Compilation of the original text: The Way of DeFi
Compilation of the original text: The Way of DeFi
"DeFi: Rebirth" is the latest report from CoinMarketCap and Spartan Labs - covering the current state of DeFi, lessons learned and progress in DeFi development, and a brief history of the emerging industry.
Is DeFi dead?
The creation of decentralized finance (DeFi) has taken the crypto industry by storm.
The story stems from a hypothetical thought experiment in 2016 by Reddit user u/vbuterin (now widely known as Ethereum co-founder Vitalik Buterin). He came up with an idea at the time to run an on-chain decentralized exchange in the form of an on-chain automated market maker, similar to a prediction market. This subsequently drove the creation of a decentralized financial system on top of blockchain technology.
Since then, the DeFi industry has exploded into a thriving ecosystem full of opportunities and worth billions of dollars. At its peak in December 2021, DeFi achieved a whopping $247.96 billion in Total Value Locked (TVL) thanks to multiple blockchain ecosystems and applications. However, the DeFi space has lost ground following macroeconomic uncertainty, geopolitical tensions, increased DeFi hacks and vulnerabilities, a general market downturn, and an increasingly pessimistic outlook due to recent events (Terra, 3AC, Celsius thunderstorms) great value. In June 2022, its TVL fell to a low of $67.46 billion.
This begs the question: is DeFi dead?
Now, this is a difficult question to answer. Saying "no" is too hasty, we see many moments of "denied" web3 maximalists; saying "yes" is also too hasty, which makes us underestimate the true vitality and robustness of this space, how much it has been through to survive, and how much more it can grow and develop.
Then the best answer is "in between". While DeFi is certainly not going to die by any means, going down the old path of market cap collapse and TVL loss is not going to do the space any favors at all.
To be reborn, DeFi must build on the ashes of previous cycles. The way forward should always be guided by the lessons of the past, so this is where we first want to focus holistically.
A brief history of DeFi
In the bitter cold of the crypto winter, Uniswap, Maker Protocol, and Compound emerged from among the first explorers to explore uncharted territory. These projects were all created with a similar vision of creating a decentralized and trustless financial system that is censorship resistant and economically inclusive without compromising its capabilities and efficiency.
With these three decentralized applications, the idea of a trustless digital asset exchange, stablecoin and crypto lending becomes a reality. According to DeFilllama, as of June 2019, the agreements had amassed a staggering figure of close to $500 million in TVL, an impressive feat at the time.
Having said that, the idea of decentralized finance wasn't really something widely available at the time, with only a handful of smart contracts living on the Ethereum blockchain.
“DeFi” is a buzzword that is often thrown around as a glimpse into the promising future of the decentralized financial system. The big shift to building DeFi really started with the birth of Uniswap in November 2018.
The Birth of DeFi: On-chain Automated Market Maker Uniswap
Building on Vitalik Buterin's thought experiment on decentralized exchanges, Uniswap launched as one of the first on-chain automated market maker protocols on Ethereum. Although Bancor first proposed the concept of liquidity pools, Uniswap popularized it for the masses with its famous "x * y = k" constant product pool formula.
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Source: Uniswap
The code of the Uniswap protocol is designed as a public product that drives the industry forward. Its code is completely open source, with no special treatment for early investors, adopters or developers, and no governance tokens or platform fees.
The choice to fully open source the Uniswap protocol code has clearly resulted in the many decentralized exchanges that span multiple blockchain networks today.
Learn about Maker Protocol and DAI, the first decentralized stablecoin
The Maker Protocol platform enables anyone to generate DAI, the first decentralized collateralized stablecoin collateralized by crypto assets such as ETH and BTC.
Since the market value of cryptocurrencies often experiences large fluctuations, the need for stablecoins is obvious. However, the only market product at the time was a centralized stablecoin backed by assets of centralized parties that faced custody and regulatory risks.
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Source: Maker Protocol
The protocol and its stablecoin have gone through several iterations since its inception.
On March 12, 2020, a day known as Black Thursday, the price of ETH experienced a sharp drop, dropping more than 30% in 24 hours. This market volatility combined with Ethereum’s rising gas fees put significant pressure on the protocol as many DAI vault owners had their vaults undercollateralized and liquidated.
At the same time, there were not enough liquidators bidding to liquidate collateral as arbitrageurs suspended operations amid network congestion. This quickly led to stability issues, as DAI was pegged to the U.S. dollar, and the price of MKR plummeted by over 50% on the same day.
To save DAI, the MakerDAO community proposed adding USDC, a centralized stablecoin backed by Coinbase's Circle, as collateral for minting DAI, providing greater stability to the protocol and its DAI stablecoin.
While a controversial decision at the time, staking USDC proved to be a good move to stop the bleeding and effectively save the Maker protocol.
Aave (ETHLend) and Compound: Pushing the Boundaries of DeFi Lending
Launched in 2017, ETHLend is the first decentralized lending marketplace on Ethereum. As the first of its kind, the platform matches individual lenders and borrowers who want to participate in mortgage positions in a safe and secure manner.
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Source: ETHLend
Having said that, ETHLend has its limitations as its entire lending process has a lot of friction in terms of user experience. As a peer-to-peer protocol, lenders are required to issue, manage and monitor loan quotes and active loans. The whole process is often slow and tedious because loans have to be financed manually. Furthermore, platform participants live in different time zones around the world, compounding the problem. If DeFi is the future of finance, then ETHLend is absolutely not.
That's when Compound came into view.
In September 2018, Compound launched its algorithmic and autonomous money market protocol on Ethereum, allowing anyone to frictionlessly earn interest or borrow crypto assets in a trustless manner without interacting with counterparties. What makes Compound stand out is its introduction of a peer-to-contract (Peer-to-contract) design and dynamic lending rates.
Lenders and borrowers only interact with the Lending Pool, which is a smart contract reserve containing the assets of the user pool, and not with another user. Each lending market automatically calculates supply and lending rates, which fluctuate in real time as market conditions adjust.
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Source: Compound Finance
Unlike traditional credit intermediaries where borrowers need to negotiate loan terms and borrowing rates, Compound reimagines the service in a trustless and automated way, making loans accessible to all and allowing lenders to leverage their crypto assets to generate yield .
This pool-based model allows a loan position to be opened permanently as the borrower pays the borrowing rate and the lender earns interest on the assets it provides. This dynamic is balanced by the loan-to-value (LTV) mechanism, which is a measure of the liquidation threshold of loan positions.
Since the protocol is fully open source, Compound has been instrumental in pioneering algorithmic on-chain money market protocol design in the decentralized economy.
ETHLend took lessons from Compound and moved away from a decentralized peer-to-peer lending design, eventually rebranding its platform to the now famous Aave Protocol.
Like Compound, Aave's infrastructure is built on top of its pool-based treasury. However, Aave has taken DeFi lending services a step further by introducing innovative features such as flash loans, interest rate swaps, and liquidity provider (LP) tokenization.
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Source: Aave V1
While they may not have realized it at the time, Uniswap, MakerDAO, Aave, and Compound were laying the groundwork for the arrival of the entire DeFi industry and paving the way for many other household names we know today.
In fact, 2020 and 2021 are the years that this nascent industry will grow by leaps and bounds, as many say they are starting to push the boundaries of DeFi beyond what was originally envisioned just a few years ago.
The Birth of Yield Farming
COMP governance token
On February 27, 2020, Compound founder Robert Leshner announced the launch of the new COMP token as a way to introduce a new community-led governance system that will replace Compound's centralized management.
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Source: Compound Finance
The COMP token is the first "governance token," enabling anyone to own a stake in Compound and have an active say in the protocol's future plans. By design, COMP tokens are distributed directly to their most important stakeholders, such as users of the protocol.
This token distribution design empowers and incentivizes the protocol community to collectively manage the future of the protocol through good governance. Before you knew it, this new design caused a sea change that changed the crypto industry forever.
Although initially intended for community governance, the distribution of COMP tokens marks a whole new paradigm shift as traders are able to speculate on the future value of the Compound protocol.
In fact, users started using Compound for the sole purpose of farming their tokens, hence the popularization of the term "yield farming".
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Source: CoinMarketCap
From a technical standpoint, this shift from centralized governance to community governance has sparked a variety of new innovations — from decentralized governance to new ways of attracting liquidity to protocols. While already popular at the time, the most active users of the Compound protocol greatly benefited from the extremely high APY in the form of the COMP token.
This approach would prove to be very successful as it attracted many new users to the protocol. The protocol's pools are so popular that the APY can quickly change by a few percent every minute. It got to the point where users actively seeking the highest yield attempted to automate the process of swapping assets into the highest APY pools.
Yearn Finance by Andre Cronje (AC)
Next up is Yearn Finance, the first yield farming aggregator in DeFi, launched by Fantom developer Andre Cronje (AC) on July 17, 2020. To optimize returns from yield farming opportunities, Yearn Finance acts as a shared vault where anyone can deposit their crypto assets.
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Source: Yearn Finance
At the time, there were several ways to generate yield on their crypto assets. The most common ways include earning transaction fees by providing liquidity to asset pairs on Uniswap or Curve Finance, or simply earning lending interest by providing assets to lending platforms such as Compound or Aave.
This all changed when the incentivized liquidity wars started and Compound was the first to start liquidity incentives with its COMP token. At that time, each DeFi protocol would introduce its own governance token and provide token distribution to users of its protocol.
This makes yield farming more complicated as yields become more profitable. For example, a user provides DAI to Compound and deposits cDAI (the token representing the right to receive DAI from Compound) into Balancer to earn COMP on DAI and BAL on cDAI.
On top of that, the strategy will generate DAI borrowing interest and transaction fees from the Balancer pool. Yearn Finance will simplify this process and turn it into a one-stop solution for passive investors.
Following in the footsteps of Compound, Yearn Finance launched its own YFI governance token. However, more specifically, Andre Cronje announced that the fair value of YFI is $0, since there will be no token sale and all YFI tokens will be earned by platform users.
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Source: CoinMarketCap
If the concept of comparing market cap to TVL is applied, it is grossly undervalued given what YFI was offering at the time. Coupled with its highly profitable gains, the protocol has seen a significant increase in TVL, leading to astronomical price increases.
From a starting point of $0, Yearn's governance token, YFI, reached a high of over $43,000 just 2 months after its launch.
YAM and the food token wave
Yield farming has created a crazy yield mining boom, prompting a large number of ordinary users to chase the highest yield. However, no one can predict what will happen next.
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Source: Yam Finance
As a monetary experiment, Yam Finance explored various DeFi concepts from the beginning, such as elastic token supply, protocol treasury governance, fair token distribution mechanism, and full on-chain governance. The governance token of the protocol is named after Yam (YAM) and is evenly distributed in eight pledge pools (COMP, LEND, LINK, MKR, SNX, wETH, YFI, and ETH/AMPL LP) to cover the entire DeFi community.
In less than 48 hours, the yield farming protocol garnered over $600 million in TVL for its highly profitable yields, sparking a DeFi food token farming frenzy. One by one, appearing out of nowhere, you'll see "delicious" names like Pickle Finance, Cream Finance, Beefy.Finance, Kimchi, BurgerSwap, Tendies, and more.
One would take this as a sign of excitement at the peak of the bull market, but degen is degen after all, they are just imitating anyway. Unfortunately, a critical bug was discovered in YAM's tokens, which led to over-issuance of tokens and ultimately a drop in token prices, resulting in a loss of wealth of over $500 million.
Likewise, many other copycat and fork projects of Yam Finance suffered a similar fate.
SushiSwap: A derivative of Uniswap
Amidst this banquet of Yam forks, backlash, and questionable delicacies, one protocol is making waves in the DeFi community. SushiSwap is a simple derivative of Uniswap, launched in August 2020, allowing users to stake their Uniswap LP tokens on the SushiSwap platform to earn SUSHI governance tokens.
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Source: Sushiswap
Since Uniswap did not have a governance token at the time, SushiSwap's approach proved to be very effective. Uniswap liquidity providers chase the highest yield opportunities on their LP tokens because they can earn SUSHI tokens.
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Source: DeFiLlama (TVL, first image = SushiSwap, second image = Uniswap)
Near the designated liquidity migration date in September 2020, the price of SUSHI plummeted by more than 70% in one day as its creator, Chef Nomi, drained the development fund of the SushiSwap protocol, exchanging it for about 37,400 ETH for $14 million.
Chef Nomi faced enormous pressure and backlash as his actions were publicly viewed as a betrayal of the SushiSwap community. To meet the needs of the community, Nomi handed over SushiSwap's smart contract private keys to FTX CEO Sam Bankman-Fried, who postponed the liquidity migration until September 9, 2020.
Shortly after successfully transferring more than $800 million in liquidity from Uniswap, Nomi voluntarily returned the cashed-out ETH to the community out of guilt, and later publicly apologized for his actions. A week later, FTX’s Bankman-Fried returned the SushiSwap protocol to its community after implementing multisig to prevent a single bad actor from taking full control of the protocol.
Despite the drama, SushiSwap’s aggressive liquidity mining incentives and launch method inspired many future projects as fighting for TVL became increasingly difficult in the ever-growing DeFi ecosystem.
Ethereum Scalability and the L1 Arms Race
The ensuing blockchain scaling problem
The DeFi summer of 2020 is coming to an end, and entering 2021, Ethereum's DeFi ecosystem is booming, with countless decentralized applications deployed on the mainnet.
The price of ETH surged to new highs, rising from $150 in May 2021 to a peak of $4,100 a year later. On-chain activity continued to accelerate as users explored Ethereum’s DeFi ecosystem, and Ethereum’s gas fees started getting higher and higher, sometimes costing over $30 in ETH for a simple swap transaction on Uniswap.
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Source: Etherscan (average transaction fees on Ethereum)
According to Ethereum creator Vitalik Buterin, every blockchain should strive to achieve three key properties: decentralization, security, and scalability. However, in sticking to simple technical cases, a blockchain project can only achieve two of the three, hence what he calls the “blockchain scalability trilemma.”
At the time, it was clear that Ethereum needed to scale. However, Layer 2 scaling solutions like Optimistic rollup and ZK rollup are not ready yet and are still under development.
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Source: Vitalik Buterin
The Layer 1 Blockchain Arms Race
The foundations of each Layer 1 blockchain ecosystem have announced their own liquidity mining incentives and builder funding programs to attract developers and users.
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Source: CoinMarketCap
Developers coming to this new ecosystem quickly realize they don't need to reinvent the wheel. Since Ethereum already had many successful applications that found a product market fit for them, developers forked and renamed them on BSC to quickly gain TVL and market share in the new ecosystem, with an eye toward $100 million in incentives Take a slice of the cake.
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Source: PancakeSwap
The narrative of Ethereum not being able to scale was strong enough that every major layer 1 ecosystem experienced its own heyday as liquidity mining incentives were thrown out during a typical bull run.
Similar to what happened on BSC, developers will replicate the same strategy of launching DeFi applications in the fastest possible timeframe to gain maximum market share and TVL to qualify for ecosystem grants. While non-Ethereum Virtual Machine (EVM) chains like Solana and Terra cannot fork Ethereum applications due to codebase differences, many new protocols build on the design architecture of existing DeFi solutions.
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Source: DeFiLlama
This trend continues through 2021-2022 as DeFi degens hop from ecosystem to ecosystem to earn liquidity mining rewards. Crypto Twitter often refers to this as "L1 Rotation", and even coined the term "SoLunAvax" when referring to the Solana, Terra, and Avalanche layer 1 rotation games.
As the TVL market share of Ethereum DeFi is gradually eaten away by new ecosystems that offer cheaper fees, faster transaction finality and an overall more user-friendly experience, Uniswap, Aave and Curve Finance, etc. Many applications of the first generation of DeFi were forced to extend their influence to newer blockchain ecosystems.
Ultimately, this narrative shift further validates the thesis for a multi-chain future. Sovereign Layer 1 blockchains are more interconnected than ever before through the creation and scaling of cross-chain application and asset bridges.
However, referring to the concept of the scalability trilemma mentioned earlier by Vitalik Buterin, these newer layer-1 blockchains are not without their own problems and growing pains, as speed and scalability are sacrificed to varying degrees. decentralization and security.
Having said that, the birth of multiple DeFi ecosystems means that a lot of load is offloaded from Ethereum’s mainnet, inevitably reducing network congestion.
Interoperability: The Future of Multichains
With the rise of young blockchains, it is clear that these ecosystems are starting to become more siled. While already a nascent industry, DeFi protocols operating within the newer blockchain ecosystem have encountered considerable difficulty in gaining liquidity and user adoption. Interoperability is a key part of the future of blockchain technology and an essential part of DeFi infrastructure.
As the number of projects and use cases increases, so does the need for interoperability between blockchains. Interoperability will enable a multi-chain ecosystem where different chains can communicate with each other, collaborate and share data in real time from an economic and technical perspective.
Many companies and teams are already doing this by creating solutions that allow one blockchain to communicate with another, directly or indirectly through a third party. At a high level, interoperable solutions can be divided into two distinct categories: (a) patch solutions retroactively built on non-interoperable ecosystems, and (b) natively interoperable solutions.
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Source: Binance
Centralized exchanges are the most commonly used type of crypto exchange, as they can be considered the "traditional" way of trading cryptocurrencies. On a centralized exchange, users deposit funds into accounts controlled by the exchange. The exchange then tracks all trades in a central order book and holds funds in escrow until an on-chain transaction is required.
While a fast and easy user experience for transactions between different cryptocurrencies is possible regardless of the blockchain network, this form of off-chain interoperability adds layers of complexity as these platforms are heavily regulated. For centralized exchanges that provide services to customers, the exchange must abide by each country's own laws and jurisdictions, most of the time requiring customers to verify their personal identity through a know-your-customer (KYC) process, and then To allow users to withdraw their assets on-chain and regain custody of their funds.
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Source: Dmitriy Berenzon, September 8, 2021
In terms of on-chain interoperability, the diagram above depicts how blockchains will connect to each other as of September 2021. Based on the core principle of decentralization, cross-chain asset bridges such as Wrapped BTC, Multichain (formerly AnySwap), and Portal (formerly Wormhole Bridge) have opted for a more permissionless approach. These solutions are built around a similar design architecture, enabling users to transfer their crypto assets from one chain to another in a trustless manner.
Cross-chain asset bridges typically operate on a "lock and mint" mechanism, where assets on the source chain are locked in the bridge's smart contract vault, while redeemable "wrapped" versions of native assets are minted on the target chain.
The rationale for this design is that since native assets from one chain cannot exist natively on other sovereign blockchains, these newly minted encapsulated assets pegged to value on the target chain can be reverse-burned and redeemed for assets on the source chain Equivalent original assets.
While still the most commonly used form of interoperability, with a TVL of over $12 billion, cross-chain asset bridges have been a prime target for many hacks and exploits due to the vast amounts of money locked in them.
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Source: Rekt News - Top Hacked Attacks
While most cross-chain bridges generally operate in a similar fashion, there are variations on each design, some of which are structurally more centralized than others, and have additional drawbacks such as censorship risk and poor liquidity. Despite these differences, Halborn’s blockchain security experts found that most blockchain bridge hacks target specific attack vectors, typically designed to result in the release of tokens on a blockchain, whereas There is no corresponding deposit on another blockchain. In recent history, exploits have mainly been carried out in the following ways:
1. False recharge event:
Cross-chain bridges often keep an eye on deposit events on one blockchain in order to initiate transfers to the other. If an attacker can create a deposit event without making a valid deposit or depositing with a token that has no value, the attacker can withdraw funds from the bridge on the other side.
2. Fake deposits:
Every deposit is verified by the cross-chain bridge before approving the transfer. This verification process can be spoofed if an attacker can make a fake deposit to verify as a real deposit. This was the case with Wormhole, where hackers exploited a weakness in digital signature verification to steal $326 million.
3. Validator takeover:
Depending on how the bridge is set up, a group of validators on some cross-chain bridges vote to approve or disapprove a particular transfer. If an attacker controls a majority of these validators, they can authorize fictitious and harmful transfers. In the Ronin Network exploit, an attacker took control of five of the bridge's nine validators, allowing them to withdraw funds from the bridge's smart contracts.
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Source: Connext - Arjun Bhuptani
Building interoperable solutions is no easy feat, although many teams have recently risen to the challenge and sought out more innovative approaches. Similar to Vitalik Buterin's scalability trilemma; there is an interoperability trilemma. As Connext founder Arjun Bhuptani describes, an interoperability protocol can only have two of the following three properties, often sacrificing one or more in pursuit of the others:
Trustless means having the same security as the underlying blockchain.
Scalability refers to the ability to be easily integrated into any blockchain.
Generalization refers to the ability to handle more complex cross-chain data.
As of this writing, many new native interop solutions have chosen to use more sophisticated approaches that attempt to achieve all three of the above properties. Projects like THORChain choose to build their own decentralized liquidity network, acting as a full-chain decentralized exchange (DEX), thereby transferring the risk of decoupling to individual liquidity pool providers; interoperability centers such as Cosmos and Polkadot are leading the way The concept of homogeneous "networks of networks" is proposed as they serve as the underlying layer 0 for an interoperable network of multiple layer 1 blockchains.
Despite being more complex in design, these protocols have had varying degrees of success in terms of user adoption and gaining more market share.
However, recent interoperability designs seem to be the most promising due to their elegant and extensible approach. Compared to traditional bridge designs, cross-chain communication protocols such as LayerZero, Axelar Network, and Router Protocol go far beyond encapsulating assets and centralized systems by relaying the idea of common and complex data, reducing many moving parts and attacks vector. A hybrid of nodes, relayers, and oracles to establish fast, cost-effective, and decentralized inter-blockchain communication without compromising security.
While not as widely adopted as its predecessors, these new solutions built with interoperability in mind appear to be a promising step forward toward building a multi-chain future and resolving the interoperability trilemma.
Troubled waters and the way forward
However, since then, as we entered 2022, the entire cryptocurrency market began to go wrong as some unfortunate events occurred.
First, all countries have a problem with rising inflation due to the COVID-19 pandemic that has plagued them for the past 2-3 years. Geopolitically, the Russo-Ukraine war that broke out in February this year also caused a lot of tension and concern. All of this culminated in massive macroeconomic instability, as the Fed eventually turned to raising interest rates to fight inflation, stoking fears of an impending recession.
So, unsurprisingly, markets around the world suffered sharp declines. The S&P 500 fell sharply, as did the broader crypto market, while the DeFi market took a considerable hit as well.
The bad news doesn't stop there. Murphy's Law states that anything that can go wrong will eventually go wrong, and at the worst possible time. This adage couldn’t be better applied to the crypto market.
The proverbial final nail in the coffin has been drilled into the cryptocurrency market from within as market players just embrace the aforementioned macroeconomic catalysts. One of the most popular darlings in the space at the time, UST, suffered an unfortunate decoupling. This led to a bank run on Anchor, and then the inevitable collapse of Terra eventually due to hyperinflation, along with a whopping $60 billion in funds. Terra's debacle had serious repercussions for the entire space.
From here, Three Arrows Capital (3 AC), one of the largest players in the industry at the time, was hit by a thunderstorm. Large CeFi lenders such as Celsius, BlockFi, Babel, and Voyager also collapsed as Terra and the 3 AC crash spread. As CeFi lenders were forced to repay DeFi lending protocols like MakerDAO and Aave to unlock their collateral, stETH started trading at a discount to ETH due to all the forced sell-offs, further exacerbating the market situation.
As the total market capitalization of cryptocurrencies plummeted, we also saw the total market capitalization of DeFi plummet by 75% in the second quarter of 2022 as TVL began to exit the ecosystem rapidly. Although the total market value of DeFi has recovered somewhat since then, the road to full recovery is still long and arduous.
Where exactly do we go from here?
Terra’s debacle, while unfortunate, helps to unearth the fragility of the algorithmic stablecoin model and the need for more sustainable token economics within the larger DeFi ecosystem. This points the way forward for DeFi.
The act of printing stablecoins out of thin air works wonders while it lasts, but alas - it is by no means sustainable.
As a very solemn reminder of the above, the moment UST lost its peg, Terra crashed in just a few days, followed by a death spiral from 9-14 May 2022 from $1 to $1 to $0.12.
It was clear that some things had to change radically. The DeFi ecosystem should not rely on super-hired capital to support it. This is simply not wise if we want a DeFi ecosystem that is vibrant, strong, and most importantly - sustainable through the cycle. If there is no sustainability, then the DeFi ecosystem will never become substantial in any meaningful way.
DeFi: Rebirth
In Spartan Labs Research’s view, we see a clear path for DeFi to emerge from the ashes of the past, at least in the short to medium term.
Warning: "Rebirth" does not equal prosperity; the two are necessarily mutually exclusive. As such, neither Spartan Labs nor CoinMarketCap is claiming that DeFi will experience a boom in the coming months. Instead, in our view, these are just a few steps the ecosystem should take to move forward from the lessons of the past.
In order for the DeFi ecosystem to rebirth from the relative trough it is currently in, and truly learn from the lessons of the past, three major pivots and progressions must take place.
First, all given DeFi protocols must prioritize their own sustainable cash flow generation capabilities to a greater extent. Over the past year or two, most DeFi projects (largely due to the euphoria generated by the bull cycle) have focused very publicly on the user acquisition/TVL onboarding aspects of their roadmaps and operations. However, following the bull cycle, we are now starting to realize that this may not be the best strategy for the long-term sustainability and overall longevity of DeFi protocols. This is what we will clarify further in the next section.
Next, the token economics models that dominate the DeFi space must also evolve to adapt to changing times. Rather than relying on hired capital, protocols must learn (through their token economic strategies) to attract the appropriate user base that aligns with their respective long-term goals and vision.
Finally, we also believe that the rise of synthetic assets will drive the DeFi space forward and largely sustain it for many years to come. After all, the derivatives space remains largely untapped when it comes to DeFi and web3. With the rise of synthetic assets, perhaps the potential of this DeFi sub-vertical can be maximized to the extent it really should be.
Moving to sustainable cash flow generating agreements
Witnessing the total collapse of LUNA and UST, both of which were (at the time) top 10 by market capitalization, collapsed with a bang in a matter of days severely shook the confidence of the entire market.
The lingering fear, uncertainty, and doubt in the market (to this day) has caused a huge shift in the narrative about what the ideal DeFi protocol should be. No longer are investors blindly craving the benefits and features of Ponzi schemes that promise ridiculously high returns if they work.
Instead, investors are starting to set their sights on true stability and sustainability, ensuring their token investments can withstand the volatile market conditions that define the crypto/DeFi market, while still delivering impressive returns that may exceed traditional markets.
So while DeFi in 2021 and early 2022 will largely be determined by the rise and fall of ridiculously high APRs (think Olympus DAO, Wonderland) and liquidity mining incentives, both of which are specific to User at Scale - Many people now realize that the real key (for users and builders) is a user retention strategy, which is lacking in both of the above models.
For builders, this is not the time to just bring large numbers of users to your platform and protocol. While important, it shouldn't be the only thing a project prioritizes. What happens after you acquire a user is also very important, since that's basically why the user was brought in in the first place. The key question now becomes: How can projects and protocols retain their established users? How do they create a sticky form and moat around said users?
For users, it should not just be about lofty promises of high returns and yields, but no financial data can provide them with a substantial reflection. Lately, it's been proven that it's all too easy (and often) for project owners to break said lofty promises as soon as anything goes too far. Now that there are projects proving that the returns and gains they tout are possible and sustainable due to their existing operations, users should definitely be strict about this before considering any kind of investment in said projects.
At this point, by the way: the ridiculously high APR and liquidity mining incentives we mentioned above have been criticized by many in and outside the crypto space as "Ponzi economics". While we do understand why they are being criticized in this way, we humbly beg to differ. For all intents and purposes, the meaning of the term "Ponzi" belies the intent to defraud. Labeling all DeFi protocols that promise high yields a “Ponzi scheme” is unfair to those who intend to provide substantial value to users but fail to do so due to the employing nature of the capital they attract. Admittedly, there are definitely some built to scam (rugs), but it would be inappropriate to talk about it in such general terms.
Back to the point, the apparent shift in focus to user retention (through real value generation) has led to the rise of revenue-generating protocols, and for some like UNI and AAVE, this is a second.
It's clear that users are now looking to invest in real value, not promised value. Much of this means operations that generate and accrue expenses in a consistent and sustainable manner.
Below, we explore a few protocols that have already done so, and others should learn from and/or emulate their bets to become part of the larger DeFi ecosystem.
Uniswap (UNI), the King of Fee Generation
As the first AMM on Ethereum and the undisputed leader in fee generation, Uniswap has revolutionized the job of liquidity provision (LP) by allowing users to provide liquidity at custom price ranges with different fee tiers Way.
Given the volatile market conditions, Uniswap, which charges an average of $160,000-300,000 per day in fees in 2022 (as of this writing), does a very good job of generating various steady income streams.
The fees generated by the agreement are all paid to LP users, and the agreement fee is still set to zero.
AAVE, the largest cross-chain money market
Next, another protocol that has generated some real substantial value through stable fee accruals is AAVE, the largest cross-chain money market with a TVL of $6.3 billion.
While centralized currency markets like Celsius and Voyager eventually collapsed during this market downturn, AAVE has stood the test of time and remains fully functional. In fact, it's even steadily generating around $700-900K per day in 2022 (as of this writing).
GMX, a rising star
Recently, we have also seen the rise of several decentralized perpetual protocols. On the one hand, GMX is a fast-growing decentralized perpetual exchange built on top of Avalanche and Arbitrum. The deal attracts massive TVL in 2022, surging from $108 million to $289 million. GMX's dramatic increase in TVL reflects the market's desire for perpetual transactions on blockchains other than Ethereum, which do not have KYC.
GMX allows users to leverage up to 30x their collateral by leveraging liquidity borrowed from other users in the form of GLP tokens, an index that measures tokens like BTC, ETH, AVAX, and stablecoins.
70% of the fees generated by the protocol are shared with GLP holders, while the remaining 30% are shared with GMX stakers.
Synthetix (SNX), a revenue sharing protocol
Finally, a revenue/fee sharing protocol that has become very popular recently would be Synthetix (SNX). In some cases, Synthetix is a derivative liquidity protocol that allows users to create synthetic assets and trade perpetual futures. Synthetix is also one of the first DeFi protocols to use synthetic assets to bridge the gap between stablecoins, stock markets, and commodity markets.
More recently, protocols such as Kwenta, Lyra, Curve, and 1 Inch have been built on top of Synthetix to leverage the deep liquidity of Synthetix's debt pools and allow for efficient trading with reduced slippage. As these various protocols transact through Synthetix, Synthetix will incur fees which will subsequently be shared with SNX stakers.
As a result, SNX incurs a dramatic increase in fees from $20,000-80,000 per day to $150,000-300,000 per day in 2022 (as of this writing).
The shift to sustainable tokenomics
From the above we can see that the ability to generate and sustain real substantial value through ongoing revenue generation may now define this existing wave of new DeFi protocols as users begin to look for the real weight behind the ease of manufacture Commitment and APR. With DeFi market cap and total TVL shrinking as much as it has recently, those who stay will certainly and rightly be infinitely harder to please, harder to retain, and stricter on their capital. Charismatic leaders will no longer cut it; effective operations must be the cornerstone of any successful DeFi protocol in this new era.
However, this is not enough. While this is the baseline standard that all DeFi protocols should meet to survive and thrive in this post-bull market context, DeFi protocols should also do more to ensure they only attract the right users. Failure to do so will result in a massive influx of employed capital which, as mentioned, could be lost if prices fall again. The fact that the survival of the protocol is inherently closely tied to the volatile price action of the crypto market is not ideal for the longevity and maintenance of any given DeFi protocol and should be properly addressed in the future.
This is where the concepts of token economics and game theory come into play. As protocols move toward a substantive model of real value and revenue generation, they must also ensure that the users serving them will be largely aligned with their long-term goals and vision. Therefore, the token economics model of the entire DeFi protocol must be enhanced and augmented from the existing system to meet this demand.
In the early stages of DeFi, as mentioned several times throughout this report, protocols offered extremely high returns as a go-to-market strategy to channel liquidity and gain market share in the ecosystem. High token release means these protocols face a race against time to leverage their market share to overcome the dilution rate of tokens flowing into the ecosystem.
This question sparked the first attempt at sustainable tokenomics when Curve created the popular ve model widely used in many protocols today.
The original ve model is a simple but effective protocol approach to reduce sell pressure while incentivizing long-term holders through increased rewards. Curve allows users to lock their CRV for up to 4 years in exchange for a x2.5 boost in veCRV rewards. Therefore, CRV's incentive locking helps reduce the circulating supply of CRV and rewards those who believe in the project for a long time and choose to lock for a long time.
While token bribery of voting rights demonstrates how protocols can monetize their governance rights, the ve model also triggers secondary impacts on the DeFi scene.
The Convex protocol aims to accumulate staked CRV on the protocol to improve its governance influence in the Curve ecosystem. This culminated in the infamous Curve Wars, where protocols raced to amass large amounts of CRV to influence governance proposals on Curve.
With the rise of the ve model, we've started to see steady progress in the various iterations that have emerged recently. In our view, this progress is unlikely to disappear any time soon, and newer protocols/builders will do well to learn from the best of these iterations.
For some (non-exhaustive) examples of the above iterations of the ve model, we will examine two protocols that perform relatively well in their own implementations.
Trader Joe (JOE)
On the one hand, Trader Joe's is the largest AMM on Avalanche with a TVL of $225.34 million. It launched veJOE, sJOE and rJOE in March 2022.
The Trader Joe team has chosen to break down the use case for the JOE token into 3 separate components:
veJOE - LP rewards and protocol governance improvements
sJOE - Profit Sharing on Agreement Fees
rJOE - Allocation from launchpad token sale
By breaking down these use cases, Trader Joe's is trying to let users focus on the aspects of the DEX that best suit their needs.
veJOE also chooses to do away with lengthy lockups and instead attempts to incentivize long-term staking through the promise of virtual point accumulation. Their premise is simple and straightforward: the longer you bet, the more virtual points you earn.
Having more virtual points allows users to earn additional rewards from the LPing TraderJoe platform. Users can unstake and trade their JOE tokens at any given point in time; they only need to give up the virtual credits they have accumulated.
Platypus.finance（PTP）
Next, Platypus.finance is an open liquidity and one-sided stablecoin AMM on Avalanche. It uses a univariate slippage function instead of a constant curve and allows for single-currency liquidity. Currently, it has amassed $191 million in TVL.
To further elaborate on the token economics of Platypus, $PTP is a governance and utility token that LPs can obtain by providing liquidity, while $vePTP is a reward boost token obtained by staking $PTP.
For the latter, users can stake PTP to obtain 0.014 vePTP per hour, which takes 10 months to reach the vePTP upper limit. This is a veJOE-like model where users will be rewarded proportional to their vePTP score.
When it comes to the vePTP model, there are also mechanisms that limit the influence of whales, which can be best represented by this equation:
In detail, deposit weights and vePTP scores will always be square root to limit the impact of whale farming of PTP tokens. This is a nice attempt to achieve a fairer distribution of PTP releases to users, but can be easily circumvented by more savvy users.
Platypus also leveraged the Platypus Heroes NFT project to inject some gamification elements into the vePTP model. Here, the Platypus Heroes NFT will allow users to accumulate vePTP points at a faster rate, while also giving them access to closed communities.
It will be interesting how these projects and more continue to build and innovate on veModel, we certainly haven't seen the last of them yet. As mentioned earlier, emerging protocols will do well to learn and build on protocol models like JOE, PTP, etc.
Sustainable DeFi protocol framework
Despite pros and cons, the ve model (and its iterations) reveals the building blocks needed for any given protocol to be sustainable and consistent with producing value.
We summarize the above cornerstone framework into a concise table, which can be referred to in the operation planning of the project:
Supply - limit release of circulating tokens by locking to minimize selling pressure
Demand - Introducing protocol-level demand by incentivizing large long-term stakers
Revenue Generation - Protocols can generate revenue to ensure the long-term viability of the business model
Income Distribution - Share protocol revenue with long-term stakers, allowing holders to participate in the success of the protocol
Simplicity - having a simple and understandable token economics model to facilitate easy onboarding
Supply and demand balancing - modeling token issuance based on expected demand growth over time
Expanding from the above, we can also draw 4 lessons from what constitutes a sustainable and moat protocol:
Need to get rid of high APR and liquidity mining to guide liquidity
Need to focus on positive cycle flywheels in terms of protocol adoption
Need to focus on building a core community that truly believes in the vision of the protocol (rather than hiring capital)
Need to get rid of dilutive rewards. Alternatives are:
Stablecoin rewards (TRI, JOE, SNX)
Hosting Rewards (GMX, SNX, ILV)
Taken together, this does not mean that the ve model (and its iterations) is necessarily the entire and final model for the next wave of DeFi innovation.
In fact, we think quite the opposite. In a space as dynamic as DeFi, there is never a one-size-fits-all model. This mentality will only fail any protocol that adopts it.
So, as times (and markets) change, so should the protocols and their respective tokenomics models. Protocol models should never remain static over time — a space where being reactive is never rewarded, and proactive reflection and adaptation are always required.
In fact, we're already starting to see some protocols push this reflexive change in their own way. We'll explore some of these new models in the sections below.
Further development of token economics
No Token Issuance Agreement
In some cases - how YFI structured their launch may constitute the best example of a tokenless release protocol. To clarify, tokens capable of generating revenue may choose to move to an emission-free model after the bootstrap phase. In such a model, there should be a gradual shift from filling issuance of native tokens to cash flow rewards generated by protocol fees.
In this way, there will be strong incentives for early adoption with a close eye on the sustainability of the revenue model. Additionally, the token (and by extension the protocol) will be more resistant to selling pressure due to the extremely scarce supply.
Of course, the protocol could also choose to adopt a very low issuance to account for the gradual growth of the protocol.
Dynamic Token Issuance
Finally, based on our belief that the DeFi space is an ever-evolving space, and that protocols will do well by actively adapting, we believe that token economic models will eventually evolve into ever-changing, robust and A high level would involve shaping token offerings based on demand and profit, providing a minimum for said tokens.
In this way, dynamic issuance allows the protocol to be conservative and not over-commit to any particular issuance structure.
One problem here, however, is that teams may exploit the dynamic nature of releases for their own selfish and/or malicious means. To mitigate this, we might consider Soulbound NFTs — essentially non-transferable NFTs that could act as digital CVs — to ensure credibility for all relevant DAO governing members.
Additionally, increasing the duration limit also ensures that changes are gradual and don't happen abruptly. This is probably something we'll be thinking about more on a deeper level, so keep an eye out!
The Rise of Synthetic Assets and Derivatives
In addition to new token economic models, another sub-vertical that has recently emerged (and will likely continue to emerge) in the DeFi space is the field of synthetic assets and derivatives, where synthetic assets are tokenized derivatives.
In traditional finance, the cash flows from synthetic assets are primarily derived from the underlying assets being replicated in the synthetic product itself. However, in DeFi, cash flows can also be generated from newly created synthetic assets as well as underlying assets. For example, staking SNX tokens to sUSD allows users to both take advantage of SNX’s staking rewards and use newly minted sUSD tokens to participate in yield-generating strategies in DeFi.
This improves capital efficiency and flexibility by allowing users to determine the parameters they want to use as the basis for synthetic assets.
These parameters include (very succinctly):
Collateral Ratio
cost
cost
profit sharing
Pegging mechanism for synthetic assets (i.e. leveraged tokens from TracerDAO)
The ability for users to configure the above parameters will completely increase capital efficiency within the ecosystem. The base asset will continue to increase in value, while the synthetic asset can be traded freely. Synthetic assets also serve as a form of leverage for users, which is a double-edged sword. However, capital efficiency can be greatly optimized if used judiciously.
For more background on capital efficiency above, and when sticking to the SNX example, users often complain about the 400% collateralization ratio (c-ratio) because they often use the money market's c-ratio as a comparison for capital efficiency.
This is where we have to make a distinction. With most money markets, users typically provide collateral for loans that they can trade or generate yield on. For SNX, users will receive SNX rewards and protocol fees from staked SNX, while still being able to trade/generate yield using sUSD Minted. The user also does not need to repay the debt position until his/her c-ratio reaches 150%.
From this, if a user wants to get as much free capital as possible from the underlying collateral, taking a sUSD loan on the money market or on ETH collateral on SNX (130% c-ratio) would be seen as more capital efficient .
If a user wishes to generate as much passive income as possible from a long-term position, SNX may still be considered more capital efficient, as the position can be held until it reaches its 150% bottom-line rate while still generating additional income from said position.
Going back to our main point in this section, synthetic assets will also allow the creation and trading of any uncorrelated asset. It is a form of hedging against volatility in the cryptocurrency market and also provides investors with more diversified investment options.
Furthermore, this has the potential to open up familiar markets to traditional financial investors who are not web3-native (even those in emerging economies and/or who do not have access to the necessary financial services and risk they can grab as they enter the web3 world.
In doing so, synthetic assets potentially democratize access to such services and tools around the world.
But that's not all synthetic assets can offer. We believe the future is very bright in this sub-vertical.
Below are two forms of innovation that we believe will gain traction in the field in the short to medium term.
Fixed Rate Bond Notes
Fixed-rate bond notes will allow the protocol to use its treasury to offer fixed-rate bonds to users in the form of synthetic tokens, where users will be able to over-collateralize the corresponding underlying assets to mint representative synthetic bonds.
The bond can only be redeemed at maturity at a reserve price and a promised fixed rate, and can be traded freely in the open market to anyone willing to take the risk of the bond.
This will provide additional funding options for projects and will also help ensure everything remains transparent and on-chain.
structured products
In some cases, structured products are financial instruments whose performance is related to an underlying basket of assets.
Most derivative-based structured products allow investors to buy or sell assets at a predetermined price or strike price. Additional conditions can be included in the product to ensure that the product is sufficiently attractive to both the issuer and the investor (i.e. the strike price is higher than the strike price).
Such structured products also allow issuers to hedge against volatile market conditions and allow investors to assume risk at an appropriate premium. However, a word of caution: structured products should only cater to sophisticated investors who understand the intricacies and nuances involved in such products.
Regulation and DeFi: what's next?
For DeFi to be reborn, we cannot look inward. While improvements to token design and protocols are important, the space must also reflect on external developments.
There have been several such external developments (and huge ones) in recent weeks. On August 7, 2022, the now-notorious privacy mixer Tornado Cash and over 40 Ethereum and USDC wallets associated with it were sanctioned by the U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC).
This represents a significant shift in OFAC's case-handling approach, where previous sanctions have typically targeted specific entities utilizing specific tools to conduct malicious acts, rather than the entire tool, or in this case directly the source code.
The consequences of this incident were swift.
Popular decentralized exchange dYdX quickly blocked accounts that had any interaction with Tornado Cash, GitHub suspended Tornado Cash’s GitHub account, and Circle froze $70,000 worth of USDC on the mixing platform while banning any interactions with Tornado Cash The associated address gets access to USDC.
On the other hand, Tether Holdings Limited, the company behind USDT, the world's largest stablecoin by market capitalization, announced that they will not unilaterally blacklist or freeze addresses related to Tornado Cash.
Coin Center, a nonprofit research and advocacy center, also filed a legal challenge to OFAC's ruling.
What does this mean for DeFi?
OFAC's sanctions on Tornado Cash will have an impact on this space beyond everything that has happened (as previously stated). There will be several factors to consider and ponder.
The censorship-resistant value of L1 must be protected and preserved
First, the value of L1 blockchains like Ethereum (the base layer of Tornado Cash) really came to the fore in this incident. Although OFAC has taken a crackdown on Tornado Cash's source code, the code is still very active today. To put that in perspective, on Aug. 8, 2022 (post-sanctions), Tornado Cash had an outflow of 13,800 ETH, according to Nansen, which is an incremental 1,400 ETH outflows per day just the day before (post-sanctions forward). In other words, while Tornado Cash's frontend may have been removed from its website, the backend code is still there, unstoppable and unkillable.
In the blockchain world, code is always king; it is censorship-resistant and cannot bend to the whim of a large centralized entity like a government. While there are illegal cases (and we do not in any way condone illegal money laundering for illicit proceeds), this certainly has value in the privacy-poor world we live in today. The Tornado Cash incident is largely a testament to this.
This value is something we must protect and maintain at all costs, not only for the DeFi space, but for the wider Web3 space as well. We bring this up for a reason.
Twitter user @TheEylon offered a very pertinent and thought-provoking post on Ethereum. In it, he discusses how the Ethereum validator community is ostensibly not decentralized enough to be truly censorship-resistant.
If @TheEylon's hypothesis is correct, and over 66% of Beacon Chain validators won't sign blocks related to Tornado Cash (thus complying with OFAC regulations), then how is Ethereum different from any given centralized platform ? So, what is the point of blockchain in this context?
So decentralization/diversity of the validator community is definitely something the industry as a whole has to think carefully about first if we even want to experience any kind of rebirth.
The Necessity of Grassroots Legislative Intervention
While what happened was very unfortunate for the DeFi space, it wasn't as dire as many thought. In any given nascent industry, there will always be turning points that help the industry mature, as long as they are handled properly.
We believe that the Web3 industry is currently at such an inflection point. How we move forward from here is critical, and the resulting discussions and conversations must be so nuanced and effective. Looking at sanctions from another perspective, this is an opportunity for the Web3 community to voice their concerns (regarding the legislation in the space) and to fight for an opportunity to define some parameters when it comes to legislation.
We now have a reference point, albeit a very extreme one, to work with; we must strive to be in this critical conversation that will likely shape the Web3 landscape for years to come
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