Overview of DeFi’s Growth, Innovation & Risks
Blockchain has been touted by many as a technology with the potential to bank the unbanked. While the 2017 ICO bubble fell short of this promise, the growing decentralized finance (DeFi) space has reignited hopes towards this vision. Leveraging blockchain technology, DeFi provides access to financial services without a trusted third party. Built on top of smart contract platforms like Ethereum, these services instead rely on peer-to-peer software and governance. By removing the reliance on companies, DeFi protocols have the potential to eliminate the risks and drawbacks of having a central organization in control.
Being permissionless in nature, blockchain allows free public access to data. DeFi protocols take advantage of these characteristics to provide transparent financial services on a global scale. While currently there are barriers to use these protocols in the form of technology expertise and required software, fast-paced innovation and incentive mechanisms have accelerated adoption of decentralized financial services. Throughout this piece we will assess this growth in adoption and value invested in DeFi while considering the risks that arise from this space.
This piece is split in two parts, each with two sub-components, and a conclusion:
- Growth & Innovation
- Risks in DeFi
- Final Thoughts
I start by introducing some of the key terms within DeFi and then dive into specifics regarding its growth and risks. Feel free to skip ahead or enjoy the whole piece.
Growth & Innovation in DeFi
“Show me the incentive and I will show you the outcome” — Charlie Munger
Warren Buffett’s long-time business partner Charlie Munger eloquently remarks the relationship between present incentives and future results. The message behind this statement resonates throughout multiple fields including behavioral economics, game theory, and — perhaps unexpectedly — in decentralized finance.
DeFi protocols have seen remarkable growth in terms of adoption, token prices, and total value locked. While websites and social media platforms relying on third-party advertising require a high amount of daily/monthly active users to capture value, decentralized protocols generally do not depend on frequent usage to create value. Instead, the dollar amount held by the smart contracts powering decentralized financial services better reflect the value created by these projects. As a result, total value locked has become a widely-followed barometer of the DeFi space since the majority of these protocols require a collateral to be locked in order to use their services.
The popular data aggregator DeFi Pulse reports the growth in total value locked in the space since the fall of 2017. As seen in the image below, it took approximately two and a half years to reach the $1 billion mark in total value locked. Despite decreasing significantly during the market-wide crash in March, the total value locked in DeFi continued growing throughout the second quarter of 2020 surpassing $2 billion just 6 months after first reaching ten figures.
In the image above, readers may have noticed a recent point of inflection for the total value locked. By zooming in, we can determine that this happened in mid-June coinciding with the release of COMP, the governance token for the lending/borrowing protocol Compound. Within less than a month, the total value locked in DeFi protocols has more than doubled. This has largely been because of the incentives users receive through so-called yield farming.
DeFi’s Rocket Fuel
In a nutshell, yield farming (also known as liquidity mining) is the process of earning rewards in the form of tokens in return for providing liquidity to a DeFi protocol. The concept has been around since the summer of last year when Synthetix — a decentralized derivatives exchange — first experimented rewarding users for providing liquidity to its derivative synthetic Ether (sETH) pair on Uniswap by paying them with their native SNX tokens. However, it was not until the launch of Compound’s native token COMP that this became a common practice and buzz word within the crypto space.
In Compound’s case, users are able to yield farm by borrowing or lending tokens to the protocol, receiving COMP tokens in return. Given COMP’s current price of around $180, the incentives received in tokens have been large enough for users to profit from borrowing money despite having to pay interests on their loans. As a result, users have rushed into Compound, increasing the total value locked in the protocol by more than 6x since this release to over $650 million.
Recognized people in the space have praised this practice as a DeFi “growth hack”. Analyzing key on-chain insights we can evaluate the effectiveness that yield farming has had in increasing COMP’s adoption. For instance, let’s observe how the number of holders has varied since the token’s inception on June 15.
As can be seen in the graph above, the number of COMP addresses with a balance has quickly risen from near-zero to over 14,000 within less than a month, effectively capturing a sizable community and decentralizing token ownership from the get-go. To put this in perspective, DeFi first-mover MakerDAO has 22,000 holders of its MKR governance token since launching back in November of 2017.
Raising the Stakes
Asides from yield farming, DeFi protocols have been leveraging other tactics to boost growth and community adoption. One common method that many projects have implemented or are looking to implement is staking. For example, the popular decentralized exchange Kyber launched its Katalyst upgrade on July 7, enabling holders of its native KNC token to stake their holdings allowing them to vote in improvement proposals.
Along with this, it restructured its governance as a decentralized autonomous organization, KyberDAO, granting decision-making capacity to members of its community. To incentivize holders to participate, they receive staking rewards in ETH in return for voting or delegating their vote. 65% of the decentralized exchange’s network fees are redistributed to the holders staking their vote through this process, incentivizing active decentralized governance.
Furthermore, being an exchange, Kyber realized that it is also critical to incentivize liquidity in order to build a robust trading infrastructure. Thus, as part of the Katalyst upgrade, 30% of the Kyber network fees are now going towards offering rebates to liquidity providers, known as reserves within the Kyber ecosystem. Through these, Kyber is effectively reducing the costs to perform market-making activities in the exchange, incentivizing the creation of more and higher quality of reserves and strengthening the platform’s liquidity.
In anticipation of the Katalyst upgrade, crypto markets have been bullish on the KNC token. The price of KNC has increased by over 700% year-to-date, leading the rally of DeFi tokens. Analyzing on-chain activity, though, we can attest that there is an actual increase in the transactions of the KNC token, which have increased by approximately 9x throughout 2020. While it is evident that staking and other updates in the Katalyst upgrade have led to on-chain growth in anticipation of the release, the long-term impact it has on the broader health of the Kyber ecosystem is what will determine the efficacy of these added incentives.
All of this innovation has been facilitated by DeFi’s permissionless nature. Given Ethereum’s transparent and open-source dynamics, DeFi projects built on top are able to leverage quick and free access to information. In a thread of Compound’s founder Robert Leshner, he highlighted how COMP’s governance is based on what was previously built by MakerDAO, and how the COMP yield farming was inspired by Synthetix’s previous incentive design scheme. Being open-source, DeFi protocols are able to freely replicate, integrate with and improve upon existing solutions, thus accelerating the building and deployment process of open financial services.
Risks of Decentralized Finance
While DeFi’s capability to incentivize quick adoption and decentralization of its token has supercharged growth, it does not come without risks and unintended consequences. Some of the risks to consider with yield farming and DeFi in general include potential hacks, loan liquidations, unpegging of stablecoins (which tend to be used as collateral) and depreciation of the tokens received as rewards.
General Risks
Readers may have heard of recent hacks in the DeFi space, like the dForce attack where the hacker exploited a smart contract vulnerability to steal $25 million and then returned most of the stolen assets. More recently, a hacker attacked the automated market maker platform Balancer using flash loans to drain liquidity of a deflationary token, STA, to manipulate its price and swap it for $500,000 worth of other tokens. While these hacks are not exclusive to the DeFi space, they certainly are an important risk to consider given that over $2 billion is locked in smart contracts held by the major protocols. A silver lining emerging from this threat has been the rise of decentralized insurance protocols such as Nexus Mutual protecting users against the risk of smart contract failure.
Further amplifying the risk of hacks is DeFi’s composability. DeFi’s permissionless nature facilitates the process to integrate with other protocols, enabling interoperability in what is referred to as “money legos”. While this composability facilitates building in the space, it could also lead to system-wide instability if one of these pieces is broken. MakerDAO’s decentralized USD-pegged stablecoin DAI acts as key infrastructure for these money legos. For instance, lending protocols allow users to earn and borrow DAI. If a hacker finds a vulnerability in DAI smart contracts, users of these lending protocols risk losing their funds, possibly leading to systemic failure.
Tied to this risk is the unpegging of stablecoins and liquidation. As readers may know, most stablecoins are pegged 1:1 to fiat currencies, typically the US dollar. While DAI has grown within DeFi applications, the most transacted stablecoin is still Tether, which is centrally managed by the team behind BitFinex. Tether has previously been under scrutiny by many in the industry with regards to its alleged reserves backing the stablecoin. This at times has resulted in a significant disparity in value versus the dollar. If circumstances like this arise again, there would be negative unforeseen consequences for those borrowing or lending Tether, or other stablecoins, through DeFi protocols.
For example, if you are obtaining a loan using a stablecoin as collateral and its peg drops below $1, then the loan may become undercollateralized resulting in liquidation. Conversely, if you are borrowing stablecoins and the value of the peg goes above the dollar mark, then the debt may cause you to pay more in interest than anticipated and also potentially ending up liquidated if it surpasses the amount held as collateral. This risk has been recently brought to the attention of many as the amount of DAI in Compound (cDAI) has seemingly surpassed the total amount of DAI in circulation.
Yield Farming’s Dark Side
cDAI’s market cap is currently over eight times greater than its underlying DAI. This is a result of an unintended consequence arising from yield farming in Compound. Since yield farmers are currently rewarded in highly-valued COMP tokens depending on the amount of liquidity provided, users are incentivized to provide as much as possible. In general, liquidity strengthens financial systems and is seen as a prerequisite for adoption. However, yield farming creates a perverse incentive to provide liquidity at all costs, which has led users to take advantage of this scheme by “recycling” their DAI.
Essentially, users are depositing DAI into Compound to earn interest plus COMP tokens, then they are using this DAI for an overcollateralized loan to borrow more DAI which in turn is redeposited as collateral and so forth. While this process cannot be executed directly within Compound, several users have been exploiting this loophole by transferring DAI to other DeFi protocols such as InstaDapp. A simplified diagram of this process is shown below:
This process is extremely risky as it artificially inflates the amount of DAI in Compound. Though the loans originated are initially overcollateralized, by redepositing the loaned amount as collateral to borrow more, the actual collateralization ratio drops staggeringly; leading to concerns in the community of an equivalent to fractional reserve banking taking place under the hood. In this scenario, Compound users appear to be over leveraged, putting the protocol at risk in the event that many users attempt to withdraw their DAI at once. To examine the extent to which this has gotten to, simply consider the fact that DAI locked in InstaDapp has increased by over 285x — from $350,000 to over $100 million — since COMP launched less than a month ago.
At first glance, this risk may seem to only affect Compound and InstaDapp. However, given DeFi’s composability this abnormal increase in demand for DAI has become a major concern within MakerDAO’s risk team. Since multiple DeFi protocols use DAI, they would be vulnerable to a severe unpegging from DAI to the dollar. At the time of writing, DAI is worth $1.02, and while it may not be a large disparity at the moment, the artificial recycling of DAI in Compound may be the most relevant near-term risk faced by the DeFi space. Overcoming this challenge and realigning incentives to mitigate the risk of over leveraging may be the largest test of decentralized governance since the DAO hack.
Finally, as is the case with agriculture, there is the risk of bad harvests. As yield farming launched this new crypto-agrarian age, “farmers” rely on quality products to profit from their endeavors. In other words, if the value of the tokens earned through these incentive systems drops significantly, users may start opting out from providing liquidity to the protocols. Furthermore, if there is a sudden large drop in the prices of these tokens, it could lead to a liquidity shock, which would further exacerbate the protocol’s issues.
Final Thoughts
Overall, there is no shortage of innovation, or risks, within the DeFi space. Leading DeFi protocols have successfully managed to create systems of multi-stakeholder incentives perhaps like nothing we have seen before. Leveraging blockchain’s transparent nature, these projects have been able to permissionlessly improve upon each other and accelerate the pace of innovation.
While the recent frenzy regarding DeFi tokens may remind some of the ICO rush in 2017, it is important to note that these protocols have actually shipped products that already create value to its users through permissionless access to financial services. Another distinction is that ICO teams generally controlled a majority of the token supply, whereas DeFi protocols are actively seeking decentralized governance; diminishing the risks of relying on founders such as using the project as an exit scam. Finally, while ICOs facilitated one financial service (fundraising), DeFi protocols are going after broader opportunities tackling use cases such as payments, lending/borrowing, exchanges and derivatives. As demand for ICOs introduced many to Ethereum for speculative means, DeFi, boosted by its incentive mechanisms, may lead to users actually benefiting from blockchain technology.
With a wide spectrum of areas where DeFi has been innovating, it is easy to understand why the crypto space has been so enthusiastic about it in 2020. Such growth, however, does not come without risks or unintended consequences. It is imperative that users are aware of these risks and consider them if they do decide to use DeFi protocols.
If you made it this far, I appreciate you taking the time to read this piece. Hope you found it insightful and that it sparked your curiosity. If you would like to to learn more about DeFi and the analytics we are building at IntoTheBlock to decode this fast-moving space, make sure to sign up for my upcoming webinar here.
