Remember the summer of 2020?
Covid. Lockdowns. But also DeFi summer.‘Twas the first-ever DeFi summer!
Good times. But Covid’s over, and so is DeFi summer. Actually, all of 2022 has been an icy DeFi winter.
But now it’s 2023, and it looks like things could start taking a turn for the better. CoinMarketCap Alexandria compiled a detailed weather report on DeFi winter 2023. This article analyzes:
- DeFi winter in numbers: The metrics behind the bear market.
- The state of DeFi now: Which protocols are still standing?
- The problems plaguing DeFi: What needs to be improved?
- The future of DeFi: Themes that could bring about the next DeFi summer.
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There is no sugarcoating the ugly truth: DeFi is down bad.
Many metrics confirm this. The simplest is to look at the total valued locked (TVL) in DeFi
. Since the start of 2022, the sector has shed 75% of its total value locked:
The start of 2023 brought a teeny-tiny uptick in TVL. We'll get to why that is. But it's also worth looking at another metric: the volume on DEXes. Decentralized exchanges are considered the most promising vertical in DeFi. But even they did not escape the icy wind of DeFi winter:
So much for the bad news. There's good news as well.
First: Ethereum fees
. Thanks to layer-two chains taking transactions from the mainnet (Arbitrum
) and app chains (dYdX
), Ethereum transaction fees have decreased drastically
Ethereum scaling will continue in 2023 with further upgrades following the merge and increased capital flows to L2s. As blockchains become more integrated, DApps
become more accessible (and cheaper to use!) even if they don't run on the Ethereum mainnet
Moreover, the DeFi to ETH market cap ratio
is bouncing off a crucial support level
It's hard to call the bottom until well after it is in, but some believe that DeFi has bottomed. The spot trading volume
indicates as much:
Even during chilling DeFi winter conditions in 2022, the spot volume on decentralized exchanges
held firm. That bodes well for a future when capital moves back into DeFi, especially considering how badly CeFi was hit in the bear market
So, the numbers look bad, but there is reason to be optimistic. But who is still around in DeFi?
The state of DeFi now can be summed up pretty easily: Where is everybody?
Ok, it's not quite that bad. But you can count the relevant DeFi protocols on one hand:
- Uniswap: still the biggest DEX.
- Curve: doing its thing, swapping stablecoins.
- Aave: developing several interesting projects.
- Synthetix: still building those synthetic assets.
- dYdX/GMX: duking it out for the decentralized derivatives exchanges throne.
Sure, many more protocols are building in the trenches, but these are the most relevant ones. We'll cover the ETH liquid staking derivatives
for example. The market-leading DEX
still reigns supreme because no one else can compete. Rivals like Sushiswap
are busy with internal issues and cannot compete with their value propositions. Uniswap remains the only billion-dollar DeFi protocol
thanks to its ability to provide concentrated liquidity and its focus on working capital requirements. Even though Messari estimates
that bots drive 70% of all volume on the network
, this is also an advantage for Uniswap. The network can support a lower take rate for LPs, increasing UNI's treasury value.
Curve retains a stable 10-15% share of the DEX volume
, bull or bear. Although the Curve Wars narrative
has died down somewhat, the exchange has a unique value proposition and hasn't yielded any market share to competitors (there really aren't any).
has two trump cards up its sleeve. Its decentralized stablecoin GHO and Lens Protocol
will be a crypto-backed stablecoin collateralized
with debt positions in other protocols. For instance, you may want to cash in on an arbitrage
opportunity but don't want to have your capital tied up. GHO will allow you to sell the debt position to Aave and free up your capital straight away.
Lens Protocol is a decentralized social graph that allows users to own their data through NFTs. Its user base is small but steadily growing:
is another "DeFi bluechip" that had a strong push during DeFi summer. The hype around its synthetic assets
has died down since but the protocol is still building. A v3 version
is soon to be released, and the protocol has found a niche on Optimism:
are two noteworthy contenders for the decentralized derivative exchange
crown. dYdX has a massive lead and controls about 80% of the derivative DEX market, but GMX was the one of the best-performing token of 2022 and continues to gain ground. Learn more about GMX in our deep dive into GMX
These protocols are still hanging in there. But which problems plague the sector as a whole?
There's so much going wrong in DeFi that it is hard to know where to start. Debbie Downer alert incoming.
Maybe best to begin with what the experts consider a problem. Delphi Digital identified four main problems
in their Year Ahead for DeFi report
- All DeFi products with traction are speculation-based primitives
- Onboarding new users is a cumbersome process, requiring deep education.
- Retaining users sustainably is a challenge in itself
- The overall UX of the space is far from ideal.
Let's address those one by one.
The speculative nature of DeFi is a blessing and a curse. A blessing because dopamine hits are an easy sell. But it is also a curse because most of DeFi has little to no real-world utility. Speculation tends to make the rich richer. A few lucky ones "make it" but many gamble more than they can afford to lose when they try to make it. Check Coinfessions for a taste of that:
That is because DeFi can so far only be secured by economic security (=collateral), but not by legal (=regulation, laws) or social security (= credit checks). Automating collateralization is the easiest and overcollateralization allows those who already have money to speculate.
Onboarding users to crypto is easy. That's what all those fancy commercials and sponsorships are for (*cough* FTX *cough*). But onboarding users to DeFi is not easy at all. Have you ever tried explaining a DeFi front-end to a mildly experienced fintech user?
Just getting your money to a DEX and understanding that there will be no one to help you when SHTF is quite an achievement. Onboarding needs to become a lot easier.
Let's say a fictional Moonlambo Protocol onboarded users, and they're happily speculating and staking. The protocol better have some darn good ponzi tokenomics
to retain those users.
Because once those users do learn how to use DeFi, they become pretty demanding.
That's where all the crazy FDV valuations
and token unlocks
come in. They are simply a mechanism to bribe users to remain loyal. The cost of switching is zero in crypto. Brand loyalty does not exist
outside of blockchain tribalism
. Since the products are often carbon copies of each other, user retention is a massive problem.
And then there's the UX. Delphi Digital put it mildly, saying it is "far from ideal." DeFi UX lacks native wallet swaps, intuitive user interfaces, better account management, and about three dozen other things that are considered normal for regular fintech apps. The UX and lack of mobile interface for DeFi is probably the single biggest factor that would move the needle towards mass adoption.
And that's not even all!
Consider the hacks in DeFi, which grow in volume every year:
According to The Block
, only 7.6% of the hacked volume was recovered
. Small wonder then that DeFi is seen as the riskiest sector of crypto by members of Congress. That’s unfair, but it's hard to blame them for not understanding a complex new technology. DeFi may have dodged a bullet with the FTX collapse since SBF was pushing for the DCCPA (one of the crypto bills in Congress
) to be passed.
Considering all these problems, is there any reason to be bullish on DeFi? Let's find out…
DeFi has a lot of problems, but it also has a lot of potential.
Some of DeFi's inherent advantages over CeFi are:
It is self-custodial: users always have control over their assets.
It is permissionless
: you can't be blocked (well, at least with a VPN).
It is immutable
: the code cannot be altered.
It is transparent: the code is transparent and works the same way for everyone.
With that and the bottoming liquidity metrics in mind, let's look at some future narratives for DeFi.
Real-world assets that come on-chain are becoming a thing. Maybe not exactly the way crypto expected it to be (as tokenized assets), but real-world collateral now underwrites a good chunk of DAI:
Moreover, Aave is partnering with BlockTower Credit
, an institutional credit fund, to bring $220M worth of collateralized lending operations on-chain. BlockTower is responsible for overseeing the onboarding, execution, and maintenance of the assets and is retaining a sizable portion of Maker's funds. There are risks to collateralizing real-world assets on-chain, particularly in a liquidation
event. However, the strategic partnership outweighs the risks (or so does Aave think).
And then there are other real-world assets like synthetic stocks and forex. Gains Network has seen increased interest in forex trading:
Forex can be brought on-chain through oracles or non-dollar stablecoins. Either way, the market seems to have an appetite for it, so you shouldn't be surprised to see more of that in the near future.
Decentralized exchanges have tailwinds thanks to the spectacular implosions of several CeFi institutions in 2022. As much is clear from the stable spot trading ratio on DEXes vs CEXes.
This makes sense. Funds in DeFi cannot be misappropriated, but the user experience is still lacking. If decentralized exchanges can find a way to attract market makers from centralized platforms and offer them a way to put up capital in the familiar order book model, DEXes would become real competition. AMMs still dominate the market for now:
This can change and with Ethereum scaling, decentralized exchanges will become only cheaper and easier to use.
and DeFi-specific blockchains like Sei
are another narrative to watch. dYdX, the derivative DEX running on its own blockchain, generated 50% more revenue than GMX despite GMX doubling the fees of dYdX. Appchains can be a game-changer for DeFi. Middleware like EigenLayer
should greatly facilitate their development.
Undercollateralized lending is the elephant in the room that may just be too big to tackle. Decentralized finance needs it to rival traditional finance. But maybe DeFi doesn't want to rival TradFi in this regard. Competing on counterparty and liquidity risks makes little sense since centralized platforms have an inherent competitive advantage there.
But competing on transparency makes sense.
If DeFi lenders know where their money goes and the borrowers' risk profiles, undercollateralized lending has a shot. Scaling it, however, is still a pain.
Margin lending needs to be sybil-resistant (no spam attacks), systemically safe (one loan doesn't wreck the whole system) and should have sound incentives (people actually want to use it). With the right design, that can work. Particularly if we talk about non-crypto loans, as Goldfinch shows:
However, margin loans still need to be secured by legal and/or social collateral. Biometric logins and social graphs will make crypto natives bounce off walls, but they could be necessary to scale this product. Regardless, there will always be a tradeoff between capital efficiency and lender security.
Delphi Digital suggests that DeFi apps should not actually be the customer-facing product. If anything, they should be the backend and UX layers and liquidity aggregators should build on top of them:
This "liquidity infrastructure" dApps provides users with efficient execution for their activities. Meanwhile, the UX layers provide the actual access and interaction. Delphi suggests an everything-in-one app that could be semi-centralized, with the enterprise holding only one of the multi-sig keys. Users would be able to access:
- Simple swaps via DEX aggregators.
- Staking ETH via Lido/Rocket Pool.
- Access to automated liquidity-provisioning services.
- Low leverage via money markets.
- High leverage via riskier products.
- Potentially derivatives and options for advanced users.
The only problem may be the actual monetization because crypto users do not like to pay for stuff. A subscription fee would probably be met with outrage.
Still, the UX is a problem that needs urgent fixing.
ETH Liquid Staking Derivatives
Even after ETH staking withdrawals are unlocked, liquid staking derivatives aren’t going anywhere. If anything, they will only become more prominent. Definitely expect the integration of protocols offering LSD with the wider DeFi infrastructure.
It feels like we’re nearing the end of DeFi winter. The snow is slowly melting, and we can at least see the horizon after the blizzard has receded.
But how long until the next DeFi summer? And will it be as hot and enjoyable (pun intended) as the last one?
That depends on the market as a whole. A second DeFi summer wave looks entirely possible, though predicting when it hits is not.
Meanwhile, keep your winter jackets on, because winter still isn’t over.
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