Why DeFi is doomed; and how DeFi 2.0 will save it
$104 Billion.
That’s the total value locked (TVL) in DeFi as of the 21st of Nov 2021. Now take a look at this awe-inspiring hockey stick chart from DeFi Pulse:
DeFi has gained nearly 90% of its current TVL in the last year.
Let that sink in…
If you’re reading this there’s a good chance you probably agree with the notion that DeFi has had a net-positive impact on technology, finance and society across the globe. It has challenged existing archaic and bureaucratic organisational structures, created a new way for people to contribute and meaningfully extract value, and has given unbanked people global censorship-resistant access to financial opportunities they previously couldn’t participate in.
Currently, most DeFi projects face an arms race similar to what Web2 startups experienced in the early 2000’s — these companies would burn their investor’s cash in a desperate attempt to gain (albeit temporary) market share and achieve hockey-stick growth. Goods and services were provided with little long-lasting utility, and sometimes even given away for free to bootstrap early adoption. It was a race to the bottom.
History may not repeat itself but it has a tendency to rhyme… Compound, Maker, Aave, Synthetix, the primogenitors in DeFi; what do these have in common? Unsustainable APYs. But instead of investor dollars, it’s protocol tokens being allocated for a similar purpose. This scheme is (in)famously known as liquidity mining or yield farming. Note: we are big fans and truly respect everything that these protocols have done as pioneers in this space.
Why DeFi is doomed
Let’s take Compound as an example given the project is often credited with inventing yield farming. When they launched their governance token, COMP, they began by distributing it for free (roughly 2,312 COMP everyday) to anyone who was lending or borrowing on their protocol. Users could deposit any supported token into the platform and earn risk-free COMP tokens. This allowed the protocol to jump from $100m to $500m TVL in a single week.
This sounds way too good to be true. Surely there’s a catch?
The below is an analysis done by Andrew Kang of Mechanism Capital when you factor in the costs of liquidity mining.
You can see Compound having consistently net negative revenues if you factor in all the COMP they’re giving away. This is also an indication of capital inefficient use of their liquidity (it’s mostly just sitting idly in a contract).
Fundamentally, this scheme makes it extremely hard to distinguish between users who were legitimately interested in Compound’s product and those who were looking for a get-rich-quick scheme. We obviously realise that the latter mercenary-like behaviour may have been unintentional but due to the nature of these reward programs, it is such an attractive bait for those looking to make a quick buck in return. All users need to do is deposit money, accumulate rewards and flip their tokens for risk-free profit.
Though extremely lucrative in the short-term, it’s unsustainable. Most projects have simply considered this an acceptable risk. Like a sugar high, a project’s TVL can quickly become inflated and new shiny projects can easily capture the top slots in popular ranking platforms like DeFi Pulse by offering more attractive returns. However, this creates a constant fear of getting ‘rug-pulled’ and makes any project prone to vampire attacks (all anyone needs to do is fork a protocol and crank up those lovely rewards, easy enough). These artificially high TVLs are extremely attractive to not only the team itself but also the wider community. Now with the vast amount of community injected liquidity in the protocol, the protocol has to build enough of a moat in the time before the mining program wraps up while capturing the attention of users (as we know, crypto changes rapidly and our attention spans are getting shorter). Easier said than done.
A ticking time bomb; that’s really what DeFi is turning out to be.
Teams behind these protocols are incentivised to keep the lights on by continuously offering better and more lucrative mining programs or risk getting overtaken. The protocol remains extremely prone to sybil attacks further diluting its token supply in exchange for temporary capital deposits as the community uses this as another avenue to suck the protocol dry. This encourages such an unhealthy cash flow cycle where users only focus on farming -> dumping -> farming more -> dumping more without any intention of contributing to the protocol’s development. This further exacerbates the chasm between demand for the protocol and token’s utility and demand purely for the artificial value of the token, i.e. value goes up, utility flatlines.
Once these rewards and incentives dry up, then all that capital is at risk of spilling out. The lights turn off, and the party’s over. It’s then a race against time, the slow farmers who pull out their yield lose out and the die-hards who genuinely believe in the project will lose their faith while the protocol itself loses all of its artificial value and liquidity, a lose-lose-lose situation for everyone involved.
A prime example of this pump and dump nature brought by these schemes can be seen in the Big Data Protocol project. They gained over $6B worth of TVL in the span of just a few days only to see it dump to 2.65% of its high just 5 days later. The main driving force behind this massive jump? 1,000%+ APYs across a six-day liquidity mining program as covered here. What happens once the APYs dry up? That’s right… Dumped.
Now imagine this in the context of the $104B of TVL locked in DeFi 1.0 protocols and seeing it drop flat the moment these unsustainable schemes run dry 😱. Currently, a lot of these tokens and their derivatives (like LP tokens) are leveraged by other protocols for further rewards which means that there will be a massive negative feedback loop and death spiral as things become more volatile. Extrapolating this to the total TVL locked in DeFi, imagine the cascading effects on these protocols as rewards run out. We could even see a similar situation play out as to what happened with the housing market in the Great Recession caused by over leveraging and irrational exuberance.
But wait, there’s more. The capital injected into the protocol is idle and locked up in a smart contract (reminds us of those low-interest savings accounts where you inevitably lose money to inflation anyway) and operating on layer-1 (Ethereum) is pretty much daylight robbery. If this does not scream ‘capital inefficient’, then we don’t know what will.
This is where DeFi 2.0 comes in.
The creator of Alchemix succinctly described this transition as “when the toxicity is gone, then the community strategizes together. What was once a PVP game turns into a comfy couch co-op game.” 🎤 drop.
What DeFi 2.0 actually means and why it’s what the people need
DeFi 2.0 creates a sustainable cash flow cycle and a synergistic relationship between every player on the protocol where the optimal outcome occurs when the incentives of all players align.
Goodbye liquidity mining; hello protocol controlled value (PCV) and sustainable liquidity.
The new wave of DeFi protocols (*cough* DeFi 2.0) are all experimenting with different ways of capturing long-term value and liquidity in their protocol, an idea centred around PCV. In ELI5 terms, this just means users are incentivised to purchase the protocol’s token (for its utility etc.) in exchange for giving away their own, which is in stark contrast to temporarily lending it to the protocol i.e. protocols are no longer just giving away free money.
Now let’s take a look at one protocol, Olympus DAO. It’s a protocol that aims to create sustainable liquidity via a dual staking and bonding mechanism with their OHM token, a free-floating reserve currency backed by a basket of currencies. As a user, you can stake OHM and earn auto-compounded OHM passively via rebase rewards coming from bond sales while the protocol ensures that any OHM remains at least 1:1 redeemable. On the other hand you can also actively purchase OHM vested over a few days at a discount in exchange for stablecoins like DAI, ETH or LP tokens such as OHM-DAI. Together they create negative sell pressure and allow Olympus to own its own liquidity while earning interest.
This creates a win-win situation for both stakers and bonders by aligning their incentives to earn OHM and without the protocol having to pay out those exorbitant mining rewards to rent liquidity. Olympus DAO now has more than $3.4B of PCV and more than 90.1% of total OHM staked in the protocol. Talk about retention.
Other protocols like Alchemix, Fei protocol, Tokemak, Abracadabra and more have also created their own innovative designs to capture long-term value and liquidity.
Alchemix has designed an auto-repaying loan protocol currently used for minting synthetic derivatives called alUSD. Users can deposit DAI, mint alUSD and the deposited DAI is then directed to Yearn vaults and used to continuously pay back the minter’s debt. No liquidity mining programs, just an innovative take on creating efficiency through synthetic derivatives.
Fei protocol on the other hand has created a stablecoin model backed by a buy-only bonding curve and allows for any funds injected into the curve to be redirected into secondary liquidity markets to provide liquidity and earn yield. Fei has over $1B of PCV and is growing.
Tokemak reduces impermanent loss as it acts as a decentralised market maker constantly navigating liquidity, an interesting dynamic between the capital providers, directors and the protocol itself. Similar to Fei, it has roughly $1.4B of PCV locked with a growing number of token reactors added every day.
There are a lot of interesting projects to come out of this recent trend towards protocol-controlled liquidity and value-backed assets but none have yet to achieve the level of usability, scalability and capital efficiency that’s crucial to build a truly sustainable financial ecosystem.
Introducing Serity
Scalability, liquidity, usability and capital efficiency.
With the current pitfalls of DeFi 1.0 and yield farming, and the gaps that exist in DeFi 2.0, we’re building Serity, a community-owned protocol powered by yield-backed synthetic assets offering sustainable and consistent returns. Serity’s goal is to align the incentives of those who want to meaningfully contribute to the protocol and to efficiently scale by offering more utility on the protocol. Capital efficiency is going to be key in the next mega-trend in crypto. Protocol controlled value (PCV) and sustainable liquidity will be one of three major pillars in the next advent of DeFi 2.0 and we believe Serity will be at the centre of this movement.
Stay tuned for more.
