Unlocking The DeFi Revolution Through Capital Efficiency
The ongoing crypto downturn may have put a damper on the sector, but there is no denying that blockchain and decentralized finance will change the world. This disruption has to do with the fact that the traditional finance world is trapped in the inescapable trap of inflation. Each coming year, your money will afford you less comfort.
Inflation is a perpetual thorn on the legacy finance system’s side and a punch in the gut for billions of cash-strapped individuals worldwide. As banks ceaselessly turn the existing debt burden into more debt, causing a fiat overhang of demand and supply, inflation could threaten social, economic, and political stability.
To illustrate this point, the Fed released over $3 trillion to the markets in its covid-19 response quantitative easing (QE) process. One effect of such wanton money printing is the rise of the US Consumer Price Index (CPI). As per the US Bureau of Labor Data, the CPI index rose by 8.5% by March 2022. It is the highest rise in inflation in a year since December 1981.
In the EU reserve holding system, a commercial bank, whose assets constitute private money, can create hundreds of thousands of euros from a deposit of as little as a thousand euros at a reserve rate of 1%. This cash is often lent to individuals at ultra-high interest rates.
Borrowers will need security to access this cash as credit. Consequently, banking sector credit is making the rich richer. By bypassing the functions of the banking system, decentralized finance can create a fairer and more sustainable financial system.
DeFi builds trust through blockchain technology and can profoundly impact lives. DeFi protocols can support fast and low-cost cross-border transactions via mobile wallets. Dapps also turn blockchain ledgers into banks via lending, borrowing, and investing protocols. Tokenization can lower the barrier of entry to lucrative real-world assets such as real estate.
The capital inefficiencies in DeFi
However, the DeFi revolution will not fully disrupt the money-rich TradFi system as long as it is capital inefficient. Capital efficiency ratios compare business spending on growing revenue to profits.
A capital-efficient business balances spending on growth with profitability. A successful business person ensures that they are not spending more than their profits. Doing so leads to wrong investment ideas, debt negotiations, cash flow challenges, and layoffs.
As per the efficient market theory (EHM), efficient capital market asset prices reflect the real-time information in the marketplace. To illustrate this point, the stock and financial markets are efficient.
Their asset prices may deviate from their true values in the short run to reflect the uncertainty brought on by market fundamentals. However, their efficiency stabilizes over time as publicly available data on their assets becomes easily available to all stakeholders.
As per the EHM, the price of these financial assets is not their actual value but is a result of the data that the public has on them.
In contrast, an inefficient financial market such as the digital currency sector lacks publicly available information regarding its assets. It has an asymmetry of data between its investors and insiders.
The crypto bulls often have more insider information than general investors, giving them a significant edge in the sector’s profitability. To this end, the sector’s asset prices rarely reflect genuine asset value making this market the speculators’ and arbitrageurs’ playground.
Various DeFi protocol inefficiencies further compound the crypto sector’s capital inefficiencies. Take the automated market model (AMM) protocol, for instance. The AMM is a high-quality decentralization idea. It is the backbone of the DeFi sector, facilitating 24/7 crypto swaps and trades, creating new markets, and supporting the yield farming sector.
Bancor was the sector’s first functional AMM model. It, however, did not catch on because its protocols made the Bancor native token key to its processes. Afterward, DeFi users flocked the Uniswap v2 AMM model after its launch because it paired tokens with ether.
Billions worth of crypto assets have flowed to AMMs since the launch of Uniswap v2, creating a self-contained ecosystem that incentivizes liquidity providers and pairs yield earners and traders.
The AMM model has placed DEX functions at par with the CEX, but its operations tie up large volumes of user liquidity in its pools. As a result, most DeFi protocols have turned ETH, the smart contract network’s native asset, into what crypto investor @Arthur_0x refers to as a “liquidity black hole that sucks in all idle assets sitting around doing nothing.”
Arthur is right. Take, for instance, the low capital efficiency dilemma of decentralized exchanges (DEX’s). 2021’s entire DEX transaction volume only reflects 10% of the larger crypto market transaction volume. This is despite the fact that decentralization is the main benefit of blockchain technology.
Reasons that contribute to the disparity between DEX and CEX activity are DEX’s inefficient automatic market maker (AMM) protocols. AMM models pair liquidity pools and use an algorithm to adjust an exchange rate as per token demand.
This process creates an inefficient market that causes poor trade execution, resulting in high gas fees. An AMM’s liquidity providers will sell their tokens passively as per the rising exchange rates and purchase them when their rates fall.
Liquidity providers will suffer an impermanent loss due to regular market movements. The AMM model mainly benefits arbitrageurs who can hop into the pools and purchase cheap assets facilitating token pairs’ price correction.
Developers in the sector have tried to tweak the AMM model to lower its inefficiencies. Proposed solutions such as third-party trade management interfaces and impermanent loss insurance have not taken off.
In cases where liquidity providers receive adequate incentives and lock in their liquidity in pools, the immobile liquidity becomes capital inefficient since it cannot support other projects. The AMM’s complexity and unproductive capital contribute to low user participation in decentralized finance.
Benefits of capital efficiency
The most successful business models attract investors through efficient acquisition. Since DeFi is capital inefficient, it attracts investors through excessive spending on rewards. It is for this reason that the sector is embroiled in liquidity wars.
Investors no longer take their time on projects’ white papers. Instead, they chase yield, making liquidity rather than innovation, the DeFi ecosystem’s killer app. As a result, the sector’s applications have gone overboard in their liquidity incentivization schemes and early liquidity provider reward systems.
Uniswap, for instance, applied liquidity yields outside of the original stablecoin-only system and released them to the ERC20 asset sector. As a result, liquidity providers would earn a fraction of the 0.3% fee that Uniswap levies on trades as liquidity provider incentives.
Balancer pushed the envelope further on this innovation, supporting three or more assets as deposits in a liquidity pool. In addition, all Balancer fees reward the liquidity provider. These protocols launched the governance token reward system, which played a huge role in the 2020 DeFi summer boom.
Consequently, the scramble for the hottest yield farm has turned DeFi into an economic vacuum that sucks in all idle assets into pools that make it unusable.
Making DeFi capital efficient
If AMMs had efficiency features such as broader order types, they could automate trades that in the real world require constant price monitoring. Such innovations would lower trading risk and attract more participants and liquidity to the market. These robust strategies would eventually create efficient, stable, and fairer-priced crypto markets.
Stablecoins are another good example of capital inefficiency in DeFi projects. While fiat collateralized stablecoins have stable price movements, their issuers have to hold large amounts of fiat in reserve to ensure the redeemability of coins to fiat.
Decentralized stablecoins are capital inefficient as well. They leverage over-collateralization to enhance peg stability. Consequently, a crypto-backed stablecoin project like PAR requires more than one euro in the crypto-asset form to create a €1 loan.
Then, since the crypto market is incredibly volatile, there could be a loss of value when users redeem PAR in fiat format. However, crypto collateralized stable coins such as PAR can be the most efficient stablecoin protocols when paired with capital-efficient protocols such as quick loan, leverage, or arbitrage protocols.
You can, for instance, borrow PAR using your ETH and pay for short-term liabilities as your collateral increases in value. Fortunately, the Mimo Protocol integrates DeFi 2 protocols such as Uniswap V3 to ensure that PAR holders benefit more from the sector’s price action.
The Uniswap team says that V3 pools are 4000x more efficient than V2. PAR holders can concentrate their capital holdings within its custom price range pools benefitting more by providing more liquidity at different price ranges. Additionally, a Uniswap V3 liquidity provider can provide capital using custom price curves that cater to their investment strategy. You can access the V3 Ethereum pool and the V3 Polygon pool on Arrakis’ platform.
Capital efficient automated market maker protocols will create a positive feedback loop for the entire sector, making crypto prices fairer, stable, and more rewarding. In addition, an efficient market will attract more participants, enhancing stability and security.
As a result, there will be more innovation in the space, creating products that offer more people enhanced access to decentralized financial services. Then the disruptive promise held within DeFi will go mainstream and change the world.