How does the composability of DeFi drive the bull market?

This article is sourced from DeepQuant Group, authored by the co-founders of the cryptocurrency quantitative investment team DeepQuant and DeepGo DeFi developers, Byte and Terence Chen.

Abstract

The bull market that started in 2020 will not turn bearish due to policy reasons; rather, a crash based on events can be thought of in reverse. A true bear market is likely due to a lack of innovation, where bad money drives out good money, and the wealth effect gradually disappears, leading the market into a recession.

The innovation of DeFi lies in its composability, combining the richness of traditional financial products with smart contract technology, allowing keen developers to leverage the advantages of blockchain to redefine financial products. In the inertia of wealth effect and collective FOMO, there are still many investment opportunities in 2021.

The key outcome of composability is cost reduction and efficiency enhancement. Cost reduction refers to lowering the costs of supply-demand matching, such as the currently popular yield aggregators in the market, while efficiency enhancement refers to increasing business benefits, such as the new features of Uniswap V3 and asset portfolio optimization tools.

The successful implementation of Layer 2 will significantly reduce the execution costs of combination trading, creating more products that meet market demands. The popularity of DeFi gateways like MetaMask and Zerion will enable more people to participate in the blockchain wave.

This bull market is different mainly because of the improved infrastructure. Compared to the air coin bubble of 2018, there will be more applications landing in 2021.

How is a Bull Market Formed?

Based on my experiences through bull and bear markets, the driving force of a bull market comes from the low-cost wealth effect. In 2013, copycat coins of Bitcoin led the first wave of the bull market. In 2017, one-click token issuance made many ordinary people wealthy. The DeFi boom in 2020 initiated a new wave of bull markets, accompanied by an endless stream of new play styles and emerging trends.

In January 2020, the well-known venture capital firm a16z published an article titled "Progressive Decentralization: A Playbook for Building Crypto Applications," describing what they believe are the three key factors for project success:

• Product/Market Fit
• Community Participation
• Sufficient Decentralization (Community Ownership)

On June 15, 2020, Compound launched liquidity mining, and over a dozen well-known DeFi projects such as Synthetix, Aave, Balancer, and Curve followed suit. Within three months, the total locked value in DeFi surged from less than $1 billion to over $9 billion. From then on, blockchain began to scale in the financial sector, and the combination of smart contracts and financial transactions truly leveraged the transparency and trustworthiness of blockchain.

In addition to the technical advantages of smart contracts, blockchain represents an innovative concept of how to achieve autonomous benefits within a community, creating value that traditional business organizations have not realized.

In October 2004, Chris Anderson, editor-in-chief of Wired magazine, first proposed the Long Tail theory to describe the business model of internet platforms like Amazon. The Long Tail effect extends from this theory, where the previously overlooked niche markets cannot be ignored, as their cumulative total revenue can exceed mainstream products. Internet platforms have surpassed traditional physical giants based on the Long Tail effect.

The best business models on the internet are mostly platform-based, while great blockchain products are not limited to platforms. In DeepQuant's quantitative evaluation system for blockchain products, we will assess whether they can become unicorns from the following dimensions:

• Permissionless: Meaning users can seamlessly switch roles on the platform, significantly reducing sales and operational costs. Only truly permissionless products can be widely applied at low costs.
• Trustless: Trust in code rather than human nature. DeFi genuinely addresses issues in the financial industry, with data publicly available on-chain, and all operations executed according to smart contract logic, reducing the possibility of malfeasance by centralized institutions and lowering users' trust costs in products.
• Robustness: Representing the system's survival ability in the face of risks. DeFi protocols, under open-source conditions, will face many risks, and a complete product must have a robust disaster recovery system. Currently, the biggest problem with most products is incompleteness and lack of risk resistance.

Bull markets do not appear out of nowhere; great blockchain products are destined to become the growth engines of bull markets. In this article, I will review DeFi star products and explore potential new stars.

DeFi Star Products

Aave

The largest application scenario for blockchain remains in cryptocurrency trading, and the lending market was validated as successful back in 2017, with lending being hailed as a fire in the bull market. Aave, originally called ETHlend in 2017, rebranded and has maintained its leading position in the DeFi wave. In December 2020, Aave V1 upgraded to Aave V2, making the protocol more flexible.

Yield and collateral swapping: In DeFi, assets used as collateral are frozen, but in Aave V2, they can be freely traded. Users can trade their deposit assets among all currencies supported by the Aave protocol—even if these assets are used as collateral. Collateral swapping is an effective tool to avoid liquidation; if the collateral price starts to drop, it can be swapped for stablecoins, eliminating concerns about price fluctuations and potential liquidation. This feature also allows for asset swapping to achieve the best market yields; whichever market has a higher staking yield can have its staked funds swapped for the corresponding asset.

Repaying with collateral: Typically, if part of the collateral is used to repay a loan, the collateral must first be withdrawn, used to purchase the borrowed asset, and finally repay the debt to unlock the deposited collateral. This requires at least four transactions across multiple protocols, consuming time and money. Aave V2's new feature allows users to repay loans directly with collateral in a single transaction, making the loan position smooth and simple.

Flash liquidation: Usually, liquidators need to have funds in their wallets or raise funds from elsewhere to liquidate positions and earn liquidation bonuses. With Aave V2, liquidators can utilize flash loans to borrow funds from the Aave protocol itself to execute liquidations.

Batch flash loans: In the V1 version of Aave, only one asset could be borrowed in a single transaction, while in V2, multiple assets can be borrowed in one transaction.

Aave V2's DeFi gateways:

• Argent
• Zapper
• Zerion
• imToken
• DeFi Saver

Changes in total locked value of Aave V2

Source: DeBank, June 22, 2021

Changes in total borrowing volume of Aave V2

Source: DeBank, June 22, 2021

YFI Aggregator

YFI is positioned as a decentralized yield aggregator, primarily using algorithms to find the liquidity mining protocols with the highest yields, helping users achieve the best returns using various lending protocols like Aave and Compound. YFI simplifies user operations and lowers investment thresholds by algorithmically packaging interactions between multiple DeFi protocols.

YFI's fair distribution is one of the most successful methods in DeFi history, where everyone earning tokens starts from the same point. The fair distribution is reminiscent of early Bitcoin mining, as no one had a first-mover advantage—even the founder Andre himself did not; the only way to obtain it was through mining. Like early Bitcoin miners, early YFI users also chose to align their interests with the protocol as closely as possible, ensuring community enthusiasm and participation.

Example of YFI's Lego game: Interaction between YFI and Curve

First, USDC is an asset with no yield. After depositing USDC into yearn, yearn will choose the optimal investment based on the different yields of various DeFi protocols, generating interest and receiving yUSDC as proof.

Depositing yUSDC into Curve's liquidity pool provides liquidity for Curve, earning a certificate yCRV, as well as transaction fees from the asset pool and Curve's governance token CRV.

Then, depositing yCRV into the YFI staking contract allows users to earn YFI tokens based on their deposit ratio.

Changes in total user numbers of YFI

Source: Dune Analytics, June 22, 2021

Changes in daily active user numbers of YFI

Source: Dune Analytics, June 22, 2021

From the popularity of Aave and YFI, it is evident that the wealth effect is an eternal theme of bull markets. Wealth creation relies on the diversity and sustainability of products, which is the composability of DeFi. The upgraded features of Uniswap V3 also prove this point; Uniswap V3 achieves product customization through increased granularity, although it weakens the simplicity and elegance of V2, it allows more people to prosper together, which may be the growth engine for the next bull market.

The Key to Composability

Traditional financial derivatives are diverse, and there are still many opportunities in DeFi protocols. The financial positions of DeFi protocols establish trust through smart contracts and do not rely on centralized institutions for arbitration, thus they are not "locked." Based on this, developers can achieve interactions among numerous protocols, and the flexibility of DeFi protocols lays the foundation for the composability of derivatives.

The importance of composability in financial derivatives mainly stems from the market's demand for wealth creation, and the key to meeting market demand lies in supply diversity. Under the flywheel effect of both supply and demand, combined with a filtering feedback mechanism, an efficiently matched curated market can be formed. How to maximize the utility of DeFi's composability? The key lies in combination protocols.

As a quantitative strategy researcher, based on my experience in developing asset portfolio models, a good asset combination protocol relies on three elements:

• Performance Attribution: Factorizing the performance results of asset strategies, i.e., extracting features from granular sub-strategies, such as profit and loss logic and risk scenarios.
• Optimization Algorithm: Based on the asset portfolio model for Lego combinations, the protocol automatically calculates and provides optimal solutions according to user risk preferences.
• Feedback Mechanism: Users can be promptly informed of market conditions, allowing for the rapid design of customized strategies, reducing R&D costs without needing to redevelop underlying code.

A good combination protocol will not stop at the YFI aggregator; beyond optimizing execution paths, the greater imaginative space lies in the financial engineering of DeFi, thus innovating and deriving more high-quality assets that meet market demands. The YFI gun pool protocol only aggregates existing yield strategy products, but the larger market for DeFi lies in the incremental expansion of the derivatives market, where there is an urgent need for more incremental wealth effects.

Exploring Composability

Since 2018, I have first encountered DeFi through the liquidation arbitrage strategy of MakerDAO. Since 2020, we have initiated projects to explore the composability of DeFi.

First, we focus on DeFi asset management platform gateways, such as Zerion and Zapper. Next, we pay attention to combination protocols, typically like Furucombo and Tokenset, followed by application layer products such as interest rate derivatives like Saffron, and finally, we focus on core issues, such as how Layer 2 can improve DeFi infrastructure?

The following exploratory products are for learning and communication purposes only and do not constitute any investment advice.

Zerion

Zerion is a one-stop DeFi asset management platform that allows users to perform all DeFi-related operations such as investment, lending, and exchanging while retaining full custody of their funds. Zerion creates a platform that is easy to use and access various DeFi protocols for users who are not technically savvy. As a DeFi gateway, Zerion has not issued tokens, and its future is promising.

Zerion aggregates DeFi functions, allowing permissionless operations.

Furucombo

Furucombo visualizes major DeFi protocols as blocks of Lego, allowing users to design their own DeFi strategies by simply dragging and dropping without needing to program. For users who want to execute operations across different protocols, they only need to input/output the relevant token amounts and set the multi-layer operation sequence, and Furucombo will package all the data into a single transaction to send out.

Furucombo allows for free combination of products and defines operations, simplifying developers' work in combining interactions.

Furucombo combination example: exchanging stablecoins and completing staking.

Saffron

As an asset staking platform, Saffron provides liquidity providers with dynamic exposure, allowing them to choose customized risk and return conditions. Based on the level of risk undertaken, liquidity providers share protocol profits proportionally. In this way, Saffron allows users to achieve risk and return grading through the free combination of yields and risks.

Yield and risk grading, S Tranche, A Tranche, different risks have different yields, belonging to the interest rate derivatives market.

Tokensets

TokenSets is built on the Set Protocol protocol, and its social trading platform Set Social Trading connects professional traders with ordinary investors, sharing professional investment strategies with regular users. On the platform, professional traders can create and manage their trading strategies and showcase them to the public. Ordinary investors can mint and hold Set tokens, replicating every trading action of professional traders.

Freely create investment portfolios.

Explore professional investment portfolios.

Polygon

Polygon envisions itself as a Layer 2 aggregator, with an overall architecture divided into four layers: Execution Layer, Polygon Layer, Security Layer, and Ethereum Layer. Among these, the Security Layer and Ethereum Layer are optional for Polygon developers, while the Execution Layer and Polygon Layer are mandatory. Based on this architecture, application developers can freely combine layers to meet different needs for security, speed, transaction costs, and sovereign governance.

Polygon's vision: Fully aggregated Layer 2 scaling solutions.

Changes in total locked value of Polygon over the past three months.

At the beginning of 2021, after Matic rebranded to Polygon, its composability increased significantly, leading to a surge in locked value.

Conclusion

DeFi is no longer as simple as the past digital currency frenzy; blockchain is truly beginning to become a part of financial technology. Previously, in a private conversation with DODO founder Radar Bear, he mentioned that programmers have become first-class citizens in the blockchain field, which I deeply agree with and find inspiring.

Compared to traditional finance, DeFi's stronger composability offers more diverse expansion forms, bringing higher freedom and more innovative possibilities, thus forming an orderly prosperity. Bull markets do not rely solely on speculation but depend on the wisdom and innovation of countless practitioners.

How to attract more excellent developers? How to enhance DeFi's compatibility and scalability? How to create more user-friendly products for ordinary users? How to achieve inclusive finance through blockchain? How to meet more diverse needs through composability? These are all questions worth pondering before driving the next bull market.

I would like to thank Kay, the Managing Director of NGC Ventures, and DODO founder Radar Bear for their inspiration and contributions to this article.