Rise and Fall of Defi 2.0
‘Decentralized finance’ has become extremely unpopular these days. So much so that investors are terming whole of Defi as one large ‘Ponzi scheme’.
In this article I examine the following:
- Rise of Defi 2.0
- Fall of Defi 2.0
- Structural weakness in Defi 2.0
- Lessons learnt for Defi 3.0
Rise of Defi 2.0
2021 can be termed as the year when Defi 2.0 arrived. It is by no coincidence that 2021 was also the year of ‘stable coins’ — stable coins, as the name suggests, are ‘derivative’ instruments whose value is always derived from another asset (mostly US dollar). Stable-coins introduced massive asset price inflation into the nascent Defi ecosystem.
Market-cap of stable coins grew from ~28 Billion USD on 01 Jan 21 to ~165 Billion USD by 31 Dec 21. That is a whopping 600% increase in crypto dollars in a single year (see figure below). The biggest use case that most of these crypto dollars were flowing into was ‘Defi 2.0’.
Bulk of this capital was institutional money that provided massive liquidity and increased asset prices. Continuously inflating asset prices created a wave of Defi protocols offering services such as lending, staking, yield aggregation, swapping etc.
Protocols out-competed with each other and started incentivizing users by offering native tokens that were in-turn appreciating in value. 400% APYs became common and retail investors started borrowing against existing assets to participate in this APY fest. Transaction value Locked (TVL) across Defi protocols continued to rise & rise until the start of this year.
By the end of 2021, we had a deluge of Youtube videos showing people how to do complex multi-chain transactions to maximize APYs. Strategies such as ‘loop lending’, ‘leverage staking’ etc were a common place. Degens were consuming content produced by Youtube & Twitter influencers like junkies looking for their next shot.
Key Underlying narrative propped up by Twitter CT was that ETH will go to $15k (post merge) and BTC will hit $200k by end of 2022. Yield farming was the coolest thing to do to earn stable income.
All this continued until the start of this year.. and then things began to unravel..
Fall of Defi 2.0
By the start of this year, the Federal Reserve, led by a bunch of retired bureaucrats completely out-of-touch with reality, got out of its delusional narrative called ‘transitory inflation’. Inflation was raging and the Fed had to do something about it — they announced a series of rate hikes followed by quantitative tightening schedule that was to drain ~$90 billion every month.
This spooked investors & institutional capital went into a ‘risk off’ mode — basically money started to move from risky assets (read tech stocks/crypto ) to money market instruments and cash. Crypto started to correct and that correction exposed weak platforms that were either partial or full Ponzis.
This finally precipitated into the demise of UST/Terra taking down billions of capital invested by common retail investors. Although institutions also took a hit, unlike (first-time)retail investors and degens, institutions only invested a small percentage of their portfolio into these assets.
A simple look at daily active Defi users gives us a true picture — more and more people are exiting Defi protocols each week. Let us look at the main reasons why Defi 2.0 collapsed under its own weight.
Structural weakness of Defi 2.0
1. No productive cashflows
‘Finance’ is the art of re-allocating money to productive resources that can optimally use that money to generate ‘capital’. Note that ‘money’ is not ‘capital’. An apple farmer can use money to buy fertilizer (capital) that can enhance crop yield and produce apples which can be converted back into money. No amount of money can create ‘fertilizer’ out of thin air — it can merely change the price of fertilizer when measured in that unit of money.
Defi 2.0 as it stands was using ‘money’ to produce…err…more money…without creating any capital… Everyone was playing along as the asset prices were increasing and there was a consistent narrative that ‘institutional adoption is coming’, ‘Crypto is going mainstream’ etc.
All the borrowing on platforms like AAVE, ANCHOR, COMPOUND was not being used to finance construction of roads or homes or to finance working capital of small businesses or to finance student loans — it was reinvested back as investment into existing crypto assets. This created a virtuous inflationary cycle that increased prices and attracted more active users into the Defi (and crypto) ecosystem. New users obviously entered at high asset prices and hence had more to lose when meltdown occurred (the first guys to call ‘Defi’ as Ponzi are usually such late entrants)
‘Price’ signals are a combination of
a. capital creation
Price appreciation from capital creation is sustainable. Price appreciation from inflation is not. In a mature market, price appreciation can signal capital creation but in a nascent market, price appreciation can be heavily influenced by inflation (pump & dump stories).
Most Defi 2.0 investors misinterpreted price signals & attributed price increase to ‘capital creation’ instead of ‘inflation’.
A 600% increase in stable-coin supply meant that a large part of price appreciation and high APY’s across Defi came from inflation & not capital creation
To clarify, I’m not against price appreciation via inflation route — infact I think it is essential for the growth of any innovative technology. In the investment world, it is very common for new investors coming in with bigger bags to give an exit to early investors. Investments into disruptive technologies with a potential to create large, future capital gain look like ‘Ponzis’ but such investment vehicles are essential for growth of new technologies.
What Defi 3.0 needs is projects that can do a much better job at allocating resources for entities in need of those resources. By better, I mean 10X cheaper, faster and smarter deployment of money to deserving counter-parties (compared to existing financial institutions).
Defi 3.0 must look to tokenize invoices, democratize insurance underwriting, simplify e-commerce payments etc. Main theme is to do deploy money 10X cheaper, faster and smarter than existing financial institutions
Another concept that was an Achilles heel of Defi 2.0 was ‘Leverage’. Leverage is the act of doing more with less.
In the world of finance, leverage is the concept of using small capital to gain a large exposure. Even a small return on a large exposure turns out into a large return on small capital.
The problem is that leverage is a double edged sword — a small loss on your large exposure can wipe out your capital or liquidate your collateral value. Leverage comes as an uninvited guest when large supply inflation happens.
Inflation causes sustained price rises -> price rises create juicy APY’s -> high APY’s suck in new capital -> investors reach their capital limits -> eventually they fall for contraptions that ‘boost’ returns without adding new capital (invariably all such schemes increase leverage — sometimes this is obvious, sometimes it is subtle eg. Lido or UST Terra)
Let’s look at a couple of protocols to understand how leverage was introduced:
Lido Finance: In my previous post, I explained how Lido Finance created incentives for investors to leverage their ETH holdings by creating a ‘stETH’ token. ‘stETH’ token could be used as a collateral asset on AAVE while the original ETH (against which stETH was minted) still was locked on the Ethereum chain.
Investors assumed that the ‘stETH-ETH’ peg will always be 1:1. They staked ETH on Lido Finance to get stETH, used stETH as collateral to borrow more ETH, came back to Lido and staked again to get more stETH. They went back to Aave and repeated the loop over and over again.
So if by doing this, each ETH resulted in minting say 2.5 stETH, each investor is leveraged 2.5 times. For more details, refer to my post on this.
Leverage built on Anchor Protocol was a massive deathblow for retail investors. Anchor launched a savings product on UST stable coin that offered 20% APR to investors. Although there was an inherent de-peg risk in Anchor, investors & general crypto community viewed it as a ‘low risk stable yield’ product. This crucial mis-interpretation led people to let their guard down and add leverage to maximize APY’s.
Before de-peg, for every 1$ demand for borrowing, 4.5$ of money supply was available. And as we have already learnt above, none of this money was being used for any ‘capital generation’ activity. With the high lending APY’s, nobody was willing to borrow while everyone was willing to lend capital. The flood of liquidity from stable coins compounded the problem further.
To incentivize further borrowing, Anchor started giving incentives that made the cost of borrowing lower than the lending APY. This created warped incentives for investors who were lending to Anchor Protocol, using this as collateral to borrow further, and then lend it back again to Anchor. This ‘looped lending’ created excess leverage.
To maximize leverage, most of Anchor’s borrowers also became its lenders. Anchor’s TVL was merely circulating within the system without creating any productive capital
‘Lack of productive cashflows’ and ‘High Leverage’ created structural weakness in Defi 2.0. This collapse was needed to rebuild the foundations of Defi 3.0 that is much more robust, has better tools to deploy capital and better risk management systems to protect against high leverage.
Key lessons we can learn as investors are:
- Defi is a powerful tool to better allocate investor capital. Defi will not magically generate APY’s until the allocation process is robust and backed by real value creation
- Defi 3.0 has to demonstrate value to the real world — all financing activities such as bill discounting, financing capital creation, cross border payments, tokenizing and financing intangible assets eg, video, patents etc, underwriting insurance and guarantees need to be the use cases for Defi 3.0. Days of merely rotating money and minting inflationary tokens are over.
- Key question to ask is — how is the platform creating better value than traditional financial institutions? Where is that value coming from — is the value in tokenizing illiquid assets, is the value in cutting down overhead costs, is the value in better security? It would be great if we always compare the problem to the way it is handled by banks today. Invest only if you are convinced there is a 10X better way of doing something.
- Ask if the project really needs a token? Can the project survive without a token? If the only way of incentivizing new users is by bribing them with an inflationary token, then maybe you are in for some bad surprises
- Ask if you are over exposing ourselves by adding leverage — what can be the worst case scenario & how could that worst case scenario happen? Visualize hypothetical scenarios which may be very unlikely, eg. what happens if chain shuts down, what happens if a centralized exchange goes bankrupt, is there a depeg risk here
- Most important — limit your worst case. Worst case total loss scenario in any Alt coin should not impact more than 10% of your portfolio (with BTC and ETH, maybe you can go to 30% but not more).
I still believe that Defi is the strongest use-case for crypto that has the potential to make the world a safer, better and fairer place to live in. Let’s hope that Defi and broader crypto community works towards that dream.