Cycle Reflections & Learnings: DeFi
A review of the current state of DeFi and the leading lend/borrow apps
Hello readers,
This week we are covering a broad overview of DeFi as well as the blue-chip lend/borrow applications.
Topics covered:
Overview of DeFi today
What works? What doesn’t work?
Where is DeFi heading?
KPIs of the top lend/borrow apps
DeFi Risks
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Total DeFi Users - 4.8 Million
Data: Dune Analytics
DeFi gets a lot of buzz in the media. But let’s not forget that users have been engaging with this new tech for less than 2 years now. While user growth is steady and promising, 4.8 million unique users is a drop in the bucket when compared to technologies that have achieved escape velocity. For reference, Bank of America has 67 million customers and Ethereum (which most DeFi apps are built on) has about 200 million unique addresses (wallets) today.
Total Value Locked in DeFi - $74 Billion
Total Value Locked = total collateral deposited into DeFi applications seeking a yield. This is akin to the total value deposited at a bank. Interestingly, the chart looks similar to Bitcoin’s price chart from the last cycle. Total Value Locked is down 70% from its peak last November. With prices down 70-90% across crypto, it makes sense that the value locked in DeFi would drop proportionately - it’s tied to the price of cryptoassets like BTC and ETH (as well as stablecoins). Below is a view of the top 10 applications in DeFi in terms of value locked:
Source: https://defillama.com/
It is painful to see the drop in TVL of late, but if we look back just 2 years, there was less than $2 billion within the ecosystem. Perspective matters.
What is DeFi?
I think of DeFi as any application built on a public blockchain that mimics existing financial services. This includes lending/borrowing, exchanges & spot trading, derivatives trading, insurance, payments, custody, etc.
Benefits of DeFi:
Smart contracts automate the tasks of an intermediary. For example, a DeFi lending/borrowing app like Aave allows users to deposit liquidity into borrowing pools. Doing so makes you a lender. Borrowers access the capital by putting up collateral (overcollateralized) and receiving a loan with a few clicks of a mouse. Smart contracts execute these financial services in a more cost-efficient manner. The output is the lender (anyone depositing liquidity for borrowers) can get a higher rate of return than a bank can offer you.
Transparency. The nature of public blockchains allows us to see exactly how much collateral is deposited into liquidity pools, or how much value is locked. Does anyone know how much $ is deposited with Bank of America right now? How about the rate of return they are earning on their book of loans? Can anyone in the world with an internet connection view and validate that data? This is how DeFi works. While DeFi is often categorized as the “wild west” today by financial regulators, this transparency could ultimately be a tool for measuring systemic risks. Instructive of this is the absolute carnage we have seen in the “CeFi” space of late. Centralized crypto banks like BlockFi, Celsius, and Voyager to name a few. These firms have demonstrated poor risk management leading to straight-up bank runs. Meanwhile, DeFi banks such as Aave and Compound have executed effortlessly during the volatility.
Reduced Costs and Scalability. Smart contracts remove the middlemen. Furthermore, DeFi leverages Ethereum (and a few other chains) at the base layer for settlement and security. This is functionally outsourcing their Capex security costs. Imagine if Bank of America operated on a tech platform that paid for its security and settlement costs? That’s one of the benefits a DeFi bank like Aave gets to enjoy. They also don’t have the same HR, Admin, and Operations costs that a typical bank would have. Finally, DeFi applications can scale revenue extremely fast with limited manpower behind them. Below we can see that Uniswap did about $40 million per employee while the New York Stock Exchange did about $300k/employee over the same time period. Uniswap has about 60 employees. The NYSE has over 1,000.
Credit: ARK Investment Management LLC
User Experience. Many refer to DeFi as “money legos” today. This is due to the composability of public blockchain applications. Composability refers to the interoperability/integration of various components within a design system. For example, I can interface with my assets on a DeFi app like Lido, Zerion, or Zapper in ways that are unimaginable in traditional finance. I can stake an asset to validate transactions on Ethereum, provide liquidity, trade assets on a decentralized exchange like Uniswap, lend or borrow on Aave, etc all from the same applications. How, you might ask? Because my assets all sit on the blockchain and are in my control - Zerion/Zapper is simply giving me an interface and connecting me to apps that allow me to do these things. Let’s say I wasn’t happy with Zerion or Zapper anymore. I can switch to a competitor with a click of a mouse (by connecting my wallet). When is the last time you switched bank accounts? I’m guessing it took you a little bit longer.
User Control of Assets. As mentioned, in DeFi our assets sit on the blockchain and we access them with our private key. Since we control the assets, we can move them around to earn yield and use them as collateral for loans. Think of taking a few shares of Amazon in your TD Ameritrade account and depositing (lending) them into the Nasdaq for others to trade, earning a fee in the process. Or taking a few of those same Amazon shares and moving them over to your Bank of America account and using them as collateral for a loan. This is possible in DeFi because we control our data. We control our assets. Visit uniswap.org to see how this works.
24/7 services are available for all. All you need is a computer or phone with an internet connection.
What’s Working in DeFi?
The most obvious product/market fit has been in the lend/borrow and decentralized exchange space. We’ll look at the KPIs of the leading DeFi lend/borrow marketplaces later in the report. Aave and Compound are the blue chips, while MakerDAO functions more like a decentralized central bank - users deposit collateral into smart contract vaults with the protocol minting new DAI (debt to be paid back w/interest). The best use case for DAOs so far has been in DeFi. Aave, Compound, and MakerDAO all function as DAOs. The native token (governance token) of each network is used by holders to vote on the direction of the protocol. For example, the community votes on which coins and types of collateral can be used by borrowers for loans. DAO communities can also vote on the interest rate of the protocol, whether to issue loans on various types of real-world assets and how to manage the treasury.
As mentioned, DeFi has held up considerably well when compared to CeFi. CeFi (centralized crypto banks) is in complete shambles today. Many of these firms are essentially insolvent (see below). Meanwhile, the core DeFi lend/borrow apps executed liquidations flawlessly during extreme volatility in markets. I haven’t heard of any lenders that have been unable to get their funds out. There haven’t been any panics in DeFi. Unfortunately, we cannot say the same for CeFi as millions of users are blocked from withdrawals at the moment.
What isn’t Working?
DAO voting. DAO voting is quite centralized today as voting rights are proportional to the number of tokens held. This means VCs and other large token holders are essentially steering the direction of these communities today. The governance of each protocol can be messy. For example, what decisions should the community of token holders vote on? Which ones should the core team have the final say over? This is still a very new concept that is being iterated on. In my opinion, it makes more sense to have the community vote on how to use the treasury and maybe a few other really important decisions, but not all management decisions should be made by the community. The people doing the work and steering the ship should probably be making most of the everyday decisions.
We may see some changes to the token holder vote going forward. Optimism, a layer 2 blockchain built “on top” of Ethereum recently announced that token holders will get 1 vote each on community decision-making.
Some critics of DeFi will point to over-collateralization as an inefficient means to deploy and allocate capital. For example, a traditional bank takes $1 in deposits and can loan it out 9 times. In DeFi, the bank receives $1 and creates $.66 worth of loans. This is fair criticism today. Crypto native borrowing/lending requires over-collateralization to stay solvent due to the volatility of the collateral and lack of insurance today. I view this as sort of a proof of concept for what we may see in the future. As the tech gets better and better, we should expect to see more real-world assets move on-chain and more under-collateralized lending as a result.
Where is DeFi Heading?
DeFi needs identity. This is antithetical to some crypto natives but we will never, ever see a world where DeFi grows and merges with traditional finance without identity. Institutions cannot come into DeFi if they cannot identify their counterparties and the developers behind the smart contracts they engage with. The good news is there are solutions coming to market to solve this problem. One such solution, ONCHAINID, provides the best of both worlds. ONCHAINID will allow users to prove the identity of their wallet address (via a smart contract linked to a third-party KYC agent) to DeFi applications and web3 companies as needed. This will be like showing your ID real quick when entering a bar. Users will control their data and can revoke access as they please. So, you get the best of both worlds - the ability to prove who you are as you engage in web3, but also full control of your personal data.
Going forward, we should also look for more DeFi apps branching off from Ethereum and deploying on multiple blockchains (L1s and L2s). Aave and Uniswap are leading the charge in this category today.
Large consumer apps like Robinhood are no doubt looking at DeFi. We may start to see some integrations in the not too distant future. I view DeFi as a financial primitive that will ultimately be hidden underneath candy-coated applications and banking interfaces at the consumer-facing level. We’ll know that DeFi has reached escape velocity when users don’t even realize they are interacting with it.
DeFi needs insurance. Users losing funds due to smart contract hacks should be seen as completely unacceptable going forward. Ethereum-based services like Nexus Mutual are looking to fill this need today.
Finally, DeFi needs regulation. Said another way, DeFi builders need clarity. They need to understand what they can and can’t do. My guess is this will take some time. Identity is likely needed first. This will allow regulators to regulate because right now they are operating mostly in the dark. Regulators regulate intermediaries. When you remove the intermediary (and the identity), there isn’t much left to regulate.
KPIs of the Blue Chip Lend/Borrow Apps
Can someone please make an ETF that includes these assets? These are the lend/borrow blue chips (note that Maple lends only to businesses). We’ll look at decentralized exchanges in the next report.
DeFi Risks
Smart Contract hacks. There were over 44 DeFi hacks last year resulting in $1.3 billion of user funds lost. This is absolutely unacceptable. At the same time, this is quite indicative of the risk/reward as an early adopter. Before engaging with any application in this industry, make sure you understand what you’re getting into. Reputable teams will post the results and dates of their smart contract audits.
Centralization. This could come from the poor risk management we have seen in CeFi. It could come from centralized staking service providers like Lido. It could come from layer 1 blockchains that are not properly decentralized. Finally, centralization (single points of failure) is by far the most common vulnerability found regarding smart contract hacks.
Regulatory. Bitcoin appears to be the only cryptoasset with clarity regarding its asset class. Bitcoin is a commodity. This is because Bitcoin is truly decentralized - anyone investing in Bitcoin is not relying on a group of founders to perform some task to give them a return. There is also no central team set to profit from investors joining the Bitcoin network. It seems that just about every other network has some element of centralization that could be exploited by regulators. We’ll see how this shakes out over time.
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Thanks for reading and your continued support. This is part of a short series we are doing in the bear market: “Cycle Reflections & Learnings.” Decentralized Exchanges are up next. If you got some value from this week’s report, please do me a favor and share it with your friends, family, and social networks.
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References:
https://tokenterminal.xyz/
https://coinmarketcap.com/
https://defillama.com/
https://dune.com/browse/dashboards
https://www.certik.com/resources/blog/567hEft7IPIS7IKEXMpmkv-the-state-of-defi-security-2021
https://www.onchainid.com/
Individuals have unique circumstances, goals, and risk tolerances, so you should consult a certified investment professional and/or do your own diligence before making investment decisions. The author is not an investment professional and may hold positions in the assets covered. Certified professionals can provide individualized investment advice tailored to your unique situation. This research report is for general educational purposes only, is not individualized, and as such does not constitute investment advice.