ViaBTC Capital|What is the Solution to the DeFi Crisis?

Following the UST depeg, the crypto market started to crumble: crypto institutions crashed, exchanges suspended withdrawals, and lending protocols suffered from liquidation and runs, presenting a huge liquidity crisis. The domino effect has also fully revealed a DeFi crisis.

In 2020, everyone had been excited for the DeFi Summer, and the huge popularity of liquidity mining has jacked up the total value of crypto assets in DeFi protocols from less than $100,000 to a stunning $300 billion. The incredibly high annual returns and the major wealth effect attracted droves of users to DeFi. Subsequently, advanced DeFi players kept increasing leverage, pushing DeFi to its peak. However, when the crypto market was threatened by unsystematic risks, DeFi quickly took a sharp plunge in market cap. As shown in Figure 1, as of July 7, the total value locked (TVL) of DeFi has dropped by 64% from its historical high. Meanwhile, the market cap of the so-called blue-chip DeFi projects has also crashed. For instance, Uniswap’s market cap has fallen by 82% from the peak, and that of Compound by 94.4%. Most DeFi projects have now returned to their initial market cap when the DeFi boom had just started.

The bubble has burst.

Figure 1: DeFi TVL | Source: defipulse.com | Date: July 7, 2022

DeFi started a bull market in 2020 for good reasons. Just as Vitalik said, permissionless access to financial instruments is interesting and important for anyone in the world. That said, today’s DeFi seems to have packaged itself as a “get-rich-quick channel”, and it has forgotten the fact that permissionless and usability are its inherent driving forces. Today, we will dive into the DeFi crisis and discuss how DeFi should regain momentum.

What led to the DeFi crisis?

Playing with LEGOs instead of innovation

In the early days when projects like MakerDao, Uniswap, Compound, and Aave were created, they laid a solid foundation for DeFi and made pioneering attempts. With simple and clear logic, these DeFi projects are permissionless and transparent and have been running safely despite the challenges from the market.

DeFi had also been praised for its composability. When an innovative project achieves market success, more projects will appear to combine this innovation with their own products or make improvements on that basis to make themselves the next hit. This is what happened to liquidity mining: Though the concept was first proposed by Hummingbot, it was Compound’s adoption of liquidity mining that helped it flourish. Later on, a series of projects also adopted liquidity mining to launch their native tokens. Sushiswap (Sushi), a fork based on Uniswap, used liquidity mining to launch Sushi, its governance token, and rewards liquidity providers with DEX earnings, which helped it seize 83% of the liquidity on Uniswap within a short period. Following Sushi’s success, a large swath of food DEXs appeared on the market. Since then, many more mechanisms have been created based on liquidity mining, covering LP pools, tricrypto pools, leveraged mining, and bonding. Many of the projects promoting such new mechanisms attracted funds in the name of increasing yields and built up a big Ponzi scheme to reap chumps’ money.

Over the past two years, DeFi has presented us with only a few innovations, and many of the so-called “inventions” are nothing but variants of a Ponzi scheme. As projects stacked up the features of different products and added extremely complicated rules to their mechanisms, DeFi has lost its transparency, and investors have no idea about the risks involved in the face of high returns. Innovations are not simply playing with LEGOs, and projects that pile functions upon functions compromise their own value. In addition, in a sluggish market, people easily notice the false narratives told by such projects.

Innovation in DeFi should be reflected via its technology stack, economic model, practical applications, and security facilities. Meanwhile, DeFi projects should strive to retain such features as permissionless, transparency, ease of use, etc. For instance, Uniswap V3 launched NFT LP to solve the problem of liquidity facing DEXs; Curve introduced ve tokenomics to allow CRV holders to choose the time of token locking so that they can get different levels of rewards.

It should be noted that not all innovations are praiseworthy, but those that are must be able to adapt to the market. Additionally, projects that seem innovative might be sugar-coated scams. With so many complicated rules, investors find it difficult to assess the risk level of DeFi projects. For example, Terra provides 20% returns on the stablecoin UST in its ecosystem, which earned extensive recognition among institutional investors and conventional institutions. However, its mechanisms go against market patterns. Ultimately, as big investors competed with one another, the project failed with a tragic ending, which started waves of crypto meltdowns.

Unsustainable tokenomics

Distribution mechanisms

In the early days of DeFi, tokens were often distributed through liquidity mining and public offerings, and liquidity or users were acquired via token incentives. Such incentives mostly attracted short-term speculators who kept mining, withdrawing and selling. As more tokens were dumped into secondary markets, the returns brought by token incentives went down. Moreover, when users notice new projects that provide higher yields, token incentives would also fail over time, and projects would not be able to retain users. To address this problem, Curve introduced ve tokenomics, which helped it attract long-term investors rather than short-term speculators by offering tiered incentives. In addition, veCrv holders can decide the weight of CRV rewards distributed by each pool, which also triggered the “Curve War” where other protocols “bribed” veCrv holders to grab liquidity. The “Curve War” also gave rise to more liquidity wars, such as the two-layer nested Convex and the three-layer nested Redacted Cartel. Since then, the ve model has been adopted by a growing number of projects. However, the tokenomics seems to have weakened the role of governance, and token holders are more concerned about how to increase their returns than voting. When a project provides more bribes, veCrv holders will offer their voting rights to the project without assessing its quality. As such, many funds went to shabby projects instead, and veCrv holders had to bear more risks due to token locking when the market declined.

The market has also seen many locking mechanisms similar to that used by the ve model: they seek to reduce the circulating supply to force participants to commit to the long-term success of the protocol. For example, Olympus coined the concept of protocol owned liquidity (POL) via the bonding mechanism. To be more specific, users who deposited stablecoins or other blue-chip tokens may buy OHM at a discounted price. Moreover, the project also offered incredibly high APYs to encourage holders to stake their tokens and reduce the circulating supply of OHM in secondary markets. Over time, this mechanism inflated the OHM bubble as the APY kept going up. Eventually, the project was swallowed by a downward spiral when the whales sold the OHM and the price plummeted.

Source: CompoundWater

When it comes to token distribution, most DeFi protocols attract users with high APYs. Although such a mechanism may quickly capture users’ attention during the infant stage, retaining users with high APYs alone is not a sustainable strategy over the long run. When hit by market swings, or if the whales in the early stage exited, the high APYs would be shattered, leading to the project’s downfall.

Token functions

Existing DeFi protocols have failed to come up with a great way to reflect a project’s value through its token worth, which hinders the price increase of the token in secondary markets, as well as the long-term growth of the project.

We have no idea when people started to decide whether a token is worth holding based on its capacity to capture values. However, most early DeFi protocols were often criticized for their inability to capture values. This was the case because most of their tokens were generated via liquidity mining or airdrops, and the only role of such tokens was governance. Despite that, when looking at the governance section of these protocols, we find that the voting governance is inactive or that most of the voting rights belong to institutional investors or project teams. As a result, users have no interest in token governance or are unable to speak up. In such cases, the token’s role as a governance channel becomes pointless, and it can only be used as a trading mark in secondary markets. Plus, such tokenomics make it difficult for the market to properly assess the value of the project. Conventional valuation focuses on a company’s profits or the cash flows generated by the company, which enable stockholder dividends. However, the governance-centered DeFi tokens do not offer dividends, and the conventional approach does not work on such projects. Therefore, investors often misjudge the value of these projects and ignore other potential risks. Concerning token functions, Aave has made a slight improvement: the fees charged by the protocol can be used to buy and burn AAVE, which deflates the token. This model resembles the strategy adopted by platform-based tokens, the value of which is bound up with the revenue of the platform. This framework also motivates users to grow together with the platform, but it is also threatened by drastic price drops when investors withdraw their funds in a bear market.

DeFi projects should strive for operating models that create long-term value for their tokens, instead of being limited to governance, liquidity mining, and the stake-to-earn model. Some tokens have made new attempts. For example, TOKE tokens can be staked in Tokemak to affect the direction of liquidity. Despite that, whether such attempts will be beneficial remains unknown.

Weak DAOs

As mentioned above, weak DAOs have also contributed to the failure of many governance tokens in DeFi, and one of the reasons lies in the uneven distribution of tokens in the early stage of the project. Project teams and private-equity investors hold the majority of the tokens, which gave most of the power. As such, when it comes to project governance, the project team has the final say, and retail holders do not play the key role in community governance. This is abundantly clear in the latest Solend proposal: To prevent the whales from being liquidated, the team initiated a proposal to take over their accounts, which was passed so quickly (the voting only lasted less than six hours) that community members had no knowledge about the proposal and thus was later challenged by many users in the community. “Despite the public chain’s top ten market cap, the many institutional investments, and the most scalable lending protocol that has been running for one year, it has not launched a single proposal to discuss the complete risk control framework. Instead, its first proposal was about how to deprive users of their legal property ownership, and the result was quickly announced to the community after less than 6 hours for voting,” suggested by an outraged user. As we can see, such DAOs are also empty shells.

Secondly, DeFi communities are not cohesive and lack community incentives. As projects enter the regular growth stage, most of them interact with the community less frequently, and even their SNS accounts become inactive because speculators only care about the token price and are indifferent to how the project develops. Although some projects did reserve some of the token supply for DAO governance incentives, they have not worked well. In many cases, users can submit any proposal and earn rewards, and communities are often flooded with rubbish proposals. To empower community governance, projects must fully engage with members of the community. For instance, they can recruit community KOLs who could encourage user participation at key moments. In addition, projects can also offer equity rewards or other types of incentives according to users’ contributions to the project.

Lastly, we will turn to the imbalance between the delegation of power and community autonomy. As the developers of a project, the project team is fully aware of the project’s goals and prospects. Meanwhile, community autonomy allows investors driven by different motivations to participate in governance, which might threaten the project with the reign of the mob. As such, project teams must find the right timing and strike a nice balance between the delegation of power and community autonomy. In particular, before deciding on when power should be delegated from the project team to the community, the team needs to consider whether dosing so facilitates the growth of the product and whether such an action applies to the current product stage. In other words, power should be delegated to the community as the project evolves, and autonomy is only feasible when the community consists of a large proportion of participants that recognize the same values.

Misuse of leverage

In 2022, as global asset liquidity tightened, the valuation of risky assets has fallen, triggering extensive debt liquidations and deleveraging. In DeFi, we have seen the massive leverage accumulated during the crypto bull, and the market is experiencing a historic, massive deleveraging. According to Glassnode, more than $124 billion in funds have been deleveraged from Ethereum in just 6 weeks. In addition, both the dumping caused by the recent Luna meltdown and the short-term stETH depeg indicate that the current excessive leverage in DeFi can easily lead to systemic risks, which could crush the entire DeFi ecosystem and even the whole crypto market.

From 2020 to 2021, DeFi witnessed plenty of “innovations” and new products, including leveraged mining, LP pools, tricrypto pools, as well as tokens with tiered rewards. By combining and splitting different features, DeFi projects packaged financial services into complicated and high-yield structured products, which attracted tons of users without educating them or warning them of the potential risks. Furthermore, these products are not even developed by professional financial engineers, nor have they been tested by professional risk analysts. In some cases, even the project team cannot predict the risks that might appear under extreme market conditions. Moreover, collateralized crypto assets are inherently volatile, which means that they are more likely to be liquidated or forced-liquidated in extreme cases. In conventional finance, risky projects have to set a certain entry threshold. Although DeFi has indeed achieved decentralization and permissionless, it has hurt users’ fundamental interests, which in turn hinders its long-term growth.

With the help of leverage, DeFi features even more appealing returns. Some projects are obsessed with APYs and announce nominal returns that are coin-margined. Attracted by nominal returns that far exceed the real figures, users tend to ignore the drastic price swings and rush into the realm of DeFi without assessing the risks that are involved. Such projects would then falsify a successful project image with high cumulative TVL and stunning nominal APYs. Therefore, many funds have gone to these overrated projects in secondary markets. Over time, users become even more fond of such high-risk and high-return projects and ignore premium projects that focus on development. Eventually, as the market deleverages, they are shocked that such DeFi projects turn out to be a Ponzi scheme.

That said, DeFi (Decentralized Finance) should not be a Ponzi scheme, and it ought to focus on decentralization, instead of compromising its transparency with complex rules and high returns while turning finance into a rigged gambling game.

How should DeFi progress in a bear market?

Although the prices of most DeFi assets have returned to their original levels, its user base and funding scale have grown significantly larger. As the market shifts from bull to bear, DeFi projects should focus on solid research in today’s bear market.

What DeFi needs is a testing system: when a new product or innovation appears, instead of blindly pushing it into the market, the project team should conduct sufficient market simulation, stress testing, and system debugging. A qualified financial product must be one that can withstand the test of extreme market risks. Meanwhile, its coding security should be fully examined and updated in real-time.

Furthermore, DeFi projects should seek to retain loyal users when developing token designs and distribution models. Instead of being confined to governance, DeFi tokens could grant investors more powers. Additionally, rather than solely relying on token locking, projects should work on the internal circulation of tokens so that users could recognize their long-term value.

DeFi projects should work on practical financial products with simplified rules and transparent deals. At this stage, DeFi does not need advanced, complicated, and structured financial products. First of all, considering the fact that the DeFi system is yet to be mature, as well as the inherent risks of cryptos, developing structured crypto products is like dancing on a cliff, and they may crumble at any moment. Secondly, existing DeFi users are not ready for complex products as most of them are not familiar with the risks involved when using such products. Plus, the complex operations also keep most users out of DeFi. Therefore, at the moment, DeFi projects should focus on developing practical financial products with simple rules, such as credit-based unsecured loans and permissionless financial management tools covering multiple cryptos.

To lower the bar for users to join DeFi, user education is required. When venturing into DeFi, many users are beginner-level investors confused by on-chain operations. As such, DeFi projects need to offer training and education programs on the basic DeFi operations and common risks. As DeFi becomes more easily accessible and offers beginner-friendly operations and experiences, projects could then acquire loyal users, which also lays the path for effective DAOs. For instance, My First NFT, a program presented by Chinese NFT communities and contributors, introduces NFT to users starting from the basic crypto know-how and teaches them how to mint an NFT at last. Moreover, the program also features many risk warnings that help users get more familiar with NFTs (no financial advice). Apart from that, we should also help users better assess the quality of DeFi projects and allow them to do their own research so that they wouldn’t pump so much money into scam projects, thereby creating positive growth cycles for DeFi.

Conclusion

The present DeFi crisis is foreseeable and matches the objective patterns of development. When a new invention appears, excessive popularity will produce a bubble over time, and it could only return to a healthy growth track after the bubble bursts. The current DeFi deleveraging is painful and has created a small financial crisis. However, when the pain goes away, DeFi gains the opportunity to eliminate the excessive leverage and start a new round of healthy rebuilding.

Source: https://bitcoinist.com/viabtc-capital%EF%BD%9Cwhat-is-the-solution-to-the-defi-crisis/