded transaction security, DEXes have become even more popular and an integral part of the whole cryptocurrency market system.
Further proof which ensures the ever growing crypto technology is that even universities, such as Yale, Harvard and Massachusetts Institute of Technology have invested their endowments into various cryptocurrency projects and assets.
So, what is hoped top gain and what can be perceived as the driving forces of the growing cryptocurrency markets? Here is the list of every potential and significant reason for it:
- 1.A potential for high returns. In the 5 years to 2020, the S&P 500 index of large cap US equities has compounded at an annualised growth rate of 14.5% (in USD, net dividends reinvested); over the same time period the price of bitcoin in USD has compounded at an annualised growth rate of 131.5%.
- 2.A potential for diversification. Some have cited cryptocurrencies as an alternative hedging instrument to gold in a portfolio context. For example, the S&P 500 declined in 17 out of the 60 months to end December 2020, of which the price of bitcoin rallied in seven. In the 5 years to the end of 2020 a portfolio consisting of 10% invested in bitcoin and 90% in the S&P 500 would have generated compound annual returns of 26.8%.
- 3.Bypassing debased currencies and threats of inflation rising. The Global Financial Crisis in 2008/09 was a catalyst for central banks around the world to engage in unorthodox monetary policies, notably large-scale asset purchases. Since the Crisis the Federal Reserve System's balance sheet has expanded by 8x, the European Central Bank's by a little under 4x and the Bank of Japan's by nearly 7x. Some people are concerned this will result in a massive debasing of national currencies and associated increase in inflation. They suggest cryptocurrencies offer alternatives that cannot be debased in the same way.
- 4.Growing overall acceptance and usage. A 2020 article on Coindesk.com claimed that Coinbase had seen USD 135 billion in cryptocurrency merchant transactions in 2019, a 600% increase over 2018. That same article cites a Chainalysis report that alleges payment processors saw approximately USD 4 billion worth of bitcoin activity in 2019. Separately, it is notable that there has been a significant increase in the number of bitcoin electronic wallets created over the past few years (see graph below) and there are an increasing number of institutional investors who are looking to invest in cryptocurrencies.
The global cryptocurrency market size is projected to reach USD 1.8 billion by the year 2027. Bearing all this in mind, let us look at the available data of convincing future prognosis for cryptocurrency market size:
Putting Bitcoin aside, various altcoins are on the rise as well. Not only your typical currency, but product-specific cryptocurrency as well. Here is the latest data for highest valued cryptocurrency market capitalizations:
As mentioned before, with the rise of cryptocurrencies there came the inevitable rise of a unique ecosystem called DeFi (Decentralised finance). According to Binance Academy DeFi can be defined as "the movement that promotes the use of decentralized networks and open source software to create multiple types of financial services and products. The idea is to develop and operate financial DApps on top of a transparent and trustless framework, such as permissionless blockchains and other peer-to-peer (P2P) protocols.[^4]"
Three main functions of DeFi are:
- Creating monetary banking services (i.e. issuance of stablecoins);
- Providing peer-to-peer or pooled lending and borrowing platforms;
- Enabling advanced financial instruments such as DEX, tokenisation platforms, derivatives and predictions markets;
Hence, DeFi provides a fully-fledged capital market, and in contrast to the, say, decentralization of money through Bitcoin, DeFi also provides a broader approach of generally decentralizing the traditional financial industry. The core of the initiative is to open traditional financial services to everyone, in providing a permissionless financial service ecosystem based on blockchain infrastructure.
Nascent though it may be, DeFi nevertheless appears set to disrupt the financial services sector in the years ahead. So, as digital finance methodologies continue to burgeon, to what extent is existing financial infrastructure on 'borrowed time'? The first wave of DeFi has already hit traditional financial markets in terms of the adoption of infrastructure for managing and storing cryptocurrencies. Ultimately, it seems, the unregulated DeFi world will merge with the regulated financial world.
For users, the appeal of DeFi is simple. There are almost no requirements to participate, except for having some form of crypto as collateral. Interest rates are attractive compared with traditional investment products. And because transactions are automated, settlement is virtually instantaneous, removing some of the traditional counter party risk.
Here we can observe the recent market capitalizations of DEXes based on trading volumes, market share and DeFi markets:
[^1]: Eric K. Clemons, Lorin Hitt, "The Internet and the Future of Financial Services: Transparency, Differential Pricing and Disintermediation". Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania, 2000, available at: <https://EconPapers.repec.org/RePEc:wop:pennin:00-35>.
[^2]: Jennifer Wu, Michael Siegel, Joshua Manion, "Online Trading: An Internet Revolution". Research notes, Sloan School of Management, Massachusetts Institute of Technology, 1999, available at: <http://web.mit.edu/smadnick/www/wp2/2000-02-SWP%234104.pdf>.