DeFi Report August 2022

2022-08-14 14:25

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2022-08-14 14:25

新加坡新跃社科大学普惠金融节点

2022-08-14 14:25

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@sussblockchain: all things FinTech and blockchain for the community

Author:@Jesse_meta

Decentralised Finance is an open global financial system in the Web 3.0 era. It enables users to manage financial assets without tedious procedures and control of third parties. Users can borrow, swap, and generate interest through DeFi to improve capital efficiency. DeFi is the first large-scale application of blockchain.

Section 1: The Difference between DeFi and CeFi

Before the emergence of DeFi, users mainly traded and borrowed on centralised exchanges, where the funds were in custody. In addition, centralised exchanges determined the coins be listed, the transaction fees, and the rules users should follow.

According to data in May from The Block Research, Binance remains the dominant spot exchange among all U.S. regulatory-approved onshore exchanges, with 64.1% of the market share. FTX surpassed Coinbase for the first time with 10.8% of the market share.

Binance, OKX and Huobi have long been the top three exchanges in market share in the global cryptocurrency trading market. Binance’s market share has grown from 32.67% in May 2018 to 76.64% in August 2022. OKX and Huobi’s market shares have declined, accounting for 10.91% and 4.89%, respectively. Crypto.com rose in 2021, holding 10% of the market at its best, then decreased significantly in 2022. Kucoin and Gate.io have 3.8% and 3.5% of the market in August 2022, respectively.

After understanding the current CeFi landscape, let us look at the differences between DeFi and CeFi.

CeFi offers unique fiat services. More DeFi Wallets are partnering with payment companies to provide fiat deposit channels, but there is no withdrawal channel. CeFi uses the login model that the general public is more familiar with. Therefore, CeFi is the first stop for newcomers to the crypto world.

However, CeFi requires KYC. There are severe consequences in the event of CeFi data leakage. In addition, CeFi may deny users’ requests to withdraw funds in some cases. Furthermore, the financial status of centralized finance is not transparent. Some centralized lending companies such as Celsius, BlockFi, exchange like AEX, and Hoo delay withdrawals in June 2022.

The pain points have prompted users to move digital assets from small exchanges to personal on-chain wallets. Figure 4 shows that the spot transaction volume of decentralized exchanges to the centralized exchanges is zigzagging up, which shows that the blockchain spirit of trustless and decentralization is beginning to take root.

According to the Paradigm report in May 2022, the liquidity of Uniswap V3 is twice that of Binance and Coinbase, while the liquidity of ETH/BTC is three times compared to Binance and 4.5 times of Coinbase. These facts show that the automated market maker model of decentralized exchanges can provide a better service than centralized order book trading. As on-chain liquidity increases and blockchain performance improves, there is reason to believe that permissionless DeFi will produce more financially efficient products.

DeFi and CeFi are competing and pushing each other. CeFi brings new users into the crypto world, DeFi keeps people with great products that have the blockchain philosophy. With good CeFi and DeFi, the crypto market will continue to grow.

Section 2: DeFi’s Development

Born in January 2009, Bitcoin was the first DeFi application, open to all, giving users the first real freedom to control their own property and circulate it worldwide. Bitcoin is a hedge against inflation caused by uncontrolled money printing with a fixed and scarce supply of 21 million units. While traditional financial markets can be shut down at some point, Bitcoin’s distributed ledger can continue to operate at all times. Bitcoin’s trustless, decentralized, and open nature is the cornerstone of DeFi.

In 2013, Ethererum bring smart contracts to the blockchain, making cryptocurrencies programmable. Smart contracts perform operations according to pre-defined rules. Since then, the roles of crypto assets are not limited to storing and transferring value.

In November 2017, MakerDAO, which runs on Ethereum, launched Dai. It is an over-collateralized stablecoin that allows users to stake ETH at Maker to mint Dai which is pegged in USD. It is the first time users receive financing through digital currency.

In September 2018, Compound, the first decentralized lending protocol, went live.

In November 2018, Uniswap, currently the largest decentralized exchange in terms of trading volume, went live with the creative introduction of automatic market maker mechanism.

In April 2019, TokenSets, a decentralized asset management protocol, went live. It enables users to participate in various investment strategies or become the initiator of a fund.

In July 2019, Synthetix, a decentralized synthetic asset protocol, introduced the concept of “liquidity mining” for the first time.

In June 2020, Compound introduced COMP governance token to reward users in a process known as liquidity mining, sparking the “DeFi Summer 2020”.

In January 2020, Curve, the most prominent decentralized stablecoin exchange, launched.

In July 2020, Yearn, the decentralized yield aggregator, pioneered a fair launch, offering token sales to whoever wanted to participate.

Between June and August 2020, the total market capitalization of the DeFi protocol peaked at 12 times.

In August 2020, SushiSwap forked Uniswap, conducting a “vampire attack” by introducing SUSHI tokens to attract liquidity from Uniswap.

In September 2020, Uniswap issued “airdrops” to addresses participating in the protocol, an innovative way of token distribution and incentives to users.

In April 2021, Centrifuge and MakerDAO partnered to provide a181,000 DAI loan against a house, the first blockchain-based mortgage for a real-world asset.

In May 2021, Uniswap launched V3, which allows liquidity providers to concentrate liquidity and select fee tiers, significantly improving capital utilization.

In November 2021, Aave launched V3, which allows for cross-chain lending, high utilization of the same type of assets and a position-by-position model for risk segregation.

Section 3: Status of DeFi

3.1 DeFi Users Surpass 4.8 Million

DeFi users have multiplied over the past few years, demonstrating the demand for alternative financial services. During the bull market from Q2 2021 to Q2 2022, the number of DeFi users based on wallet addresses grew by 11.2 times. The number of DeFi users grew 6.45 times between Q2 2018 and Q2 2019, the slowest growth period before 2022.

The number of new addresses increased by 1.96 million from Q2 2021 to Q2 2022, bringing the number of users to 4.82 million. But the number of DeFi users increased by only 60% year-on-year, a significant slowdown compared to before. In particular, the number of new DeFi users in the first half of 2022 was 630,000, half of the 1.33 million new DeFi users added in the second half of 2021. As a DeFi user may have multiple wallet addresses, the actual number of DeFi users is lower than the number based on wallet addresses.

3.2 The Growth Speed of DeFi Users Is Slowing

The DeFi protocol snowballs between 2020 and 2021 but slows down in 2022. From Figure 5, in terms of the number of users, Uniswap is leading the way, with cumulative transaction volumes exceeding 1 trillion on 22 May. 1inch, the decentralised aggregator, ranked second among DeFi protocols . Compound has the most users among lending protocols.

Figure 5 DeFi Project Users (Source: Dune Analytics)

3.3 TVL in Deep Correction after Rapid Growth

DeFi’s TVL (Total Value Locked) exploded 250 times from 1.1 billion USD on June 1 2020, to a peak of 184.75 billion USD on December 1 2021. This was followed by a oscillation for five months. The depeg of the algorithmic stablecoin UST on May 8 triggered panic and massive sell-offs, causing the TVL of the entire DeFi market to fall off a cliff from 139.31 billion USD on that day to 84.67 billion USD on May 14. Some of the Terra-based protocols were rebuilt in the subsequent Terra 2.0, partially migrated to other public chains, and others were suspended or failed. Prominent hedge fund Three Arrows Capital also lost a lot of money on Luna and UST. Three Arrows Capital went bankrupt in June, sparking another panic. The sharp drop in the price of the currency triggered a massive liquidation that saw TVL fall rapidly from 77.51 billion USD on June 11 to 53.29 billion USD on June 19. Since then, the market has rebounded, and TVL has gradually increased. As of August 10 2022, DeFi TVL was down 64% from its peak and 37.7% compared to last year.

Figure 7 Change in Total Value Locked (Source:Defillama)

3.4 Only super power and multi-great power

At the beginning of 2020, Ethereum’s fees were still friendly to most DeFi users. With the fast growth of the Ethereum ecosystem during the “Summer of DeFi”, TVLs and new users are multiplying. However, Ethereum’s limited TPS can not meet the demand of users, which leads to high costs and discouraged users who have less money. These users are looking for a cheaper and faster alternative to Ethereum. In the figure 8, we can visually see that Ethereum’s TVL continued to fall from a peak of 97% to roughly 55% of the overall market.

3.5 Market Chill Affects DeFi Revenue

As seen in Figure 9, DeFi protocol revenues are closely related to market and positively correlate with prices. In June 2022, the major DeFi protocols had total revenues of USD 80 million. Uniswap received USD 60.77 million, making it the market leader. The number of staff employed by DeFi protocols is much fewer than in the traditional finance for the same volume of business, and the cost of compliance is low so far.

Figure 9 (Source: The block on 12 August)

3.6 DPI underperforming BTC, ETH

From Figure 10, we can see the DPI Index, made up of primary blue chip tokens of DeFi, continues to underperform ETH from March 2021 onwards and BTC from May 2021 forward.

Figure 10 Price charts for DPI (blue line), DPI/BTC (yellow line), DPI/ETH (red line)

The token underperformed from July to November 2021 when revenues were good. In 2022, when revenues declined, the token price trended downwards in accordance with market. Some investors have said that “DeFi is dead”. Prices fluctuate around value. Let’s look at the fundamentals of DeFi’s various markets and see if the current price is a good bargain.

Section 4:DeFi’s Performance across the Markets

4.1 Decentralized Lending Protocols

The largest segment of the traditional finance industry is commercial banking. Decentralised lending protocols, considered “commercial banking on-chain”, are one of the early markets in DeFi to boost. Decentralised lending protocols offer fixed and variable interest rates. They allow users to deposit assets permissionless to earn interest or leverage positions. The smart contract eliminates the middleman, increasing capital efficiency and reducing costs. SMEs with difficulty borrowing money in traditional business can obtain loans by staking existing assets or future cash flow.

Figure 11: Top 10 Decentralized Lending Protocols (Source:DeFillama)

Anchor, the top TVL in the lending market with nearly 20 % annual percentage yield for a long time, fell from grace after the UST depeg in May. AAVE is now the largest “on-chain commercial bank” with twice the total TVL of the second place JustLend. AAVE has deployed on multiple blockchains. Four of the top ten protocols are from the Ethereum ecosystem.

Most lending protocols nowadays use the over-collateralisation model. In times of market decline, borrowers who fail to increase collateral or repay loans in time suffer liquidations. Because of the open and transparent nature, highly leveraged whales are targets for short sellers.

Much of the market decline in June 2022 was caused by whales selling off mortgage to pay off loans, so that the liquidation threshold can lower. But the large sell-off of assets led to market panic. Falling collateral prices again led to unhealthy collateral ratios, causing the need for further deleveraging. As such, privacy decentralised lending protocols are the next niche market. In addition, the fall of the Three Arrows Capital hedge fund reminds practitioners should be mindful of risk control when engaging in financial innovation. Decentralised credit lending protocols allow loans to white-listed entities without needing collateral. Investors should be cautious about such protocols.

On 19 May 2022, Stani Kulechov, founder of Aave, said that Aave is testing to use NFT as collateral for loans. At the same time, we have seen several funding rounds in the market for NFT collateralised lending. NFT is an easy way to attract new users. Using illiquid NFT as collateral will help to ease the downward pressure on floor prices, improve capital efficiency and boost the industry. NFT collateralised lending is a business worth expanding.

The current decentralised and central lending platforms are mainly focusing on blue-chip tokens, with long-tail assets still underappreciated. Altcoins holders also demand to lend, and advanced players can make strategic investments by borrowing altcoins. Trustless, permissionless nature of decentralised lending protocols is fit for long-tail assets. Euler Finance is the leading player in this overlooked area.

4.2 Decentralized Exchange

Both investors and traders need to swap tokens. Before the rise of DeFi, centralised exchanges facilitated the majority of transactions. However, the real financial status of centralised exchanges was not transparent. Users do not own the tokens. If the centralised exchanges broke down or refused withdrawal, the user would suffer lost.

A series of exchanges went bankrupt from June to August 2022. In addition, due to compliance, reputation and technical reasons, only part of tokens can be listed on major centralised exchanges. Some valuable tokens have to pay a high cost to be listed. Furthermore, centralised exchanges are not in line with the spirit of decentralisation.

To address these pain points, people started to think about building decentralised exchanges that would allow users to trade peer-to-peer at any time to protect their cryptocurrencies. Uniswap is a huge success. It invented an automated market maker mechanism that allowed anyone to act as a market maker to provide liquidity to a pool of tokens. More and more users are withdrawing their tokens from exchanges and trading them on decentralised exchanges.

Figure 12: Top 10 Decentralized Exchanges (Source:DeFillama)

Four of the top 10 decentralised exchanges in TVL are deployed to the Ethereum ecosystem. Uniswap has the highest TVL, and it is currently the decentralised exchange with the highest revenue, most users and most enormous trading volume. Based on data from Crypto Fees on 23 June 2022, Uniswap’s fees exceed Ethereum. Curve, in second place of TVL, is a decentralized exchange focused on the stablecoin and synthesis of assets. Numerous emerging stablecoins, and wrapped tokens rely on the Curve’s liquidity pool to remain pegged. SushiSwap is by far deployed on most chains. Pancakeswap is a standout on the Binance Smart Chain.

In the past, decentralised exchanges focused on fungible tokens. On 20 June 2022, Paraswap, a decentralised exchange aggregator, launched a peer-to-peer NFT trading app that allows sellers to create custom orders for their NFTs. 22 June, Uniswap announced the acquisition of Genie, an NFT aggregator. In the future, we will see more decentralised exchanges expanding their reach into the non-fungible token market.

4.3 Decentralized Yield Aggregators

Decentralzied Yield Aggregators playing a important role in DeFi by leveraging different protocols and strategies to maximize user profits. However, the security of the new protocols has not yet been tested. So they require professionals to look at the code. In this context, decentralised yield aggregators have evolved. Their roles are similar to that of actively managed hedge funds, helping users to find the best investment opportunities. Key strategies include pooling multiple small funds to reduce gas costs, automatic reinvestment, asset rebalancing and taking advantage of cost-effective mining opportunities.

Figure 13: Top 10 Decentralized Yield Aggregators (Source:DeFillama)

Yearn Finance, Beefy Finance, and Badger DAO are the top three yield aggregators. Beefy Finance and AutoFarm have deployed on multi-chains. Yield Yak is the only aggregator in the top ten protocols that has not expanded into the Ethereum ecosystem.

Yield aggregators are more vulnerable to hacking because they derive high returns from riskier protocols. Of the top 10 protocols, Yearn Finance, BadgerDAO, Rari Capital, and Harvest Finance have all suffered losses.

TVLs for the top 10 aggregators (in USD) fell sharply in June, generally by 40–50%, with the most significant drop of 75.17%. To exclude the impact of the fall in cryptocurrency prices, the TVL (in ETH) Yearn Finance, for example, was 1.73 million ETH on January 25, 2022, 655,000 ETH on May 27, 469,000 ETH on June 27 and 339,000 ETH on August 13, showing a steep decline in TVL trend.

4.4 Decetralized Derivative Protocols

A mature trading market has a much larger volume of derivatives trading than the spot. However, crypto is still a nascent market, so the derivatives trading mainly happens on centralised platforms such as Binance, FTX, Deribit and others. There is still a lot of space for decentralised derivatives to develop. This market consists of decentralised perpetual contracts, decentralised options and decentralised synthetic assets.

Figure 14: Top 10 Decentralized Derivative Protocols (Source:DeFillama)

Ethereum continues to dominate the derivatives market, with eight of the top ten protocols deployed on Ethereum or its Layer 2 ecosystem; BNB Chain’s derivatives market is growing strongly, attracting four of the top ten TVL protocols.

dYdX is the flagship Ethereum-based perpetual contract protocol. It partnered with Starkware in the first quarter of 2021 to create a Layer 2 trading solution for faster and cheaper transactions. dYdX planned to develop a specific blockchain based on Cosmos for perpetual trading.

In January 2022, The options protocol Opyn launches a multiplier perpetual contract product, Squeeth, which tracks the ETH² index rather than ETH. Compared to a perpetual contract, Squeeth is a leveraged position in the form of an ERC-20 token, where the long position is not liquidated. Centralised exchanges do not offer this way of combining options with multipliers and perpetual.

The actual trading volumes in the on-chain options and futures are relatively low. The reason is that the current speed of on-chain trading is not satisfying, and the liquidity is not deep enough. In addition， decentralized options and futures protocols would not be able to provide a differentiated service compared to centralized exchanges. An important reason for the growth of decentralized exchanges is that they allow anyone to add liquidity pools at their discretion. Those altcoins that are not listed on a centralized exchange can be traded on the chain. However, long tail tokens are not suitable for options and futures trading.

4.5 Decentralized Insurance Protocols

In the world of blockchain, “code is law”. Hacking and breaches occur from time to time, resulting in enormous losses for investors. A sound insurance system is vital in bringing DeFi to the general public. Decentralised insurance protocols cover the following issues currently.

Management Risk: Private keys are being lost or stolen for protocols that are not fully decentralised.

Technical Risk: Smart contracts are vulnerable and subject to hacking.

Impairment Losses: Compensation to liquidity providers.

Liquidation of Bad Debts: In extreme market conditions, there is a risk that over-collateralised loan protocols will not liquidate assets on time, resulting in bad debts.

Figure 15: Top 10 Decentralized Insurance Protocols (Source:DeFillama)

Ethereum’s massive TVL attracts all the top 10 insurance protocols, with Armor and Nexus Mutual having a distinct advantage.

Decentralised insurance is still an inactive market at the moment, with not enough participants. Retail investors are unwilling to pay the insurance fee or do not have the time to understand the mechanisms. The current start-up phase is mainly subsidised by tokens, failing to form a good balance between supply and demand, which results in difficulties in pricing insurance. As retail investors and institutions have experienced or witnessed frequent security incidents, they will be aware of the importance of this market.

4.6 DeFi 2.0 and DeFi 3.0

DeFi 1.0 uses “liquidity Farming” to incentivise users to become market makers. However, short-term incentives create a permanent expense on the balance sheet of the protocol. Users chase high APY mining opportunities without the promise of being loyal often causing a vicious cycle of “farming and selling.”

Therefore, it became the goal of DeFi to further develop a better liquidity solution. Building on DeFi 1.0, the DeFi 2.0 and DeFi 3.0 entered the spotlight.

DeFi 2.0 is consists of Liquidity-as-a-Service, Automation-as-a-Service, Enhancement-as-a-Service and Extenders-as-a-Service.

Liquidity-as-a-Service refers to protocols that buy liquidity directly from the market through a liquidity service provider or rent liquidity from a protocol that offers cheap and high-quality liquidity. Olympus DAO is the first protocol to offer liquidity-as-a-service. It incentivises liquidity providers to sell liquidity to Olympus DAO to get protocol’s token OHM at a discount in the future. This is equivalent to bonding the liquidity. However, Olympus DAO’s (3,3) model requires a constant flow of new funds and participants to be loyal holders to maintain high yields. Otherwise, it becomes a situation where the slow runners provide exit liquidity for the fast runners. In a prisoner’s dilemma, its token price has fallen 99% from highs, and treasury funds backing OHM have been declining.

Automation as a Service means automating a small part of DeFi. Convex Finance is a great project for automation as a service. It absorbs users’ CRV and Curve LP tokens and helps them to lock, vote and reinvest automatically, distributing additional CVX tokens to boost returns.

Enhancement-as-a-Service means reusing the fruits of the DeFi 1.0 protocol to provide users with a more optimised solution. One fastest growing project is Abracadabra.money, a over-collateralised Stablecoin Protocol. Abracadabra minted the stablecoin MIM using yield farming tokens such as yvUSDT and yvUSDC as collateral. The liquidation threshold decreases over time as the interest increase the value of collaterals. But the Abracadabra is not decentralised and transparent so far.

Extenders-as-a-Service use existing DeFi to achieve new functions. For example, users can borrow a synthetic asset form of the underlying collateral, which allows the collateral and the loan to be denominated in the same underlying asset, eliminating the possibility of the collateral being liquidated.

DeFi 2.0 and DeFi 3.0 hit a temporary lull due to the token economics model, contracts issues or personnel management concerns . However, we are still seeing a steady stream of innovative DeFi’s emerging on the market, working to solve existing pain points.

Section 5: Current problems of DeFi

5.1 Frequent security incidents and huge financial losses

In the world of DeFi, the code is the law. However, most users do not have the ability to check the code and rely on the protocol for security . If there is a breach in the contract, it can result in huge losses. Once the stolen funds enter the Tornado cash, the chances of recovering them are very low. Cross-chain bridges and yield aggregators are high incidence areas. In addition, if the team members of protocols lose private keys, it is difficult to check whether they did it intentionally. In the case of anonymous projects, the likelihood of problems is even greater, and it is even more difficult to track down responsibility.

On June 10, 2022, at least ten browser plug-in wallets, including MetaMask, were revealed security vulnerabilities. Many users had to abandon wallets they had used for a long time. We can see the infrastructure of DeFi is not yet perfect.

5.2 Over-innovation and Lack of Risk Awareness

While traditional financial markets have regulators to control risk, DeFi places more emphasis on financial innovation. The brutal growth of DeFi has resulted in risky projects due to over-innovation.

The (3,3) model, popular in late 2021, has been proven that “making the Ponzi scheme workable” is a false proposition. The collapse of the algorithmic stablecoin UST in May 2022 left a host of institutions and investors out of pocket, causing the dominoes to collapse. Three Arrows Capital’s credit loan problems blew up in June 2022, reminding market participants that on-chain credit lending is a minefield to be wary of.

The root of DeFi lies in the fundamentals of finance. The complex token economics often hide risk. Stakeholders should discipline themselves to promote the healthy development of the industry. Investors should not FOMO innovative projects, without understanding the mechanics.

5.3 Liquidity Fragmentation in a Multi-chain Landscape

Ethereum is the dominant player, but its high costs at peak times are overwhelming for most users. New public blockchains with lower transaction fees and faster speeds have taken up part of the market shares. With the support of major investors, developers and users, ecosystems of some new blockchains have outstanding achievements in the past year. However, due to technology and competition, most public blockchains are not interoperable, leaving users, assets, data and DAPPs sealed off within their own ecosystems. This is contrary to the spirit of interoperability and scalability of blockchain. The current multi-chain landscape is like a single computer not connected to the internet. There is still a lot of potentials to be unlocked.

In this context, the demand for cross-chain is increasing, and various cross-chain solutions are being introduced to the market. However, there are many bad news happened from cross-chain solutions. on 29 March 2022, the validation nodes of Ronin Bridge were compromised, resulting in a loss of approximately $600 million. On 24 June 2022, Harmony’s official cross-chain bridge, Horizon, was hacked, resulting in a roughly $100 million loss. Nomad Bridge was stolen $190 million on 1 August, a few days after announcing to receive investments.

8 January 2022 Vitalik writes that multi-chain is the future but is pessimistic about cross-chain. He said if the blockchain suffers a 51% attack, the native tokens are unaffected, but the wrapped tokens may not be fully backed. Furthermore, the vast amount of liquidity incentivises hackers to launch attacks.

5.4 Inconsistency between Token Price and Protocol Value

The DeFi business acts as a money printing machine to make a lot of revenue. However, to avoid being classified as securities, most protocols do not pay dividends to holders. Tokens are held with governance rights only. Most retail investors are not interested in governance or do not have the time or energy to follow through, resulting in the protocols controlled by whales or core teams. So it is difficult for governance rights to support the price of tokens.

The token price has a long-term downward trend. In contrast, Curve’s token mechanism better captures the value of the protocol. Curve uses governance tokens to vote on the weight of liquidity incentives. Pools that receive more votes are rewarded with more $Crv. Users are more willing to provide liquidity in pools with more rewards, facilitating the stability of new stablecoin and wrapped token prices. Stakeholders strongly demand to buy $Crv to maintain the token price stable. Uniswap has been discussing whether to distribute fees to token holders recently.

Therefore, while avoiding being deemed as securities, the protocols should consider how to make the tokens capture the value of the protocols. Protocols should not ignore the interests of the token holders. The community can be dynamic and sustainable if the protocols and token holders win together. Investors had better not invest blindly.

5.5 The Number of Actual Users is in doubt

The retroactive airdrop pioneered by Uniswap gives crypto users a fair way to participate and incentivises crypto users to test new products. The teams refine the product based on the feedback and eventually receive funding from venture capitals by showing significant user engagements. Institutional investors find projects that have the potential to grow. Users spend money and time testing new products for free, equivalent to mini early investors. After receiving funding, teams reward back to the early users. This mechanism is beneficial to all related stakeholders.

However, motivated by the huge wealth effect of airdrop rewards, airdrop hunters have arisen. Airdrop hunters transfer the money to their next wallets after testing protocols. Some programmers have even developed scripts to test at hundreds of wallet addresses automatically. As a result, there is no longer an accurate way to assess the true number of users and it is more difficult to give a reasonable valuation. After the airdrop rewards were given out, airdrop hunters sold off tokens in large numbers and the price of the tokens dropped all the way down, hurting investors who had bought tokens from second market.

In May 2022, Optimism and Hop Protocol announced a crackdown on airdrop hunters and removed their airdrops to curb this phenomenon. In the future, we will see protocols scrutinise the authenticity of their users more closely when giving out airdrop, referencing more on-chain behaviour such as whether they have made Gitcoin donations, whether they have voted on governance and so on. Zksync has even publicly stated that it will check the IP addresses of its users.

In addition to the airdrop mechanism, protocols also use subsidies to attract users at early launch. For example, dYdX encourages trading farming, Looksrare and X2Y2’s reward users tokens when they list NFTs. It is worth thinking about how protocols can retain users with excellent services and reasonable token economics.

Section 6： The Future of DeFi

6.1 Regulation is Coming, and Traditional Financial Institutions will Develop DeFi Businesses

The collapse of the UST in May caused many people losing a lot of money in a single day. On 10 May, US Treasury Secretary Yellen spoke at a hearing of Senate Banking Committee about the UST depeg and highlighted the regulations for stablecoins. In June, Three Arrows Capital was serially liquidated and left insolvent. 23 June, Sopnendu Mohanty, Chief Fintech Officier of the Monetary Authority of Singapore, said they would crack down on malpractice in the cryptocurrency industry. On the same day, Jerome Powell, Federal Reserve Chairman, said the time had come to regulate stablecoins and digital financial markets.

The lack of self-regulation in the uncontrolled growth of the industry eventually brought about regulation. As it turns out, even good technology needs regulation to guide it. Governments will introduce CBDC to capture the market share of “unstable” private stablecoins. Some native DeFi protocols may embrace regulation actively. After the regulatory framework becomes clearer, traditional financial institutions will enter the DeFi. Using blockchain technology, traditional financial institutions will become more transparent and efficient. At the same time, they will also bring resources from the traditional industries to provide “liquidity as a service” for DeFi and to match users with native DeFi protocols.

6.2 Introducing Real-world Assets

Some DeFi protocols are already being proactively regulated to bring in real-world assets. For example, on 30 March, 6s Capital, a commercial lender backed by MakerDAO, completed a real estate financing deal worth 7.8 million DAI for Tesla. Compound Labs has launched Compound Treasury, a new product for businesses and financial institutions. The Compound Treasury allows non-crypto companies and financial institutions to swap their dollars for USDCs and receive a fixed interest rate of 4% through a partnership with Fireblocks and Circle. In addition, Decentralised insurance to provide insurance services for users’ real lives is also the next possible growth track.

DeFi’s financial efficiency is much faster than traditional finance. But the DeFi market is still a tiny volume compared to the real world. By combining with real-world assets, DeFi can explore a larger market.

6.3 Privacy DeFi

DeFi is public and transparent. Anyone who knows the wallet’s address can see the number of assets and the history of past transactions. It is the equivalent of everyone in the world being able to check someone’s bank statement. This can, in some cases, pose a threat to an individual’s life and property. During the down market in June, large investors suffered a spotting blow because their margin was open to seeing. In addition, with regulation looming, some users will also need privacy about their on-chain assets.

On 8 August, United States Treasury imposed sanctions on virtual currency mixer Tornado Cash. Advocating for absolute freedom will be a niche group’s self-importance. Privacy protocols must fulfil regulations’ requirements so they can continue to develop. Zcash is doing well to meet compliance.

6.4 Cross-chain DeFi

As the major layer 1 and layer 2 ecosystems develop, users are no longer limited to Ethereum, and money flows more frequently. Cross-chain DeFi built on cross-chain protocols is a hot topic for future innovation. For example, a decentralised lending protocol could allow users to borrow money on Polygon using Ethereum assets as collateral. This will enable users to repay faster in times of market decline and reduces the high gas costs in the case of congestion. Cross-chain aggregators, for example, have a better chance of finding high yield farms. However, improved security and speed are prerequisites for the development of cross-chain DeFi.

6.5 DeFi 1.0 Becomes Infrastructure

Some fork have lost users due to bad debts arising from mechanisms or contract loopholes. Several rounds of extreme conditions have tested blue-chip projects such as Uniswap and Aave, and users have recognised their security. A combination of innovations based on blue-chip projects is the next step for financial innovation. For example, decentralised insurance to insure against impairment losses, using existing yield farming tokens as collateral , and creating a layer2 option protocol based on synthetic assets. Those protocols that fork blue-chip items without differentiation will gradually disappear.

6.6 DeFi Protocols for Web3 investments

The DeFi protocol is well financed, but does not pay dividends. In this fast-growing market, we are seeing more and more protocols setting up venture arm to strengthen their moats. on 12 April 2022, Uniswap Labs set up Uniswap Labs Ventures, to invest in Web3 infrastructure, development tools and other projects. The next day, the Aave founders said they were launching Aave Ventures, where each funded team would receive a ticket to rAAVE.

Section 7: Summary

DeFi is the first large-scale application of blockchain technology, birthed in the last bear market, exploding in the early stages of a bull market starting in 2020 and heading towards a peak in late 2021. With the impact of interest rate hikes, DeFi is stepping into a temporary downturn. Some over-innovative projects are being disproven. However, the foundation of DeFi has been built, with well-established infrastructure and a growing user base. As the underlying blockchain technology continues to advance in the future and DeFi education becomes more widespread, DeFi will take off again with even better products.