Messari: Looking for Alpha in DeFi Sub-tracks

Author: Dustin Teander, Messari

Original Title: 《The DeFi Sector Map》

Compiled by: Deep Thinker

Key Points

• DEX is the highest-grossing sub-sector in DeFi, accounting for half of DeFi's revenue.
• The TVL of lending protocols is nearly 25% higher than that of DEX, yet they generate nearly 1/4 less revenue.
• Perpetual exchanges are becoming the preferred trading venues for users seeking leverage. This year, trading volume on perpetual exchanges grew by 20%, while lending volume decreased by nearly 50%.
• Due to unique capital structures, the TVL in the derivatives sector is 4-9 times that of other DeFi sectors.
• Liquid staking projects (e.g., Lido) are the fastest-growing industry in terms of TVL, having increased by over 50% in the past 90 days, while both DEX and lending exchanges have seen declines of over 14%.

DeFi is the largest and longest-standing sector in the crypto space. Its market capitalization (excluding stablecoins) is approximately $70 billion, accounting for 10% of the L1 market. Given DeFi's foundational role in the Crypto industry, understanding the various sectors within DeFi and their evolution provides valuable contextual insights.

DeFi can be broken down as shown in the diagram below, and it can be further subdivided.

I. Base Layer: Public Chain Layer

The base layer of the DeFi ecosystem is the public chain layer. Smart contracts like Ethereum, Solana, and Avax provide the infrastructure for DeFi operations. Additionally, there are several scaling solutions that enhance the speed and efficiency of fundamental smart contract transactions. Infrastructure tools complete this layer and provide DeFi applications with API access to networks, data, and even liquidity.

II. Middle Layer: DeFi Core Layer

The DeFi core layer is situated in the middle and constitutes the main value of today's DeFi. DEX, lending, derivatives, and stablecoins form the core of DeFi. Each category has its unique revenue model and revenue efficiency. The income generated from this layer is the primary source of DeFi returns. Understanding the revenue models of these sub-sectors is the first step to mastering the DeFi framework, as they form the foundation of DeFi.

III. Upper Layer: Aggregation Layer

Above the DeFi core layer is the aggregation layer. Aggregators are divided into two camps. Supply-side aggregators pool funds into a single pool and then distribute them to other projects. For example, yield aggregators. The demand-side differs in that it concentrates user demand for services like DEX trading or lending. User demand is aggregated or sent to the best DeFi native projects, thereby improving execution efficiency.

IV. Breakdown: Decomposing DeFi Native Projects

The amount of capital locked in a sector can be used to measure its significance within the DeFi ecosystem. By analyzing the amount locked and the revenue generated, it becomes clear which sub-sectors are of significant importance and which are best at converting locked capital into revenue. The derivatives sector can be further broken down into: liquid staking, synthetic assets, perpetual contracts, and options.

Sector 1: DEX

Currently, speculation remains the premier use case for cryptocurrencies. As such, DEX has gained immense value by facilitating the token swaps necessary for speculation. DEX trading fees range from 3 basis points to 100 basis points of the trading volume. The trading fee revenue from DEX is the largest organic income source in DeFi, totaling the equivalent of all other sectors' revenues combined.

DEX makes revenue generation more efficient. Liquidity providers (LPs) supply funds to liquidity pools and expect to earn trading fees in return. Compared to lending protocols, DEX has about 1/3 less locked capital but generates nearly 4 times the revenue. Unlike lending protocols, DEX LPs face impermanent loss.

While DEX offers relatively high returns, like other sub-sectors in DeFi, its revenue is subject to greater volatility. When cryptocurrency prices rise, users become more active (thus driven by speculation). Consequently, revenue fluctuates as the crypto market experiences various ups and downs. DEX revenue has been declining over the past 90 days.

Sector 2: Lending

Lending projects lock up nearly half of DeFi deposits (44%). Deposits in lending protocols serve as collateral for loans, meaning users must deposit more assets than they borrow. Lending protocols operate as a secure but inefficient over-collateralized system.

If the risk of a loan is too great relative to the collateral, the deposits (collateral) will be liquidated to repay the debt. While this keeps the entire system stable, it results in low capital efficiency. To increase revenue like other sub-sectors such as DEX, lending projects must utilize more capital to compensate.

In the past, users accepted the shortcomings of lending protocols because they were the only source of on-chain leverage. However, this has changed with the rise of perpetual trading. Since the beginning of the year, the ratio of [perpetual protocol trading volume/lending protocol total loan issuance (30-day rolling)] has doubled and is now at an all-time high. Additionally, the relative share of deposits in the lending sector has declined over the past 360 days.

Sector 3: Staking

Liquid staking and proof-of-stake (PoS) chains integrate seamlessly. Liquid staking does not directly send tokens to node validators, which would result in losing positions in DeFi. Users who stake their assets can earn both the usual staking rewards and rewards from derivative tokens.

Lido holds nearly 90% of the market share in this sector. It generates revenue by splitting the staking rewards of the original project.

With the upcoming Ethereum merge and the rapid rise of emerging PoS networks like Terra, liquid staking has become the fastest-growing area in terms of TVL. This sector has grown by over 50% in the past 90 days.

Sector 4: Yield Aggregators

As the name suggests, yield aggregators (e.g., Yearn) are situated in the aggregation layer of DeFi. Users deposit funds into a project. The protocol then deposits the funds into various core layer sectors, such as DEX, lending markets, and liquid staking, with returns ultimately depending on the yields provided by core layer projects. However, since core layer projects often have token rewards, they can typically offer higher returns.

In addition to normal income, core projects usually reward users in the form of governance tokens. Yield aggregators increase their positions in the initial investment tokens by immediately selling these reward tokens. This is a compounding process, as the size of the rewards is often tied to the amount invested.

Relying on the core layer provides limited growth momentum for aggregators. The income of the core layer primarily comes from the demand for loans and trading. Therefore, yield aggregators can only profit from this demand. Investing too much capital does not increase demand in the core layer, and increased investment does not necessarily generate more income.

Sector 5: Synthetic Assets

Not all assets are on-chain. It is also impractical to own all on-chain assets on a single chain. Users can deposit into synthetic protocols, which can then be minted into corresponding assets. As long as there are reliable oracle prices, any asset (whether stock or its token) can be minted.

Synthetic protocols can provide support for the deployment of other protocols. For example, Synthetix supports Kwenta. Kwenta is a protocol deployed on Optimism for perpetual contracts. Kwenta can access liquidity from Synthetix, allowing it to execute trades on specific assets with low slippage.

Synthetix generates revenue from the swap trading of its synthetic assets. However, compared to other sectors, the relatively niche nature of synthetic assets makes it difficult to achieve high revenue. High collateral ratios and the current low acceptance rate have led to a slow penetration rate for this sector. However, as other cooperative protocols like Kwenta on L2 attract more users, the penetration rate may increase in the coming months. Some signs indicate that synthetic assets have become the fastest-growing sector in terms of revenue.

Sector 6: Perpetual Contracts

The most traded assets on CEX are a type of derivative known as perpetual contracts. They are popular because they look and feel like ordinary tokens (with the same price). Their design does not require any trader to actually hold or deliver tokens. By removing the delivery constraints, exchanges can offer traders leverage for long positions. Due to their inherent multiplicative effect, these assets are widely favored.

Since Q3 2021, perpetual contracts have seen significant growth on-chain. On-chain protocols like dYdX and Perpetual Protocol operate simple exchanges where traders can access these products without permission. Similar to spot DEX, these perpetual exchanges charge trading fees per transaction.

Unlike spot DEX, perpetual exchanges charge fees based on leveraged trading volume (nominal trading volume). Therefore, compared to other DeFi sectors, perpetual protocols have significantly higher asset return on assets (ROA). Essentially, the income per unit TVL of perpetual protocols is nearly 10 times that of DEX and over 40 times that of lending protocols.

Sector 7: Options

Options have started slowly on-chain. Although options are the most popular product on Robinhood, retail investors prefer other forms of leverage, such as perpetual contracts. However, there has been a growing interest in decentralized options vaults (DOVs) recently. DOVs accept user deposits and underwrite smart contracts, which are then sold to other parties. In exchange, buyers pay a premium, which is sent back to the DOV as revenue.

The generated revenue becomes project income. Protocol providers typically take a cut of the revenue and may also charge a fee on deposits.

In terms of capital efficiency, options can rank second. Each unit of TVL can generate four times the revenue. While the yield appears high, it is important to recognize that DOVs are the second-lowest revenue-generating sector mentioned in this report and can only wait for an increase in options demand to expand their revenue base.

V. Outlook

As L2, multi-chain, and modular solutions begin to reshape the entire industry, understanding the DeFi landscape and current dynamics becomes crucial. Currently, DEX may continue to dominate the DeFi space. They not only account for nearly half of DeFi's revenue but also attract an increasing amount of TVL.

Across various sectors, the most significant shift is the growing popularity of perpetual protocols, which are steadily eating into the market share of the lending industry. The ratio of [perpetual protocol trading volume/lending protocol total loan issuance (30-day rolling)] can describe this trend.

The analysis above is based on a single, oligopolistic chain (e.g., Ethereum). However, as more chains join in the future, the liquidity of the DeFi industry may undergo new changes. For example, Aave's V3 can provide instant liquidity to cross-chain users.

Data and the mentioned projects can be found here.