DeSci, NFT financialization, ETH L2 Who can save DeFi in a downturn?

DeFi has been in a slump for most of last year. As liquidity mining fades out of focus, investors and retail investors are turning their attention elsewhere. The DeFi winter started months before the broad market sell-off, with most DeFi tokens down more than 90% from their all-time highs.

DeSci, NFT financialization, ETH L2 Who can save DeFi in a downturn?

Growth in other crypto industries will provide a catalyst for DeFi as more assets come on-chain. In the short term, the 2020/2021 bull run has helped put billions of dollars into crypto projects’ money that will inevitably go into DeFi. In the medium term, emerging Web3 categories such as DAOs, NFTs, games, and physical networks will exponentially expand on-chain economic activity. These assets will expand the potential market for DeFi by an order of magnitude. Betting on DeFi is betting on the success of cryptocurrencies.

The DeFi of the future will look very different from the DeFi of summer 2020. A patient trustee will replace the adventurer. A low-risk 10% yield will replace the four-digit APY denominated in junk coins. Future DeFi investors will be concerned about the benefits of stablecoins, ETH and other L1 tokens and their native tokens. This will provide a catalyst for structured products. Crypto-native companies will need working capital, which will drive demand for credit.

DeFi Bear Market

Cryptocurrencies tend to be an extreme industry, and the market sentiment towards DeFi is certainly no exception. Summer 2020 (often referred to as DeFi Summer) saw the rise of liquidity mining with the introduction of novel token mechanics and massive price increases in every token whose white paper mentions reflexivity. Things have clearly changed. DeFi summers have been replaced by Alaska winters.

DeSci, NFT financialization, ETH L2 Who can save DeFi in a downturn?

DeFI has been in a persistent bear market for the past nine months

What’s driving this emotional shift? While DeFi fundamentals explain some of this, I believe the answer is: narrative drives the DeFi sentiment shift:

  • The initial wave of hype that drove this market – liquidity mining – has faded
  • There are brighter things elsewhere

A detailed analysis of the disadvantages of liquidity mining is beyond the scope of this article, but needless to say, it is now clear that liquidity mining alone does not lead to sustainable growth. A few biggest questions:

  • Subsidized liquidity is highly mercenary, and funds leave the pool once the incentive ends.
  • Earnings are primarily generated through token rewards – if the price of those tokens falls, the rewards drop. Therefore, any broad drop in DeFi prices would reduce the attractiveness of liquidity mining activity, creating a negative flywheel.
  • As with most things in cryptocurrencies, very few projects have actual product-market fit, and retail players eventually lost interest after multiple pulls and hacks.

Another factor that brings resistance to DeFi is the emergence of something brighter. Interest in NFTs has exploded, driven by high-end collectibles and celebrity adoption. Blockchain gaming has also seen massive growth in 2021/2022 and has taken retail focus away from DeFi.

Crypto vaults: a catalyst hidden in plain sight

While the industry has wasted a lot of brain cells arguing about when well-known institutions will enter DeFi, little attention has been paid to the billions of assets already on-chain. Over the past two years, the value of on-chain vaults has ballooned as more and more projects such as Uniswap have launched governance tokens. Despite the severe market downturn, there are still a large number of projects with more than $100 million in funding. There are also a growing number of on-chain investment vehicles. BitDAO is the largest with over $1 billion in assets.

DeSci, NFT financialization, ETH L2 Who can save DeFi in a downturn?

Crypto vaults are usually dominated by the project’s native assets, but also often hold stablecoins and ETH (or whatever L1 token the project favors).

DeSci, NFT financialization, ETH L2 Who can save DeFi in a downturn?

Despite the record amount of money raised over the past two years, crypto projects have been deploying surprisingly little money in DeFi. Part of the reason is (reasonably) risk management — DeFi is risky, with massive thunderstorms on Terra and 3AC last month. Private startups with small amounts of capital should of course be highly conservative about their assets.

DeSci, NFT financialization, ETH L2 Who can save DeFi in a downturn?

Few DeFi vaults meaningfully embrace DeFi

However, the established on-chain vault protocol is a dynamic economy and should optimize the (risk-adjusted) performance of its vaults. DeFi is the obvious way for them to do this. The protocol will reasonably seek compound returns of 3-5% per annum by deploying a portion into a diverse basket of established DeFi protocols. Given that the looming bear market always prioritizes burning speed, these vaults may start to focus on yield sooner or later.

Many cryptocurrency vaults have explored entering DeFi. Some examples of early adopters and discussions

  • Synthetix Treasury Deploys $5M USDC to Maple in November 2021
  • In February, PoolTogether began exploring the use of Notional to earn yields in its stablecoin
  • Notional proposed in March that Angle should use Notional to earn profits from its coffers

Index Coop has one of the most sophisticated money management strategies and has been earning steadily since August 2021. Index Coop’s financial lair uses its funds to back its own product and expand its runway. Index Coop has deployed nearly $3 million to support liquidity across its product line. On the financial side, Index Coop has a steady gain of over $5 million in Balancer, Aave, and Uniswap. Given Index Coop’s success in expanding its runway with DeFi, I expect many other vaults to follow suit.

DeSci, NFT financialization, ETH L2 Who can save DeFi in a downturn?

The advent of DAO treasury tools may help facilitate this adoption, as it makes it easier for DAOs to deploy treasury and manage risk on-chain. On the software side, Coinbooks (a Lattice portfolio company) and Coinshift make it easier for DAOs to track their finances. Llama has also established a crypto-native accounting to advise on the financial management of the DAO.

Web3 drives DeFi

The past year has seen an explosion of interest in emerging Web3 categories like games and DAOs. Funding has flooded the space as Axie Infinity has become one of the most discussed games on the planet, with at least 100 blockchain games raising funds last year. Likewise, the Constitution DAO brought mainstream attention to the DAO and helped catalyze tens of millions of dollars into on-chain crowdfunding campaigns. In my opinion, these categories are clear catalysts for DeFi. Both bring more and more on-chain assets, thereby expanding the potential market for DeFi.

If the blockchain game succeeds in any form, it will inevitably bring more assets and users into DeFi. Blockchain gaming will expand the installed base of crypto wallets and familiarize users with on-chain assets such as stablecoins. Blockchain games will also create virtual economies, expand the scope of on-chain assets through in-game assets, and increase demand for economic primitives such as credit.

The rise of DAOs will also expand the potential market for DeFi. Crowdfunding campaigns like ConstitutionDAO will allow more users to join Web3. They will also increase on-chain economic activity by moving corporate financial activities such as payroll and financial management onto the public blockchain.

DeFi 2.0: Sustainable gains

The leading DeFi protocols of the future will meet the needs of patient and more conservative capital allocators. These allocators will want to grow their treasury bonds by earning sustainable yields through stablecoins, L1 tokens like ETH and their native tokens. Project treasuries and DAOs will want to obtain working capital without having to constantly sell their treasuries. This provides a tailwind for structured products and credit.

Structured products are prepackaged investments that use derivatives to make it easier for investors to achieve specific risk-return goals, such as improving yield. In the DeFi environment, structured products often come in the form of single-asset vaults to earn yield. Leading structured product platforms include Ribbon and Friktion. Ribbon’s most popular product is its Theta Vault, which makes money by running automated options selling strategies.

Structured products will grow as DeFi matures, as they can provide sustainable yields for a variety of assets. Structured products generate sustainable (though often not risk-free) returns through volatile natural market forces and participants wishing to transfer risk. They can also support yield generation for most liquid tokens, making them attractive for projects looking to compound native tokens in their vaults. For example, Ribbon supports vaults for long-tail assets like $APE and $AAVE.

As the range of Web3 entities requiring working capital expands, the decentralized credit market will also grow by an order of magnitude. Crypto projects looking to fund their operations without selling their vaults will tap the on-chain bond market. Just this month, Ribbon raised $3 million by leveraging Porter’s bond platform. Maple (a Lattice portfolio company) has provided over $1 billion in credit to crypto-native institutions. While their client base today is mostly made up of ETFs, I expect to include crypto projects in the future.

DeSci, NFT financialization, ETH L2 Who can save DeFi in a downturn?

Maple’s on-chain credit product grows rapidly

Credit will also grow as it will provide one of the only sustainable competitive gains in DeFi. Today, Aave offers <1% yield on USDC. Aave’s yield seems likely to become a “risk-free” DeFi rate and hover in the low single digits. For those looking to earn 5-15% APY on stablecoins, going further up the risk curve and funding true credit protocols like Maple would be a natural choice. Fixed-rate lending platforms such as Notional (a Lattice portfolio company) will also benefit from those looking for higher yields.

Beyond the DeFi downturn

As we enter a seemingly ongoing bear market, the industry will inevitably look to the next story to save us: DeSci, NFT financialization, ETH L2. I think the answer is right in front of us – decentralized financial products that process billions of dollars in transactions every day and have successfully weathered extremely volatile markets. Almost all crypto papers involve financial activity that moves on-chain, which by definition increases the potential market for DeFi. This is all a DeFi argument.

Note that the content of this article is not investment advice.

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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