The digital asset market fell into a liquidity crisis in May this year. The plummeting token price led to the liquidation of positions on the chain. The liquidity crisis had a very serious impact on the DeFi ecosystem . Referring to the DeFi LIama data, the overall lock-up value (TVL) dropped sharply. Compared with the high retracement rate of more than 70%, many well-known DeFi protocols have encountered problems such as payment difficulties, management confusion, and lack of credit during this crisis. This article intends to review the current round of liquidity crisis, so as to explore the root cause of the crisis and the impact of the bear market environment on the ecological development of DeFi.
1. The beginning and end of the liquidity crisis
Bittracy will first review this liquidity crisis with you: In May 2022, Terra ecology was shorted by attackers, LFG failed to save the market, and LUNA with a market value of tens of billions of dollars returned to zero. Institutions such as Jump Capital, Three Arrows Capital (3AC), Celsius and others have suffered huge paper losses due to their large LUNA positions. Due to the high degree of “stacking” of the DeFi ecosystem, “Finance Contagion” occurs rapidly among crypto institutions, which is an important time for the market to turn from bull to bear.
The following June saw Bitcoin price fall below $20,000, a 50% retracement from its May high. 3AC lost a lot of liquidity on LUNA, which brought great pressure on its capital. In addition, due to holding a large number of digital assets such as GBTC and ETH, the poor market performance made 3AC’s situation worse, so it sold its investment. Token. Almost at the same time, the incident that the lending platform Celsius concealed its losses was revealed. In response to customer redemption requests, Celsius sold the digital assets it held to the market in exchange for liquidity, and sETH was de-anchored.
The sharp fluctuations in the price of digital assets have led to a liquidity crisis in DeFi: the loan agreement liquidated the positions with insufficient margin, and the huge selling pressure triggered spiral selling, and the price fell further. At the same time, the exchange pool spread of stablecoin projects has expanded; unsecured and semi-collateralized agreements have begun to have bad debt risks. This decentralized financial ecosystem, once widely trusted by investors, seems a little overwhelmed when faced with a liquidity crisis. As of publication, the price of Bitcoin has risen above $20,000, and the impact of this liquidity crisis on DeFi deserves our reflection.
2. The root cause of the DeFi liquidity crisis
Looking at the whole process, Terra zero seems to be the starting point of the entire market crash, but can the bull market continue without Terra? In fact, the overall market value of U.S. dollar stablecoins stopped growing in April, and Celsius and Babel have always had problems in risk management. So what is the root cause of the liquidity crisis? The article will analyze the root cause of the liquidity crisis with an “Up to Bottom” approach.
1) Macro: The tightening of the U.S. dollar has lowered the valuation of digital currencies and tightened liquidity, adding pressure to the market
After the outbreak of the new crown epidemic in 2020, the global central bank launched monetary expansion to stabilize the economy. The US base currency increased by more than 300% year-on-year, and the spillover liquidity quickly pushed up the price of financial assets. That rose to $8.92 trillion, more than doubling. In 2021, the global economy will gradually return to normal. However, monetary expansion has led to a sharp rise in inflation, and the US CPI has risen to a 40-year high. Powell has decided to tighten the scale of bond purchases from November 2021 and shrink the balance sheet from June 2022. According to the calculation of the Fed’s balance sheet reduction path announced on May 4 (reducing assets by $95 billion per month), by the third quarter of 2025, the size of the Fed’s balance sheet will fall below $6 trillion. The tightening of liquidity margins has put significant pressure on highly valued assets.
U.S. bond interest rates have always been known as the anchor for global asset pricing, and the rise in benchmark interest rates has reshaped the valuation of major assets. In 2021, the overall market value of the digital asset market will exceed one trillion US dollars for the first time, and Bitcoin has transformed from a minority value consensus to a truly major asset class. Under the macro background of liquidity contraction, Crypto, which is very sensitive to liquidity, naturally bears the brunt, which is the macro factor leading to the DeFi liquidity crisis.
2) Changes in the cryptocurrency market cycle: the end of the Bitcoin halving market, Dapp innovation is exhausted, and the number of new addresses is declining
We analyze the market changes in the second quarter from the perspective of the encrypted world from a meso perspective:
Taking history as a reference, this Bitcoin halving market has come to an end. Since Bitcoin is of great significance in the world of digital currency (the market value ratio is around 70%), the author reviewed the historical performance of Bitcoin after the block halving in the past three times. We can find that: Bitcoin block output halved is the encryption market. In the unique cycle of 2019, the reduction of block output will increase the cost of Bitcoin mining and promote the market situation. Referring to the performance of Bitcoin after the past three halvings, the duration of each round of the market is about 22 months. On May 12, 2020, Bitcoin began its third halving, and this round of bull market began. As of May 2022, the length of this bull market has exceeded 2 years, and the push of Bitcoin’s halving on the market is gradually coming to an end.
From the perspective of technological progress, developers are showing signs of fatigue in innovation. In 2020, thanks to the innovative development of smart contracts by technical personnel, the decentralized world will become colorful: “DeFi Summer” in Q2 2020; GameFi wave and Layer 1 rise in 2021. As the time enters the second quarter of 2022, the newly emerging Dapps are more replicas and optimizations of existing models, and there are fewer and fewer innovations that make people shine. As an investor, it is difficult for Bittracy to see a better investment target. In the environment of “lower prices + weak innovation”, the market began to turn to “narrative-led” NFTs, and market liquidity was gradually consumed. Starting from May 2022, due to weak endogenous growth, the number of new addresses has gradually decreased, and the crypto world is becoming less attractive to external users.
3) DeFi mechanism: when the price fluctuates downwards, it is easy to cause the liquidity to shrink and increase the transaction risk
The price drop magnifies the Impermanent Loss, and the pledger withdraws funds : When the Crypto price rises or falls, it will cause a certain Impermanent Loss. Due to the asymmetry of Impermanent Loss, when the price falls, the stakers will suffer more seriously. About Impermanent Loss In the face of market volatility, Pintail made a more detailed explanation in the article “Uniswap: A Good Deal for Liquidity Providers?”: If the price of the token changes greatly, it may cause the Impermanent Loss of the pledger to be much greater than the return. Therefore, when there is a crisis signal in the market, pledgers often choose to withdraw funds, which leads to a negative cycle of tightening DeFi liquidity, and the overall lock-up value (TVL) will shrink sharply in a short period of time.
Huge transactions magnify AMM slippage: AMM mechanism is the core foundation of DeFi, but it cannot avoid the price shock caused by large transactions. When the market falls, users often have a timely need to redeem funds. When the transaction occurs on a large scale in a short period of time, the pledged funds in Swap cannot meet the user’s transaction needs. First of all, in the DeFi ecosystem, the scale of pledged funds in Swap Protocols is roughly the same as the scale of pledged funds in Lending Protocols. When large-scale liquidations occur, Swap Protocols cannot provide sufficient depth for liquidation. More importantly, under the AMM trading mechanism, large-value transactions will significantly affect the market price (a single large-scale liquidation will significantly affect the position of the transaction on the fixed product curve), resulting in a price offset. Igor Mikhalev and Zoia Mandrusova showed their findings in “Agent-Based Modeling of Blockchain Decentralized Financial Protocols”: transaction size is positively correlated with slippage, and a single large transaction will disrupt the transaction price. The de-anchoring of UST on the Curve protocol is the best example. On May 7, in the STw-3CRV Curve fund pool, a transaction of UST exchanged for USDC of 85 million US dollars directly led to the depletion of UST liquidity. When AMM-based DeFi faced a market crisis, it seemed a little powerless.
Summary: Under the pressure of the macro environment, the downturn in the digital asset market affects not only DeFi, but also CeFi and even traditional financial institutions. The Fed shrinks its balance sheet and recycles excess liquidity, which will lead to a tightening of financial conditions and a rise in risk-free interest rates. The spillover of the Fed’s policy will lead to the rise of the global interest rate center, which will cause varying degrees of pressure on the global financial market, especially for some high-valued risk assets. At the same time, blockchain innovation has stagnated, the industry’s endogenous growth momentum is insufficient, and its ability to attract the outside world has declined. More importantly, due to the operational characteristics of the DeFi trading mechanism, in the face of market adjustments, the situation of the financial system on the chain will be more dangerous.
3. The impact of the DeFi liquidity crisis
1) DeFi enters the stock market, and the head concentration may increase
First, a lower market will directly lead to weaker on-chain transaction volume and lower borrowing demand, and the competitive environment for DeFi will intensify. Trading Fee and Interest Spread are the main sources of revenue for DeFi, and in a bear market environment, trading volume and lock-up volume will drop significantly, which will lead to shrinking market space. For a long time in the future, DeFi developers will need to face the stock, or even the decreasing market. And the increased competition is not kind to those DeFi Dapps that are just getting started.
Compared with the bull market, it will be more difficult for the new protocol to obtain liquidity in the bear market, and the market share of the DeFi leader may increase significantly. Investors are losing interest in participating in new mines due to reduced risk appetite. Specific to the market-making mechanism, the DeFi protocol obtains income by selling tokens when it goes online. The development team uses tokens to motivate market makers and users: arbitrage costs (impermanent losses) and token rewards are used as a function of transaction fees. And determine the reward amount for liquidity providers. However, in a market environment with low liquidity, the possibility of users wantonly FOMO is reduced, and it will become more difficult for the new protocol to ensure market makers’ profits (maintaining currency prices).
Investors are reminded that leading protocols are eating away at the living space of other protocols. Curve announced in July that it would launch an overcollateralized stablecoin. At the same time, the lending protocol AAVE also plans to release its own stable currency GHO and provide corresponding Swap services. In the context of weakening on-chain transactions, leading DeFi protocols are cutting into other tracks and using their own advantages to expand growth space. Therefore, Bittracy believes that in the next two years, DeFi will have the logic of increasing concentration.
2) DeFi protocols need to optimize governance structure and improve governance efficiency
The “oligarchic governance” of DeFi protocols has not been resolved until now. To put it bluntly, the project team and investors have a strong ability to control the protocol, which leads to the easy occurrence of moral hazard. In the face of this stress test, those organizations (Celsius, Terra, etc.) that claimed to be decentralized governance chose to sacrifice the interests of customers, made illegal operations, and strived to protect themselves, while the rights and interests of users could not be guaranteed. In fact, the problem of DeFi governance structure has always existed. During the bull market, users turned a blind eye to their choices. When the crisis occurred, it was too late.
How DeFi governance should be optimized has begun to become a part of investors’ widespread concern. In recent roadshows in contact with DeFi protocols, how to ensure the interests of all parties in the face of market pressure has become the most discussed topic. In the early stage of project development, centralized governance is required to ensure efficiency, and the community should also establish an effective mechanism to prevent the project team from doing evil and avoid repeating the same mistakes.
I once wrote about governance at the beginning of the year: ” 2022, where will DAOs go?” ”, as discussed in the article, DAO governance is not suitable for all scenarios, and the proper use of centralized governance can ensure the effective operation of the protocol. DeFi protocols should choose appropriate governance mechanisms according to the nature of the business, so as to promote the longevity of the protocol.
Innovation direction: asset security attracts attention, and development opportunities for insurance and privacy tracks
In 2020, DeFi has built a financial system for the decentralized world, which is the basis for the booming industry. As the market strengthens, DeFi evolves towards higher efficiency and better returns. We saw semi-collateralized and even unsecured algorithmic stablecoin protocols (UST); unsecured lending protocols (TrueFi, Maple Finance); higher yielding staking protocols (Alpaca Finance, Lido). Such liquidity innovations improve the efficiency of capital use and help users increase their income. Among them, some protocols sacrifice liquidity for high yield, and some use higher leverage to obtain FarmingYield. However, due to the composability of DeFi, once the liquidity of the economic system shrinks, the highly stacked financial system can easily fall into crisis. So when the market fluctuated downward, we saw LUNA zeroing, sETH decoupling, mass liquidation, and Dapps in a hurry.
In the long run, risk management should be taken seriously by practitioners. In the decentralized financial ecosystem, establishing an effective risk management system should be the focus of developers’ work. After the DeFi liquidity innovation blossoms, I personally look forward to the emergence of a variety of “safety tools” in the DeFi world. Taking Gauntlet as an example, as a decentralized risk management platform, its role is to help DeFi protocols control risks and improve capital efficiency. The protocol provides guidance for the capital utilization efficiency of DeFi protocols through sensitivity analysis in different scenarios, in order to provide more direct incentives for market makers and users.
Currently, Gauntlet has cooperated with AAVE, Compound, MakerDAO, Sushiswap, and Balancer. Meanwhile, Gauntlet has partnered with DeFi Pulse to assess “economic security levels” for different funding platforms. For example, users mortgage funds to Anchor to get a 19.5% interest rate return, and senior players do not know what the level of risk they encounter. Gauntlet can be used as a rating tool on the C side to help users quantify risks. From the perspective of practitioners, we must admit that risk management is the shortcoming of the current DeFi ecosystem. Because of this, insurance and safety tracks may usher in a good development window.
DeFi is an important foundation for the development of the decentralized world. In the bull market, its benefits come from the excess inflation of governance tokens and the leverage ratio that ignores risks. Obviously, when the market falls, these are no longer reliable. In a bear market, the protocol needs to earn its own living space through fees and spreads. But this is also good. The development of DeFi will be closer to the essence of finance, and the development team will also provide the market with reliable business models and stable products; more balanced governance models, more solid revenue methods, and safer risk management. But the logic of future DeFi development is fundamental.
2、《Uniswap: A Good Deal for Liquidity Providers?》
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/defi-minsky-moment-stress-tests-and-implications/
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