After the UST de-anchored, the cryptocurrency market began to collapse. Institutional thunderstorms, exchanges suspended withdrawals, loan agreements were liquidated and run on one after another, and the liquidity crisis became prominent. Behind this domino effect of all losses, the crisis of DeFi is exposed.
In 2020, DeFi Summer is coming, and everyone is excited about it. The prevalence of liquidity mining has jumped the total value of encrypted assets in DeFi protocols from less than $100,000 to a high of $300 billion, with a high annualized rate of return, prominent wealth effects, and a continuous influx of users, followed by high End players continue to increase leverage, pushing DeFi to its peak. However, when the cryptocurrency market encountered unsystematic risks, DeFi also hurriedly ended in a sharp decline in market value. As shown in Figure 1, as of July 7, the total lock-up value (TVL) of DeFi has dropped by 64% from the highest point, and the market value of those known as DeFi blue-chip projects has also plunged. For example, the market value of Uniswap has dropped by 82% from its peak, and the market value of Compound has dropped by 94.4%. The market value of most DeFi projects has almost returned to the level of the initial market launch period.
The bubble was punctured.
Figure 1: DeFi TVL
Deadline: July 7, 2022
It makes sense for DeFi to lead the bull run in 2020, and as Vitalik said, permissionless access to financial instruments is interesting and important for anyone in the world. The current DeFi seems to have only put on the emperor’s new clothes of “getting rich”, forgetting that no permission and availability are its inherent development. This article will deeply analyze the reasons why DeFi is in crisis, and explore how DeFi should be brought to life.
Causes of the Defi Crisis
Think of LEGO stacking as innovation
Initially, when projects like MakerDao, Uniswap, Compound, and Aave were created, they did lay a solid foundation for DeFi, and the attempts on DeFi were groundbreaking. They are permissionless, transparent, have simple and clear logic, and have survived several market trials and still work safely.
DeFi has also been praised for its composability. When the innovation of a project detonates the market, a series of projects will appear that combine or improve the innovation with its own products and become a popular item in the market again. This is the case with liquidity mining. Hummingbot first proposed liquidity mining, and the adoption of Compound pushed liquidity mining to prosperity. Later, a series of projects have adopted the mode of liquidity mining to launch their own project tokens. . Sushiswap (Sushi) is also a fork based on Uniswap. It uses the liquidity mining model to launch the governance token Sushi first, and rewards DEX earnings to liquidity providers. This move by Sushiswap seized 83% of the liquidity on Uniswap in a short period of time, and a large number of DEXs named after food appeared on the market in an instant. Since then, on the basis of liquidity mining, there have been nested “two pools” or “three pools”, leveraged mining, and Bonding, which attract funds in the name of increasing yields and expand its Ponzi effect. The project side’s sickle lit up, and all the leeks were harvested.
The innovations that have unfolded in DeFi over the past two years have been minimal, essentially an evolution of a Ponzi structure. The characteristics of different products are superimposed in turn, and very complex rules are added to their mechanism, which wipes out the transparency in DeFi and makes it difficult for investors to distinguish their risks in the face of high returns. Innovation is not a simple LEGO stacking. The value of the stacking project is greatly reduced, and it is easy to be falsified under the cruel market conditions.
In fact, innovation in DeFi should be more reflected in its technology stack, economic model, practical applications, security facilities, etc., while retaining as much of its permissionless, transparent, and easy-to-operate features as possible. For example, the NFT LP launched in Uniswap V3 to solve the problem of DEX liquidity, and the ve token economics launched by Curve allow CRV holders to choose the time to lock the tokens to obtain different levels of token rewards.
It should be noted that innovation is not necessarily good, but good innovation must be adapted to market development. Those seemingly innovative projects may just be sugar-coated cannonballs. Under the complicated rules, the market is also difficult to identify risks. For example, Terra provides a 20% return on the stable currency UST in its ecology, which was favored by many institutions and traditional capital at first, but its mechanism is against the laws of the market. Under the pursuit of capital, it ended in a tragic way, and a series of thunderstorms sounded.
The unsustainability of the token economy
In the early days of DeFi, tokens are usually distributed through liquidity mining and public offerings, and liquidity or users are obtained through token incentives. This kind of incentive method attracts more short-term speculators, users continue to “dig and sell”, and the secondary market sells heavily, resulting in a decline in the token incentive yield, or when other projects that can provide higher yields appear, Token incentives will gradually fail, and long-term users cannot be retained. In order to solve this problem, Curve launched the ve token economy, in the way of tiered incentives, to gain long-term investors in the project and reduce short-term speculators. veCrv holders can decide the weight of CRV rewards emitted by each pool, which also triggers a “Curve War”, where other protocols can “bribe” veCrv holders to snatch liquidity. “Curve war” has also spawned more liquidity wars, such as two-layer nested Convex, three-layer nested Redacted Cartel and other projects. Since then, the ve economic model has also been adopted by more and more projects. However, the ve economic model seems to have weakened the role of governance, and token holders are more concerned about how to increase the yield, rather than voting. Some projects give more favorable bribes, and veCrv holders will cast their voting rights to the project without caring about the quality of the project, which can easily lead to a mismatch of funds in the market. And when the market falls, ve token holders need to bear more downside risk due to token locking.
There are also many locking mechanisms similar to those in the ve economic model that try to stabilize the secondary market by reducing circulating supply, forcing participants to align with the long-term success of the protocol. For example, Olympus created the concept of protocol possessing liquidity (POL) through the bonding mechanism. Users who deposit stablecoin assets or other blue-chip tokens can receive OHM at a discounted price, and provide an annualized rate of return that is higher than the sky to motivate Holders pledge their tokens, reducing secondary market circulation. The mechanism gradually inflated the bubble in the positive feedback of the yield, and finally fell into a downward spiral of Ponzi burst after the giant whales sold the currency and the price fell.
Image credit: CompoundWater
In the token distribution of DeFi protocols, most of them cannot escape the mechanism of attracting users for token distribution with ultra-high APY. Although this mechanism can quickly catch the attention of users in the initial stage of the project, but in the long-term development of the project, Simply relying on high yield to retain users is not a long-term solution. When affected by market fluctuations and the departure of early giant whales, it will break the high-rise castle in the air and eventually collapse.
The current DeFi protocol has not proposed a better way to feed back the value of the project itself to the value of the token. It is not a good development direction for the project token, whether it is the price performance of the secondary market or the long-term development of the project. .
I don’t know when, when the market considers whether a token is worth holding, it usually considers its ability to capture the value of the token. But in the early DeFi protocols, what was often criticized was that their ability to capture the value of tokens was very poor, because most of them were produced by liquid mining or airdropped, and the only role given to tokens was governance. However, when we look at the governance section of these protocols, we can find that either the voting governance is inactive, or that most of the voting rights are in the hands of investment institutions or project parties, and users have no interest or are unable to really speak out in governance. The function of the token as a governance vote is useless, and it can only be left in the secondary market as a transaction target in the end. In addition, it is difficult for such a token economic model to make a correct valuation of the project. The traditional financial valuation method will focus on the profit or cash flow generated by the company, and stock holders can receive company dividends. The central DeFi tokens do not have such a dividend distribution mechanism. Traditional valuation methods cannot be properly evaluated in these projects. Investors will erroneously value the projects and ignore other potential risks. Aave has slightly improved the role of the token, and the fees charged by the protocol can be used to buy and destroy AAVE tokens, making it into deflation. This model is more similar to the platform currency, which binds the platform revenue and the token value, and encourages users to grow together with the platform for a long time. However, under the background of the bear market, the capital is narrowed, and the risk of the token plummet is inevitable. .
The role of DeFi tokens should seek an operating model that can give tokens long-term value, rather than just being limited to governance, liquidity mining, and staking to earn more income. Although some tokens have made other attempts, for example, TOKE tokens can be pledged in Tokemak to affect the direction of liquidity, but it is not yet known whether it is a favorable attempt.
Weakness of DAOs
As mentioned above, governance tokens in DeFi have not played an effective role because of the weakness of DAOs. One of the reasons is that many projects have uneven distribution of tokens in the early stages of startup. Project parties and private equity institutions have the majority of the shares, and they have the majority of the right to speak. As a result, in the subsequent project governance, most of the right to speak is still in the hands of the project party, and ordinary users cannot really play a role in community governance. to a key role. As can be seen from a recent proposal by Solend, in order to prevent the giant whale from being liquidated, the team initiated a proposal to take over the giant whale account, which was passed quickly in less than 6 hours of voting time, so that most communities The decision has been made without even knowing the proposal, and then it has attracted large-scale questions from the community. Some people even questioned, “On this top ten public chain by market value, the largest lending protocol with many institutional investments and a one-year operation has not launched a proposal to discuss the complete risk control framework. The first proposal was to discuss how to deprive a user. The legal ownership of the property, and the community is only given less than 6 hours to vote to announce it quickly.” Suffice it to say that the current DAO is also useless.
Second, community cohesion is weak and lacks community incentives. After most projects enter the regular development stage, community interaction is gradually reduced, and even social media is silent. Speculators only pay attention to the currency price and are indifferent to the development of the project. There are also projects that allocate some tokens for DAO governance incentives, but from the results, such incentives are not ideal, either random proposals are passed to get rewards at will, or a lot of invalid proposals. Community governance needs to fully mobilize the enthusiasm of community members. It can cultivate a group of key opinion leaders in the community, drive community members to participate at critical moments, and give token options or other forms of incentives according to the project contribution.
Finally, there is the imbalance between project party decentralization and community autonomy. As the developer of the project, the project party is undoubtedly the most aware of the development direction and prospects of the project, and community autonomy is to allow investors with different purposes to participate in governance, which may lead to the dilemma of the mob. Therefore, in the project decentralization and autonomy, it is necessary to seek a suitable timing and a balance of decision-making. The key to when the project is decentralised is whether decentralisation at this time is conducive to the development of the product itself, and whether the product is suitable for the current stage. That is to say, the decision-making authority of the community needs to be gradually obtained during the development of the project. When the community can gather a considerable number of participants with value recognition, it is the time to gradually open up the autonomy of the project.
abuse of leverage
In 2022, global asset liquidity has tightened and risk asset valuations have fallen, triggering widespread debt liquidations and deleveraging. In DeFi, the huge leverage accumulated by the bull market has also been exposed, and the market is experiencing a historic large-scale deleveraging. According to Glassnode statistics, more than 124 billion US dollars of funds have been removed from Ethereum in just 6 weeks. leverage. The recent sell-off caused by the crash of Luna and the short-term de-anchoring of stETH all show that the current excessive leverage in DeFi can easily lead to systemic risks, which in turn has caused a very serious blow to the entire DeFi ecosystem and even the cryptocurrency market.
In 2020-2021, DeFi has launched a large number of “innovations” and new products, among which “innovations” also include the aforementioned “leveraged mining”, “two pools”, “three pools”, and income Layered tokens, etc., through layers of nesting and splitting, packaging financial products into very complex and high-yield structured products, attracting users to participate, but without user education and risk warnings. These products are not even developed by professional financial engineers, nor have they undergone professional system risk testing, and even the team itself cannot predict what risks will occur under extreme market conditions. Moreover, the collateral asset itself is a highly volatile encrypted asset, and under extreme market conditions, it is more prone to the risk of liquidation or liquidation. In traditional finance, high-risk projects still require a certain entry threshold. In DeFi, decentralization is indeed achieved without permission, but it hurts the foundation of users and is detrimental to the long-term development of DeFi.
Under the package of leverage, the gains will appear even more attractive. What’s more, they made a big fuss about the annualized income figures, and used the currency standard to calculate the nominal rate of return, so that users ignored the fluctuation of the currency price and only saw the nominal rate of return that was far more abundant than the real rate of return. Users entered the market hastily without being able to distinguish the risks among them, and then conveyed to the market the illusion of high quality of the project through the accumulation of high TVL and astonishing nominal annualized rate of return, which in turn led to a mismatch of funds in the secondary market. . In the long run, users prefer such high-yield and high-risk projects, and ignore those high-quality projects that are developed with great concentration. Finally, with the deleveraging of the market, it was exclaimed that DeFi is Ponzi.
DeFi should not be Ponzi, the focus of DeFi (Decentralize Finance) should be on Decentralize, instead of erasing transparency in DeFi by formulating complex rules and high returns, turning finance into a fake game of gambling .
How does DeFi settle in a bear market?
At present, the prices of most DeFi assets have returned to their original levels, but the number of retained users and funds have increased significantly compared with before. After a round of bull and bear changes, DeFi project parties should further concentrate on research in the bear market. and precipitation.
DeFi needs an alchemy field. When new products or innovations appear, the market cannot be pushed blindly, but should be fully simulated, stress tested, and systematically trial-and-error. A qualified financial product should be able to withstand the test of extreme risks in the market, and at the same time fully inspect the security of technical codes and update them in real time.
DeFi’s token design and distribution model should aim to cultivate long-term users. Tokens can give investors more rights, not just limited to governance. Tokens can be fully circulated in the project, deepening users’ sense of long-term value belonging to the project, rather than simply relying on lock-up.
DeFi products should develop towards practical financial products with simplified rules and transparent transactions. DeFi does not actually need advanced and complex structured financial products at this stage. First, the DeFi financial system is not yet mature, and cryptocurrencies themselves are high-risk assets. Developing structured products on high-risk assets is like Dancing on the cliff, at any time at risk of collapse. Second, the current level of DeFi users cannot use such complex products. Most users are not familiar with the risks they face when using such products, and the complexity of operations also prevents most users from entering the DeFi field. Therefore, the current development space of DeFi should focus on the development of practical financial products with simple rules, such as credit-based unsecured loans and permissionless multi-asset financial management tools.
write at the end
This DeFi crisis can be said to be foreboding, and it also conforms to the objective laws of the development of things. When new things appear, the excessive pursuit of the market will gradually create a bubble, and it will return to a healthy development after the bubble is pierced. DeFi’s current deleveraging is painful, tantamount to a mini-financial crisis, but with this pain comes the opportunity to eliminate excessive leverage and gradually carry out a new round of healthy reconstruction.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/what-is-the-solution-to-the-crisis-of-defi/
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