The effect of expansionary monetary/fiscal policies on DeFi protocol capital and TVLs

Expansionary monetary policy refers to a macroeconomic tool used by central banks to boost economic growth by increasing the money supply in the economy. The policy involves lowering interest rates and injecting more money into the economy, which results in increased demand for goods and services, leading to economic growth.

DeFi, short for Decentralized Finance, refers to a financial system built on decentralized blockchain technology that operates independently without the involvement of traditional financial intermediaries like banks or other centralized authorities.

Today’s article aims to explore the potential impact of expansionary monetary policies on DeFi protocol capital and total values locked (TVLs). As such, the following paragraphs will delve into the concepts of expansionary monetary policies and DeFi protocols, analyzing their relationship and the possible outcomes of their interaction. By the end of this article, readers will gain a deeper understanding of how expansionary monetary policies can affect DeFi protocols, and what implications this could have on the wider crypto space.

What are expansionary monetary/fiscal policies?

Expansionary fiscal policy refers to the government’s use of budgetary tools to expand the money supply in the economy by increasing spending or cutting taxes, thereby providing consumers and businesses with more money to spend and potentially stimulating economic growth.

These policies are macroeconomic policies used by central banks to stimulate economic growth and increase the rate of monetary expansion in a domestic economy. These policies increase the money supply, lower interest rates, and boost demand, which in turn stimulates economic growth. The three expansionary monetary policy methods used by the Federal Reserve in the US are:

• lowering interest rates,
• increasing the money supply, and
• decreasing reserve requirements.

Expansionary monetary policies are used when an economy is declining or experiencing a recession, as they aim to increase consumer spending and capital investments by businesses. The Federal Reserve is the central bank in the United States and it uses various tools to implement expansionary monetary policies to stimulate the economy. These tools include:

• open market operations,
• discount rates, and
• reserve requirements.

Open market operations involve buying government securities, which increases the money supply and lowers interest rates. Discount rates are the interest rates that the Federal Reserve charges banks to borrow money. By lowering these rates, banks are encouraged to borrow more, which increases the money supply. Reserve requirements refer to the amount of money that banks must hold in reserve. Lowering these requirements frees up more money for lending, which increases the money supply and stimulates economic growth. The overall goal of expansionary monetary policies is to increase the money supply, make borrowing easier, and encourage spending and investment, which in turn can stimulate economic growth.

What are DeFi protocols?

DeFi, or decentralized finance, is a movement towards an open financial system that is not controlled by centralized institutions. DeFi protocols are specialized autonomous programs designed to address issues related to the traditional finance industry, such as slow transaction times, high fees, and the need for intermediaries. These protocols use blockchain technology to create a trustless, permissionless financial system where anyone can participate without needing permission from a central authority.

The significance of DeFi protocols lies in the fact that they offer a decentralized alternative to the centralized financial systems that we are used to. Instead of relying on centralized intermediaries, DeFi protocols use smart contracts, decentralized applications (dApps), and peer-to-peer networks to enable financial transactions and services such as lending, borrowing, trading, and investing more securely and transparently.

As of March 2022, the total value locked (TVL) in DeFi projects was around $77 billion, according to DeFi Pulse. DeFi protocols also offer greater accessibility to financial services as they can be accessed by anyone with an internet connection, unlike traditional finance which can be limited by geography or socio-economic status. The growth of DeFi has also spurred innovation in the crypto space and is seen as a potential disruptor to the traditional financial industry.

DeFi protocols play a crucial role in the crypto space by enabling a wide range of financial services to be performed without the need for traditional financial institutions. Some of the most popular DeFi categories include cryptocurrency exchanges, lending platforms, wallets, and stablecoins. These protocols provide users with greater control over their finances, as well as access to financial services that may not have been available to them otherwise. Furthermore, DeFi protocols can help increase financial inclusion by enabling people without access to traditional banking services to participate in the global financial system.

The relationship between monetary policies and Defi

DeFi protocols are specialized autonomous programs that have been designed to address issues related to the traditional finance industry. They operate within the decentralized finance (DeFi) space, which is a new, open financial system that aims to give people more control of their finances and reduce dependence on large financial institutions.

Among the most popular DeFi protocols are lending protocols such as Aave, Maker, and Compound, which allow users to borrow cryptocurrencies instantly and earn interest by lending out cryptocurrencies. DeFi protocols also provide other functions such as staking, lock-ups, farming, and mining.

Staking involves holding cryptocurrency in a wallet to support the operations of a blockchain network and earn rewards. Lock-ups require users to deposit cryptocurrency for a certain period of time to earn interest. Farming is the process of providing liquidity to DeFi platforms and earning rewards, while mining involves participating in the verification of transactions on a blockchain network and earning rewards.

Overall, DeFi protocols operate by leveraging blockchain technology to create a decentralized financial system that provides users with more control over their finances and greater accessibility to financial services without the need for intermediaries.

But there is a hindrance…Expansionary monetary policies could have adverse effects on DeFi protocols’ capital and total value locked (TVLs).

Lower interest rates may reduce the incentives for DeFi users to lend assets to the protocols and instead opt to borrow funds at a lower cost, leading to a decrease in capital and TVLs.

A decrease in interest rates could also lead to a decrease in the value of stablecoins, which are commonly used in DeFi protocols. Stablecoins are pegged to a specific asset or a basket of assets and their value is supposed to remain stable regardless of market conditions. However, when interest rates decrease, the opportunity cost of holding stablecoins increases, which can cause investors to move their funds to higher-yielding investments, leading to a decrease in stablecoin demand and value.

Historically, expansionary monetary policies have had varying impacts on DeFi protocols. For instance, during the COVID-19 pandemic, the US Federal Reserve cut interest rates to near-zero levels, which initially led to an increase in DeFi’s TVLs as users sought higher returns. However, as the pandemic continued, inflation increased, leading to a decrease in the value of stablecoins and lower demand for borrowing and lending on DeFi protocols.

This shows changing user behaviour on DeFi platforms. It shows how government policies can affect TVLs in the DeFi ecosystem.

However, it’s important to note that expansionary monetary policies are not the only factor that can impact DeFi protocols. Market volatility and regulatory changes are other potential factors that could impact DeFi protocol capital and TVLs.

The volatility of the crypto market is a significant factor in determining the capital and TVLs of DeFi protocols. For example, a significant drop in the price of Bitcoin or Ethereum could lead to a decline in the value of DeFi protocols built on those blockchains. For example, in May 2021, the cryptocurrency market experienced a significant crash, which resulted in a sharp decline in the TVLs of many DeFi protocols.

Additionally, regulatory changes can also impact DeFi protocols. For instance, in September 2020, the U.S. Commodity Futures Trading Commission (CFTC) charged BitMEX, a major DeFi exchange, with violating anti-money laundering and other regulatory requirements, which led to a significant decrease in its TVL [3].

Another example was in September 2021, the U.S. Securities and Exchange Commission (SEC) announced that it was investigating Uniswap, a popular DeFi platform, which led to a decline in the platform’s governance token.

Conclusion:

The impact of expansionary monetary policies on DeFi protocols depends on several factors, including the specific protocol, the assets held by the protocol, and the overall economic conditions.

Lower interest rates may incentivize investors to seek higher returns in riskier investments such as DeFi protocols, which could lead to increased investment and liquidity in the DeFi space. Additionally, an increase in the money supply could lead to inflation, which could further increase the demand for alternative investments such as DeFi protocols…and vice versa.

However, it is important to monitor the impact of macroeconomic policies on the crypto space, as unexpected changes could lead to volatility and risk in the market. Investors and enthusiasts need to stay informed and continue learning about DeFi protocols and the broader crypto ecosystem to make informed investment decisions and navigate potential risks.