Summary of this section:

● The total lock-up value of DeFi has exceeded 100 billion US dollars, most of which have been allocated to lending platforms and decentralized exchanges. However, most DeFi tokens underperformed Ethereum.

● The amount of funds stolen from DeFi has increased eightfold compared to last year, with a total of 50 attacks totaling $610 million.

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The State of DeFi in 2021

Decentralized Finance (DeFi) is an open financial system powered by smart contracts and blockchain oracles that has the potential to replace decades-old financial systems with opaque infrastructure and processes. DeFi provides users with permissionless and location-free access to a variety of financial instruments without ceding control of assets to intermediaries such as brokers or banks.

The "Summer of DeFi" in 2020 has set off an upsurge in liquidity mining and opened up unlimited opportunities for DeFi. The total value locked (TVL) in DeFi protocols soared from $16.1 billion to $101.4 billion this year, with most of the funds allocated to lending protocols and DEXs.

However, after DeFi tokens dominated the crypto market in the first quarter of this year, their performance began to fade. The “DeFi” index was at 1.0% in January, peaked at 3.2% in April, and is now at 1.5%.

If DeFi's "blue chips" (UNI, AAVE, COMP, SUSHI, SNX, CRV, and YFI) are used as proxy indicators for DeFi tokens from the beginning of the year to date, most of their prices have outperformed Bitcoin, but not Ethereum square. from the first quarter. CRV is the only DeFi token to surpass Ethereum after its explosive growth in Q4, while SNX, YFI and COMP have been the worst performers recently.

The massive increase in Ethereum’s strength can actually be seen in light of most of the DeFi growth centered on Ethereum. Uniswap is the most used DeFi protocol, with more than 1 million active users in May, and on average, 45.7% of Uniswap's monthly active users are new users.

borrow money

borrow money

Lending is one of the main pillars of DeFi, and Value-Locked (TVL) has witnessed the unstoppable growth of loan protocols, from $7.1 billion in 2020 to $46.8 billion in 2021, an increase of 559.2%. The top three lending agreements by value locked are Maker, Compound, and Aave, with TVLs of $18.3 billion, $12.8 billion, and $10.8 billion, and total outstanding debt of $9.1 billion, $7.7 billion, and $6.5 billion, respectively.

A common feature of these widely used lending protocols is that all loans issued must be overcollateralized. If the position is deemed to be at risk (when the position falls below a certain minimum collateralization ratio), the custodian can force liquidation of the collateral to pay off the outstanding debt. That way, loans can be drawn out anonymously and trustlessly, while reducing the risk of protocol bankruptcy should delinquent borrowers default.

While established lending protocols have long dominated, the lending landscape is becoming more diverse as new lending platforms fine-tune and target different niche audiences.

Alchemix and Abracadabra can use yield-generating positions as collateral, which mitigates some of the capital inefficiencies but introduces composability risks. Additionally, TrueFi is the first on-chain unsecured lending platform to maximize capital efficiency for creditworthy borrowers.

Decentralized Exchange (DEX)

In addition to lending protocols, automated market makers (AMMs) are also able to attract liquidity from market participants eager to deploy idle assets for yield.

Overall, the total monthly DEX transaction volume peaked at $162.8 billion in May 2021, with the most significant month-on-month growth coming in January, up 137.3%. However, trading volumes have not fully recovered from the market drop in May, with the ratio of DEXs to spot trading volumes on centralized exchanges remaining below 10% for the year.

Curve has become the largest DEX with a lock-up value of up to 16.8 billion US dollars, accounting for 6.8% of the total lock-up volume of DEX. Curve is an AMM optimized for transactions between similar assets, which achieves low risk and sustainable returns thanks to its liquidity mining (LM) and changeable price curve.

On the other hand, Uniswap continues to lead in volume. Uniswap v2 was the most traded DEX before being overtaken by Uniswap v3 in June. At its peak in May, Uniswap v2’s monthly trading volume hit $59.2 billion, but was dwarfed by v3’s centralized liquidity design, which greatly reduced slippage.

Derivatives

Derivatives

Perpetual futures contracts have been the largest segment of the crypto industry, and while DEXs have become competitive over the years, it only makes sense that the next step in growth would be to expand into the derivatives market.

Perpetual Protocol led the way in derivatives market volume in the first half of 2021, setting a record weekly volume of $551.1 million in the market's down week in May. Perpetual runs on the xDai sidechain and is built on top of a virtual AMM (vAMM) that parameterizes depth of market. Using this model, the protocol can provide instant liquidity without the need for a counterparty.

dYdX made a comeback after launching the native token DYDX in August and launching the liquidity mining plan. dYdX relies on StarkEx, a zk-rollup (Layer2) solution. It employs a hybrid infrastructure model utilizing non-custodial on-chain settlement, and an off-chain low-latency matching engine with an order book. Liquidity on dYdX comes primarily from professional market makers such as GSR and Wintermute.

Perpetual futures typically operate independently of other DeFi protocols, sacrificing composability through leverage for capital efficiency.

Synthetic assets are tokenized derivatives. Synthetix is ​​the oldest and largest synthetic asset distribution protocol to date. SNX stakers can over-collateralize to mint synthetic tokens and trade them against other synthetic tokens on the platform, which offers slippage-free execution at oracle prices.

Synthetix's trading volume is dominated by FX (52.2%) and cryptocurrency (47.1%) synthetic tokens, with July being the highest volume month at $1.6 billion. The average number of daily traders on Synthetix fell from 167.5 in January to 13.8 in November, indicating that it has failed to attract interest from trading users. It remains to be seen whether it can regain user favor after its recent migration to Optimism.

On the other hand, Mirror, a synthetic stock protocol on the Terra public chain, imitates Synthetix's over-collateralization method, but removes the no-slip trading product, so synthetic tokens can only be traded on the secondary market. This shifts the burden of open interest to the open market, causing the synthetic tokens issued by Mirror to continually trade at a premium.

The TVL of the two platforms has remained stable over the past few months, with Synthetix at $1.7 billion and Mirror at $1.3 billion. Their growth could be hampered by mounting regulatory pressure, as the Securities and Exchange Commission (SEC) recently brought enforcement action against Mirror.

structured products

structured products

In recent years, the growth of DeFi has also been accompanied by the increasing complexity of portfolio management, which has spawned many pre-packaged structured products that abstract the complexity of different financial instruments to save investors time and costs.

The first iteration of a structured product is the Yield Aggregator, which automatically optimizes yields for depositors. Convex is TVL's largest revenue aggregator. Launched in May 2021, it specifically boosts rewards for liquidity providers on Curve, TVL's largest decentralized exchange. With Curve's $16 billion TVL, Convex has surpassed the first revenue aggregator, Yearn.

Other types of structured products are also starting to develop this year. For example, yield tranche protocols like BarnBridge divide returns into portions for investors with various risk appetites, while indices like the DeFi Pulse Index offer holders passive exposure to a basket of select tokens.

On the other hand, automated liquidity providing (LP) managers such as Charm and Gelato automatically balance LP positions on Uniswap v3, while automated trading strategy managers such as Ribbon combine various derivatives with risk-reward adjustments. These products are in their infancy, and it remains to be seen whether they will be widely adopted.

liquid pledge

In December 2020, the beacon chain launched by Ethereum initiated the transition to the proof-of-stake (PoS) consensus mechanism under Ethereum 2.0. Users can pledge ETH to become the verifier of the network and get more ETH rewards. However, becoming a validator requires sufficient technical knowledge and funds, and the pledged ETH cannot be withdrawn until Ethereum 2.0 goes live.

The liquid pledge solution can tokenize and "liquidize" the pledged ETH shares. Users who pledge ETH in the Eth2 contract through Lido will receive equivalent liquid tokens in the form of stETH, so that participants can access PoS pledged At the same time, it can continue to be used in other DeFi applications, just like the collateral of the lending platform.

Decentralized stable currency

Decentralized stable currency

Decentralized stablecoins facilitate permissionless payments on-chain. Maker's DAI is the largest decentralized stablecoin, and its share of the total stablecoin supply will rise from 4.1% to 6.3% in 2021. This year, DAI circulation soared from 1.2 billion to 9 billion.

DAI was trading at a premium for some time in 2020, so the Pegged Stability Module (PSM) was introduced to stabilize the price of DAI near the USD peg. PSM allows users to directly swap collateral for DAI at a fixed rate. 14.9% of DAI in circulation is backed by USDC or USDP originating from the PSM.

Similar to other fields, the decentralized stablecoin landscape has become more diverse. Abracadabra's MIM, a stablecoin primarily backed by yield-generating positions, is by far the second-largest collateralized decentralized stablecoin with a market capitalization of $3.5 billion. MIM borrowers increase capital efficiency by earning income on collateralized assets.

The “stablecoin trilemma” has also been notoriously difficult to resolve over the years. The trilemma refers to the dilemma of stablecoins with regard to these three attributes: decentralization, capital efficiency, and price stability. Extensive experiments with algorithmic stablecoins have aimed to address the aforementioned trilemma, with mixed results.

In early 2021, we saw many unsecured algorithmic stablecoins (such as Empty Set Dollar) collapse at lower than expected exchange rates due to lack of risk-free arbitrage opportunities. However, other forms of algorithmic stablecoins that rely on fractional reserves or native assets are starting to flourish, with four of them having a market cap of over $300 million.

UST based on the Terra public chain is the largest algorithmic stablecoin with a market value of 7.6 billion US dollars and is minted as seigniorage shares by the native asset LUNA, which is the native asset of the Terra blockchain. Users can burn 1 USD worth of LUNA to create 1 UST and vice versa. UST has benefited from the explosive growth of Terra's DeFi ecosystem, as UST is heavily used in lending platform Anchor Protocol and synthetic asset issuance platform Mirror Protocol.

Low Volatility Tokens

Algorithmic low-volatility tokens, often referred to as “non-pegged stablecoins,” are an emerging asset class that has captured the market’s attention this year. Their goal is to be a decentralized reserve currency that is less volatile than most crypto assets and less prone to long-term changes in purchasing power due to unforeseen monetary policy or economic situations.

These tokens have a feedback mechanism that dampens price volatility by regulating token supply as demand fluctuates. Launched in March 2021, Olympus DAO's OHM is the largest low-volatility token with a current market cap of $4.1 billion.

OHM tokens are backed by collateral, but trade at a premium. It is because of artificial demand that investors are incentivized to stake OHM to earn more OHM tokens. The DAO accumulates more collateral by selling vested OHM at below-market prices, allowing the protocol to issue more OHM tokens backed by additional collateral. This creates a circular economy driven by speculative demand.

But it remains to be seen whether these tokens will generate demand beyond pure speculation.

"Anchoring Bitcoin" in DeFi

In a way, Bitcoin is the first "DeFi" that allows holders to store and transfer funds without permission. Despite the lack of a quasi-Turing-complete virtual machine on the Bitcoin network, Bitcoin is heavily used in DeFi applications on other blockchains. This is not surprising considering BTC has a 39.1% market dominance in the crypto space. The number of "anchor bitcoins" on Ethereum has risen steadily from 140,000 to 316,600 this year, equivalent to 1.7% of the total bitcoin.

Centralized custodians play a key role in porting Bitcoin’s value to DeFi, likely due to capital efficiency and user-friendliness. WBTC is the most popular anchored version of Bitcoin, accounting for 80.0% of the Ethereum market share, followed by HBTC at 12.6%, surpassing renBTC in January 2021. The top three holders of WBTC are all lending protocols, Maker (20.8%), Compound (13.1%), and Aave (10.1%).

Insurance

Insurance

While most areas in the DeFi ecosystem are booming in 2021, DeFi insurance may be one of the very few categories to decline. The amount insured in Nexus Mutual, a leading insurance solution, peaked at $2.3 billion in February and then fell to $688.2 million, a drop of 70.0%.

IDO

IDO refers to token issuance through DEX, which is currently one of the most popular token issuance methods. However, the issuance of tokens through the creation of liquidity pools on DEXs attracted "scientists" and bots to compete with ordinary users and significantly increased the market price, which they then sold on the open market for profit.

The Liquidity Bootstrap Pool (LBP), pioneered by Balancer, has become a more efficient way to issue tokens this year. Initial listing prices for new tokens will start at a high level to dampen scrambling. Prices will adjust based on immediate buying demand, algorithms, and over time. It is similar to a Dutch auction, but more responsive to peak demand.

On the other hand, the Initial Bonding Curve Offering (IBCO) popularized by the Hegic protocol has become the preferred token issuance method for most Solana-based projects. Investors can deposit and withdraw funds during the sale, after which they can redeem tokens proportionally. The more funds raised, the higher the implied token valuation. Unlike LBPs, IBCO offers the same settlement price to participants of any capital size.

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Summary of DeFi Vulnerabilities in 2021

In 2020, the popularity of DeFi protocols has led to an increase in the number of users and the TVL of projects. In turn, large protocols have attracted the attention not only of investors, but also of hackers, who stole more than $77 million in user funds through bugs in 2020.

The public chain compatible with Ethereum EVM, as well as smart contracts that cannot be upgraded quickly and are vulnerable, have led to repeated theft of funds this year. This year, the amount of stolen funds has increased eightfold compared to last year, reaching $610 million. There were 50 attacks in total, and about 60% of all funds ($355 million) were stolen by attackers through flash loans.

Another situation is that the attacker can return some of the stolen funds to the project, and this usually happens because the attacker agreed to a bug bounty or their identity was found out. Overall, 53% of the total stolen funds in 2021 ($404 million) were returned to projects, the majority of which was stolen from Poly Network.

While the majority of vulnerabilities still occur on Ethereum, hacks on BSC, Polygon, and Avalanche have also emerged since April. Roughly a third of the stolen funds ($200 million) belonged to projects on the BSC, and it was in May, dubbed by crypto users “BSC’s Gray May.”

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prediction market

prediction market

Prediction markets are platforms where investors can bet on the occurrence of real-world events. It is the first concept of distributed applications implemented on the blockchain, such as Augur.

Despite its early start, it failed to generate surprising volumes compared to other classes of DeFi protocols. Polymarket on Polygon is the leading prediction market for 2021, featuring popular times, major global events (e.g. US presidential election) and crypto trends (e.g. Bitcoin's price, Ethereum upgrade). Surprisingly, sporting events have not attracted more participation from crypto investors.

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Non-USD stablecoins

Most stablecoins are pegged to the U.S. dollar, as stablecoins are primarily used to trade cryptocurrencies that are settled in U.S. dollars. While there are currently a large number of stablecoins pegged to various fiat currencies, most of them have no demand or liquidity. Nonetheless, it is expected that euro stablecoins may gain adoption in the coming years.

First of all, the current euro is already the second largest stablecoin group. Two euro-pegged stablecoins already exist in the DeFi space: sEUR is Synthetix’s synthetic euro with a market cap of $118.7 million, and STATIS EURO (EURS) is a custodial euro stablecoin issued by Stasis with a market cap of $102.2 million.

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Tokenization of real-world assets

While cryptocurrency as an asset class has grown into a $2 trillion market, it remains relatively isolated and disconnected from other industries. As the tokenized economy grows, everything that carries value, be it financial or cultural, will be tokenized in some way. Bridging the gap between real world assets (RWA) and DeFi can bring a lot of "old wealth" to the new digital economy and strengthen the DeFi ecosystem.

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Governance reform

The interests of governance token holders and protocol users are not aligned. Only 7% of users fall into both categories. Token holders generally prefer to maximize short-term value extraction, even at the expense of the protocol's long-term sustainability. In contrast, protocol users prefer the persistence and neutrality of the protocol.

Maker is a classic example of this governance dilemma. Token holders benefit from higher interest rates on DAI borrowing, while borrowers prefer the opposite. If users cannot rely on governance to make decisions in their best interest, that will drive users away.

Curve’s staking voting solution solves this dilemma. Curve's native token, CRV, does not directly provide voting rights. However, CRV holders can lock tokens, issue veCRV 1:1, and grant veCRV holders voting rights. The longer tokens are locked, the more veCRV (voting rights) they receive. In this way, both token holders and users have vested interests in the development of DEX. In addition, liquidity providers on Curve will receive higher rewards if they directly lock the proceeds, thereby incentivizing users to actively participate in governance.

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Forks of DeFi

Institutions are eager to deploy funds into the DeFi space, but face numerous obstacles due to regulatory uncertainty (KYC/AML, securities laws). Some protocols have spawned the concept of "permissioned DeFi", which can satisfy existing compliance requirements.

Some people think that such a development is against the purpose of DeFi, that is, against the principle of decentralization. Still, some applications require trust in certain parties, such as borrowers for unsecured loans, custodians for RWA tokenization, etc. Open finance should be more than just decentralized finance, it should also provide users with options and transparency.

These projects will be able to access funding from institutional giants who have never touched DeFi. Some existing decentralized protocols gradually expand their forks for institutional clients, such as Aave Arc and Compound Treasury.

Still, most protocols will remain permissionless, and a growing number of protocol developers will continue to remain anonymous. They will speed up the process of full decentralization and try to avoid regulatory scrutiny. The threat of limited access will also accelerate the development and adoption of a privacy-enhanced DeFi ecosystem powered by zero-knowledge technology.

Today, many "decentralized applications" rely on centralized components, such as centrally hosted user interfaces, proprietary routing optimization algorithms, and more. As regulatory pressure mounts, they will be forced to choose sides. Some protocols will observe and enforce KYC processes or restrict users in certain jurisdictions; while others will remain anonymous and relinquish control of front-ends and smart contracts, becoming decentralized.

In any case, the fork of DeFi seems inevitable.

Finally, attach the DeFi ecological map of Ethereum:

According to the "Notice on Further Preventing and Dealing with the Risk of Hype in Virtual Currency Transactions" issued by the central bank and other departments, the content of this article is only for information sharing, and does not promote or endorse any operation and investment behavior. Participate in any illegal financial practice.

risk warning:

According to the "Notice on Further Preventing and Dealing with the Risk of Hype in Virtual Currency Transactions" issued by the central bank and other departments, the content of this article is only for information sharing, and does not promote or endorse any operation and investment behavior. Participate in any illegal financial practice.