The bear market is disrupting the entire crypto space.
Prices have fallen severely. Major industry players are being burned at the altar to worship heaven. Market sentiment on Crypto Twitter (CT) also feels like a funeral for shock therapy.
Terra and Celsius were exposed and dismembered by market forces within days. Now, Three Arrows Capital (3AC) is also rumored to be facing bankruptcy.
The environment is bad. Bad actors are being evicted. It also means it’s DeFi open season — no one is safe.
The crypto market continues its rapid downward spiral, macroeconomic alarms are sounding every day, and multi-billion-dollar crypto businesses have gone from Twitter whistleblowers to bankrupt players within seconds of Thanos snapping his fingers.
When everything blows up right in front of our eyes, you might be asking… “Is DeFi dead?”
Below, I will put on a stethoscope to find the answer for you.
State of DeFi
Let’s take a look at some on-chain performance metrics to assess the current state of DeFi and the extent to which liquidity and activity have contracted since the bear market.
Source: DeFi Llama
The total TVL of DeFi protocols on each chain was $62.59 billion, down 66.5% from the December 2021 all-time high of $186.8 billion. This drawdown was driven by a decline in broadly integrated assets such as ETH and wBTC, as well as capital outflows that could be attributed to falling yields.
DEX trading volume
Source: Token Terminal
The current monthly trading volume of DEX is at the level of 103.3 billion US dollars, which is far below the peak of 308.6 billion US dollars on November 21, 2021, that is to say, the trading volume of the 10 sample platforms in the figure has dropped by 66.2%. Since trading activity and price appreciation are highly correlated, this downtrend may be due to market weakness over the past few months.
Source: Token Terminal
Borrowing volume — a measure of the value of outstanding debt on lending agreements — is currently $5.1 billion, down 75.3% from its December 2021 peak of $21.1 billion. Reduced demand for lending leverage is a direct factor in the current bear market environment.
Source: DeFi Llama
The market cap of stablecoins is currently $156.7 billion. This is down 17.1% from the May 2021 peak of $188.9 billion. This decline coincides with the collapse of UST, which at its peak had a market cap of more than $18.7 billion. And this has also led to a contraction in the supply of other stablecoins — such as USDT, BUSD, and DAI — as holders redeemed their assets in a panic.
DPI price; source: CoinGecko
DeFi tokens have shrunk from their all-time highs in the spring of 2021. DPI — the largest DeFi index by assets under management (AUM) — has fallen 90.3% from a peak of $656.49. It is currently trading at $63.45.
In addition to these broad market weaknesses, the decline in DPI — which holds a basket of 14 DeFi tokens — has been exacerbated by inflationary token rewards. Many tokens in DPI offer active liquidity mining programs, but these rewards are not attractive under current market conditions.
Capital is leaving the ecosystem. The transaction volume of users is decreasing, and the amount of borrowing is also decreasing. Stablecoins are being exchanged for fiat, in the billions.
This all comes at a time when DeFi tokens continue to lose market value and the global economy enters its own bigger and worse bear market.
Just a reminder: DeFi is in a major contraction.
DeFi’s self-harm struggle
After shedding some light on DeFi’s first historic major contraction, we’ll delve into some of the root causes of the price drop and the associated slowdown in on-chain activity.
reflexivity of gains
DeFi yields are highly reflexive due to the correlation between price action and on-chain activity.
As the broader crypto market rebounded in late 2020 and beyond, so did protocol usage, liquidity and leverage. This increased usage also leads to higher yields as liquidity providers earn more swap fees, deposit rates in lending markets rise, and the value of token-denominated incentives increases. Higher yields have led to more inflows into DeFi. Degens and farmers rejoice at the often four- or five-figure APR advantage.
Some call it a utopian virtuous circle. Others call it greed.
Here’s the thing: Reflexivity goes both ways.
As prices have fallen, so has on-chain activity. This has led to a consistent fall in yields and fueled an outflow of liquidity. Deploying capital in DeFi is less attractive when the returns are low, and now the returns are so low you don’t even want to take a peek.
The compression of yields is real. Stablecoin deposit rates on Compound and Aave (between 0.7-1.7%) are currently lower than yields on t-bills (t-bills are the shortest-term U.S. Treasury bonds).
Even if the federal government were able to offer better transactions than DeFi, users may feel that they are not being properly compensated because of the considerable risk involved in participating in the frontier economy of decentralized finance.
Over-reliance on liquidity mining
DeFi activity and price contraction have been exacerbated by the industry’s overreliance on liquidity mining. Degens may see liquidity mining as the gamification of finance and a big win for DeFi, but the practice has pursued a monetary incentive system that spurs unsustainable growth that needs to be improved.
In July 2020, the liquidity mining incentive program promoted by Compound powered the first wave of DeFi adoption, giving the protocol an incredibly effective tool to bootstrap quickly by subsidizing the yield of its native token use and grow.
Although liquidity mining is effective as a short-term growth hack, it has several important drawbacks. First, incentive programs have proven to be an attraction to hiring capital, as liquidity tends to flow out of the protocol or DEX pool once rewards start to fade or yields compress.
Additionally, liquidity mining puts downward pressure on the price of the reward token — almost always the protocol’s own governance token — as farmers realize their gains by selling the asset.
This, in turn, accelerates the decapitalization of the DAO treasury, as protocols typically allocate a significant portion of their native token supply to these reward programs. This reduces the source of funding for the protocol, while also reducing its resilience to adverse macroeconomic conditions – like the one we are in right now.
Broken Protocols and Vulnerabilities
As the bear market continues its biblical carnage, a number of events have undermined trust and highlighted key risks inherent in DeFi.
By far the most prominent is the collapse of Terra .
As you’ve probably heard, Terra’s UST and LUNA both collapsed in May. UST was decoupled, LUNA was hyperinflated, and the result was a 99.9% collapse in value in just a few days. Based on the peak market capitalization of each token, this means a total of about $59.8 billion worth of investor wealth was quickly wiped away. That’s almost the GDP of the entire country of New Zealand, vanishing like a kiwi in a mountain fog.
The UST death spiral has also affected other Terra protocols like Anchor, a money market that pays a fixed ~20% interest rate on UST deposits and opens it to users as a “savings account”. The protocol was one of the largest in all of DeFi, amassing over $17.15 billion in TVL at its peak.
Aside from the collapse of the protocol, DeFi was already ravaged by hackers before the bear market started. In 2022 alone, more than $1.44 billion in user funds will be lost in 20 breaches, which already exceeds the value of all losses in 2021. The frequency and scale of these attacks may have exacerbated the dramatic reduction in on-chain activity, as the potential for loss of funds, combined with yield compression, makes deploying capital on-chain less risk-reward.
The destructive power of UST, along with billions of stolen funds, has sown deep distrust in DeFi protocol design and security among users.
The catalyst for the DeFi revival
Now that we understand why DeFi prices and activity are shrinking, let’s explore some potential catalysts to revive the industry’s growth model.
1. Scalability unlocked
One of the main reasons why DeFi adoption has so far been limited to a small group of dedicated degens is — yes — scalability limitations.
Despite the respite, Ethereum’s gas fees are still so high that a significant portion of potential users are excluded. Not only does this limit the types of applications that can be built, but it also encourages poor risk and position management of those already built.
For example: in order to save gas fees, users dealing with smaller funds are forced to concentrate funds on fewer protocols. This means that they cannot adjust their positions as they wish, and may not even adjust at all. Imagine playing chess where your moves are only half of your opponent’s. That’s your hurdle on the CeFi platform.
While the scalability problem is not limited to congestion on Ethereum, it is on Ethereum that we are rolling out solutions through initiatives like optimistic and zk-Rollups . While the technology is still in its infancy, these Layer 2 (L2) networks are already starting to see meaningful adoption and transaction volume. Arbitrum and Optimism have managed to attract a total of $1.2 billion in TVL, and dYdX — built using Starkware’s StarkEx — is now the largest perpetual DEX by trading volume.
By offering users cheaper transaction fees and near-instant partial confirmations, L2 will not only greatly improve the user experience and unbundled platform, but will enable a new wave of users to enter the DeFi space at scale.
Additionally, L2 unlocks a new design space for developers. Many of the most popular applications on these rollups today are applications that are unlikely to be created on L1 — for example, derivatives protocols. Along with dYdX, other perpetual exchanges such as GMX and Perpetual Protocol, as well as options protocols Lyra and Dopex, have become some of the most trafficked platforms on their respective networks.
As these scalability solutions gain traction, popularity and liquidity, we should continue to see novel applications being built that would not be possible to create within the confines of L1 or TradFi tracks.
So, if you think Degens and liquidity mining are crazy, just wait and see Degen regens and their definition of “financial instrument”.
2. Practical real-world adoption
Another factor that helps revive DeFi is our ever-elusive old friend “real world adoption.”
While there are billions locked in DeFi today, most of it comes from a small group of whales and retail investors. Due to the lack of accessibility and regulatory considerations, there is very little adoption and use of DeFi outside of liquidity mining in this selected group.
There are now countless routes through which DeFi can be leveraged by more diverse market participants, which in turn will foster growth and inject new liquidity into the ecosystem. The road to bringing in tens of trillions of dollars is being paved.
For example: Protocols such as Maple Finance, Clearpool, and TrueFi provide institutions with access to under-collateralized loans using DeFi in a compliant manner, allowing them to benefit from the low transaction costs and efficiencies that on-chain operations bring. These lending protocols have exploded in popularity, with Maple’s recent loan origination volume exceeding $1.5 billion.
While these loans have largely extended to CeFi entities such as market makers and hedge funds, the same infrastructure could eventually be leveraged by traditional financial institutions, which hold more capital.
Products like Aave ARC (which offers whitelisted KYC pools) provide another venue for TradFi institutions to dip their aging, gouty feet into the waters of the on-chain economy — then, DeFi’s The real battle will begin.
Beyond institutions, we are also seeing early signs of real-world enterprise leveraging DeFi. Goldfinch is a decentralized credit protocol that has disbursed over $102.2 million in loans to businesses operating in markets including Nigeria, Southeast Asia, and Mexico.
This represents another avenue through which DeFi can expand its user base, bring in new capital, and prove its value proposition by actually providing financing in the real world.
The rapid succession of burns by UST (stablecoin), Terra (L1 of UST), Celsius (CeFi bank), and Three Arrows (VC of Terra) was by no means spontaneous. The phenomenon rapidly spread from the sick product layer to the parent tissue within days of its discovery, with lethal consequences.
But at the end of the day, none of these projects are built on Ethereum, and none of them are DeFi platforms. In fact, after them, the value proposition of the fully transparent and open financial system that DeFi offers has never been clearer.
A bit decentralized is NGMI. The acronym sounds a little different now.
So, what’s next? Scalability solutions like L2 mean DeFi will soon have enough bandwidth to accommodate a new generation of users. Building a marketplace means developers have the freedom to prototype edge-cases, not rush-for-copycats. DeFi lenders are intersecting with brick-and-mortar businesses, leading to real-world adoption.
This paves the way for trillions of new capital to flood into the ecosystem and drive its growth.
Yes, DeFi could be down quite a bit.
However, it’s definitely not dead.
In fact, DeFi is fine.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/bankless-what-this-bear-market-means-for-defi/
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