DeFi pseudo-innovation leads to market failure, what is the future of DeFi?

Author’s note: Exactly two years ago, on June 15, 2020, Compound launched what came to be known as “yield farming” incentives, detonating the “Summer of DeFi” and subsequent year of the entire crypto market Half bull. As before, this bull market ended with a sharp decline. As of June 15, 2022, the total value of the entire encrypted digital asset market has dropped by 67.5% from its peak.

We believe that there are five main reasons for this market crash:

First, global central banks tighten their currencies.

Second, the opaque operation of a large number of centralized institutions in the Crypto industry has led to the inability of the market to timely and fully understand the leverage risks accumulated within them, increasing the risk of sudden market collapse and panic.

Third, the products of the Crypto economy are still dominated by speculative digital assets. There are very few services and products that have clear value and meet real needs. The consumerization transformation has just started and has not yet become the ballast for the stable growth of the industry.

Fourth, mortgage lending has become the main mechanism for creating liquidity in the crypto market since 2020, and this mechanism has not yet matured, leading to a liquidity death spiral in the fall of the market.

Fifth, a large number of DeFi pseudo-innovations have led to market failures, misled a large amount of funds and misallocated them, and suffered heavy losses.

The first problem above is a macroeconomic problem, which belongs to external causes, and the other four problems are internal causes of the industry. We are going to write four articles to discuss the four internal factors and propose suggestions for improvement.

This article discusses the market failure caused by DeFi pseudo-innovation. It should be said that this factor is relatively minor in this market crash, but for the DeFi industry, it cannot be ignored.

DeFi’s extraordinary slump and market failure

In this market crash, DeFi has performed exceptionally poorly. As of June 15, 2022, when the total value of DeFi locked positions fell by 69% and was basically the same as the market, the market value of DeFi projects suffered an extreme collapse, Uniswap’s market value lost 88.5%, Compound’s market value fell by 94.2%, A large number of well-known DeFi projects are in short supply, and the prospects are bleak. Even the DeFi “blue-chip” projects that were once known as the future of finance mostly fell by more than 95%.

We believe that such a crash in the DeFi market is not normal. DeFi is the first pure on-chain application category with a clear profit model. Compared with CeFi in the traditional financial and crypto markets, it is more open, more transparent and secure, and has higher overall efficiency. Therefore, there was a time when people not only took DeFi’s outbreak for granted, but believed that its success could be sustained, not only that DeFi could lead a bull market, but that it could resist a bear market.

In this case, why is DeFi particularly bad in this slump?

One of the factors that cannot be ignored is the market failure caused by pseudo-innovation, which means that many DeFi projects deliberately create complex financial assets, business logic and incentive mechanisms under the distorted purpose, and transmit a large number of false price signals to the market. This results in a large amount of misallocation of funds.

Market failure is a phenomenon used by economics to describe the failure of the market mechanism in allocating resources. In most cases, market mechanisms can guide participants to adjust and optimize resource allocation spontaneously through price signals. But in some cases, the market mechanism is out of order, and resources cannot be effectively allocated, resulting in serious waste of resources and low efficiency.

All economics textbooks will tell us that there are three main reasons for market failure, the first is product externalities, the second is poor market structure, and the third is information asymmetry. The main reason for the failure of the DeFi market this time is information asymmetry.

Asymmetric information can lead to market failure. George Akerlof revealed this in “The Lemon Market: Quality Uncertainty and Market Mechanisms”. In the second-hand car market, because buyers and sellers have unavoidable information asymmetry about the actual condition of a certain car, buyers are either deceived and bid a high price, or they always offer the lowest price out of an anti-deception mentality. This leads to the loss of the role of price signals and the failure of the market mechanism.

The key role of blockchain and DeFi is to reduce information asymmetry. The two biggest characteristics of DeFi are that it is completely open without permission, and the other is complete transparency. The business logic and transaction records are completely transparent, and anyone can query and audit.

In this case, why is the DeFi market malfunctioning? Why do you think DeFi’s extraordinary slump is related to market failure?

The leading projects developed in the early days of DeFi, such as MakerDAO, Uniswap, Compound, Aave, etc., are indeed open, transparent, and eliminate information asymmetry as their value propositions. They have relatively simple and clear logic, complete documentation, and after a long period of operation, the outside world can fully understand their business logic.

However, in the past two years, some so-called innovations in the DeFi industry have not only not given full play to technological advantages and reduced information asymmetry, but have tried to construct new information asymmetries inappropriately. These pseudo-innovations not only failed to solve real problems, but also obscured the core of DeFi, causing serious failures in the capital market under the deliberately created information asymmetry. That is to say, in the investment and financing and asset trading of DeFi, investors, traders and DeFi users allocate a large amount of funds to the wrong places. Therefore, when the market adjusted and corrected, these misallocated funds suffered severe losses that far exceeded expectations, which increased the market volatility and led to the collapse of the market value of DeFi projects.

Therefore, we think it would make sense to view this plunge in DeFi from the perspective of market failure.

Four manifestations of DeFi market failure

The failure of the DeFi market is caused by new and deliberately created information asymmetry, which at first sounds counter-intuitive, because DeFi is known for its transparency and credibility. DeFi fans often proudly claim that in DeFi, everything from transaction records to financial logic to implementation code is transparent. As long as you are willing to study, you can have equivalent information and knowledge with the project party.

In theory, it does. DeFi does achieve mandatory transparency in its technical infrastructure. However, many DeFi projects have recreated information asymmetry for various reasons, misleading the market intentionally or unintentionally.Specifically, there are the following situations.

The first situation is to carry out various whimsical financial pseudo-innovations, and cover up the fatal flaws through complex logic, code and incentive mechanisms such as “liquidity mining”.

There have been many fantastic ideas in human financial practice for hundreds of years, and most of them have been eliminated by history because of serious defects. After the outbreak of “DeFi Summer” in 2020, thousands of troops entered DeFi, and many “innovators” who lacked relevant professional knowledge and had little knowledge of financial history, close to the enthusiasm of gold rushing and a little cleverness, started various projects. A DeFi project. Many of these projects have no rigorous theoretical derivation, let alone any market tests. Some even violate the basic financial principles and have serious loopholes. Their good performance depends entirely on the rise of the currency price or the overall market. Once it exceeds expectations The situation, especially in extreme market conditions, will be full of flaws and be falsified in tragic ways.

But these pseudo-innovations are often very good at stacking complexity to create opacity and mask their flaws. They often construct complex mathematical formulas to “finish the finishing touch”, claiming that they can produce magical effects, and then copy a large number of codes from mainstream protocols, mixing, modifying and stirring them to form a pot of smart contract code that no one can understand. soup. We contacted and studied a lot of projects at that stage, many of which have weird ideas and complicated codes. Even if we are familiar with smart contracts like us, there is no way to quickly understand all the logic and distinguish its authenticity.

Faced with such complexity, the market does not have the ability to identify and evaluate, resulting in a large number of venture capital being misallocated into pseudo-innovation projects. Many of these projects have received financing, and once achieved a high market value. After a period of testing, most of them have been falsified by the market, resulting in a loss close to zero of the funds allocated in them.

To make matters worse, in order to compete for capital volume and traffic, and to cover their shame, almost all such projects have established very complex mining incentive mechanisms, which often include more than three kinds of assets, a large number of intertwined complex rules, and high Random, ever-changing governance model. Even relatively simple businesses, churned and obscured by this chaotic incentive model, are completely lost in transparency and predictability, and no one can evaluate them.

For this kind of project, value investors naturally stay away, and the project party can only create a highly speculative Ponzi structure to attract gamblers. The “three pools” condone leveraged vote bribery, induce participants to carry out multi-level circulation, and continuously increase the nominal rate of return. Of course, the high rate of return provided by the project party is unsustainable, and the miners are well aware of this. Therefore, one side wants to enlarge the disk surface as much as possible through the Ponzi structure, and the other side is like a swarm of sharks, coming and going like the wind, smelling fishy and moving. It has created a very vicious and intriguing game structure, which is contrary to the original intention of the DeFi project.

In this actually fraudulent game structure, misleading has become the goal of deliberate pursuit, and information symmetry is like a mirror.

The second situation is to treat the “governance currency” as a stock, and when the total value of the governance currency is regarded as the market value of the project, it misleads a lot of funds to make a wrong allocation.

In order to avoid being identified as a security token, the governance coins of most DeFi projects are described as only having “political rights” such as voting rights and governance rights, but we all know that these governance coins are rarely used for voting, mainly is used for trading. A conundrum then arises: how to value votes? This is of course impossible to explain clearly. As a result, the actual value of these governance coins has become very difficult to judge and has great volatility.

We do not criticize this situation per se, as it is an inevitable consequence of an uncertain regulatory environment. In fact, it is worth exploring whether there is information asymmetry in this asset. Because the project party, like the trader, knows little about the actual value of this asset, in this sense, this asset is opaque but information symmetric. So a more appropriate description is a price game on an asset whose valuation logic no one knows about. There is nothing wrong with that in itself, Bitcoin is the representation of this asset.

The problem is that there is a misleading narrative in the DeFi market that treats the “governance currency” as a project’s stock to calculate the project’s market value. This narrative misleads a lot of funds to be allocated in governance coins, or even in leveraged assets based on governance coins, and thus suffer unexpected losses. In fact, this also leads to the asymmetry between the rights and responsibilities of the project party: in the bull market, you can enjoy the benefits of the market value bubble, but when the market falls, there is no obligation to support the price of the governance currency with real business income.

For example, at its lowest point on June 15, Compound’s TVL was still as high as over $4 billion and still had good spread income. But the $COMP market cap is only $212 million. If the Compound project is valued, many people may give a higher value, but as a governance currency, the relationship between $COMP and the value of the Compound project is unclear, and Compound’s operating income cannot support $COMP. s price.

Misleading narratives like this make a large number of investors think they are investing in the DeFi project itself, but in fact are only investing in a voting right with a vague value. When the market is plummeting, the healthy profitability of these projects cannot be passed on to the governance currency, and it is difficult to form support for the market.

The third scenario is the formation of nominally safe, in fact high-risk assets through a chain of nested complex structures that send false interest rate signals to the market.

Many DeFi projects after 2021 are not really solving any financial problems, but spend all their energy on constructing assets with false risk-return structures. Compared with the first case, these “innovations” do not use the complexity of the code to create information asymmetry, but use the open infrastructure of DeFi to create a very long chain of financial structures that often includes several third parties. Protocols and dozens of assets, and layers of nesting and complex combinations to construct more opaque assets. Of course, no matter how they are packaged, these assets are essentially leveraged on high-volatility assets, and must also be high-risk assets. However, due to its complex structure, few people, or even no one at all, can fully penetrate and understand its mechanism and laws of motion. Just add a nice story and package these assets into innovative high-yield, low-risk financial products that can attract a lot of money. As long as it lasts long enough, it can shake people’s sanity.

This method also has a particularly bad effect, that is, it sends the wrong price signal of risk-free yield to the market, resulting in price disorder in the primary and secondary markets: a large amount of funds are misallocated to high leverage disguised as safe assets Many high-quality start-up projects are not fully funded due to their inherent high risks.

We’ve all seen what happened to this asset. These supposedly risk-free assets collapsed quickly and unexpectedly when the market corrected systematically. Many investors who thought they could lie on the safety pad and charge high interest suddenly found that not only the interest was like a mirror image, but also the whole capital was lost.

Such a large amount of funds were misguided and allocated to high-risk assets without knowing it, and they were not fooled until the crash or even zeroed. This is one of the important characteristics of this market crash, which has never happened before.

The fourth scenario is that under the pressure of competition, spurious demand is forcibly incentivized through liquidity mining and high yields, leading to false prosperity and sending wrong signals to the market.

Since Compound successfully launched liquidity mining, almost all DeFi projects have launched their own liquidity mining incentives. It should be said that the proper use of this mechanism can help the project to rapidly expand the scale of users and form a network effect. However, the use of liquidity mining incentives should be limited to realistic business goals and serve to promote real business growth. Once you deviate from this goal and use high yields to incentivize false demand, huge risks will accumulate and lead to a vicious game structure.

For example, for some complex derivatives protocols, there is no real demand in the early stages of DeFi’s development.However, in order to rapidly increase the transaction volume, the project party uses a special structure to increase the incentive strength and create short-term false prosperity. Since there is no real demand, the collapse occurs immediately after the incentive strength weakens.

A typical example is that many DeFi protocols divide about 4% of the APY above Aave into priority and inferior, and then give more than 10-20% of the APY through governance currency incentives, in order to create the illusion of high transaction volume. However, such a game structure is obviously unsustainable. These protocols are ruthlessly smashed after a large number of governance currency incentives are given. It is impossible to establish a loyal user group through a large number of early incentives, and it is impossible to accumulate and survive. The required funds, the project will die immediately after the income cannot be maintained.

Lessons learned from the crisis

Our Advice: Return to Simple, Clear, Principled Innovation

DeFi is destined to be a great innovation movement that will change human finance and economy. This movement has entered a new cycle in the tragic decline in 2022. In the last cycle, many famous tricks and fashionable concepts have shown their original shape in the unexpected market winter. However, in the Metaverse of financial markets, which infinitely magnifies the flaws of human nature, they are destined not to die, but to hibernate. In the next warm spring of the crypto market, they are bound to have a makeover and a resurgence. Although the star of market innovation at that time may have become Web3, as the indispensable and core infrastructure of Web3, DeFi will still be the protagonist of the center stage. There are two things we can be sure of: the first is that DeFi will once again shine, and the second is that all kinds of monsters and monsters will make a comeback.

The DeFi industry should learn from the crisis and avoid repeating it. We make the following recommendations:

First, advocate a new innovative concept of DeFi, which is clarity, simplicity, adherence to principles, and pointing directly to the core. The market should form a culture that disgusts all complicated and complicated tricks, rejects all amplification and manipulation of human greed and fear, and dislikes tricks that use complexity to cover up the essence as much as a liar.

Second, use economic principles to explain the meaning of DeFi innovation. As the latest technological tool of the free market system, all blockchain and DeFi innovations should conform to the basic principles of economics, solve practical problems, create real value, and improve practical efficiency, not just a trick to divide the cake. Such innovation should be able to use the basic theory of economics to explain its value creation mechanism, such as: promoting the refinement of the division of labor, expanding the scale of collaboration, reducing transaction friction, improving transparency, lowering entry barriers, and increasing The efficiency of supervision and so on.

Third, oppose pseudo-innovations that do not create real value, such as “serial mining”, “circular pledge”, and “leverage bribery”.

Fourth, create more transparent assets with clear valuation logic, such as debt assets, correct the wrong narrative that treats governance coins as stocks, and reduce active and deliberate use of opaque assets such as “governance coins”. Overlay leverage.

Fifth, establish an industry-level stress testing mechanism, such as establishing a simulated market on the test network, advocating or even requiring DeFi projects to conduct stress testing in it to test its performance in extreme market conditions.

We know that Crypto and the DeFi market will never be free from the stupidity driven by human greed and fear, but we also believe that DeFi will not stand still. As the past thirteen years of this crypto industry have proven, as long as we can be honest about our problems and learn from our lessons, we can make real progress and be able to do better next time.

Posted by:CoinYuppie,Reprinted with attribution to:
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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