A Casual Discussion on the Current State of DeFi and Its Future Direction: Can It Reignite in the Next Cycle?

Original Title: 《Brave new world》

Original Author: knower

Translation: DeFi Path

Introduction

I hold positions in some of these tokens, but legally I cannot trade them in a way that benefits me. None of this is financial advice, and I believe many of these tokens will not perform as we hope. So please invest in your own way.

Several hours have passed since my last post, but it seems my writer's block has disappeared. I discussed the crypto market in a very brief article, and now it's time to write something more substantial with more data to support my claims. At the time of writing, the DeFi TVL is approximately $106 billion, down from its peak of nearly $250 billion. The top five protocols are Maker, Curve, Aave, Lido, and Uniswap—these five protocols are currently referred to as "blue chips" in the cryptocurrency native space. How can competitors replace the top five and take over Maker's dominance? The goal of this article is to explore the current state of DeFi to determine its future direction.

To avoid confusion, I will mention some categories that may not fully align with DeFi cases in this article, but I choose to include them because I believe they will ultimately become synonymous with what the public refers to as DeFi. Moreover, I do not intend to mention all the protocols inserted into the article; dear readers, it is up to you to explore—consider it your bear market homework.

More Losers than Winners

As DeFi grows, we see Ponzi schemes becoming increasingly complex and obscure, masking multi-layered economic alchemy designed to strip traders of their precious funds. Whether it's the food yield farming of DeFi's distant past, the relatively recent OHM forks, or the now hard-to-suppress long-standing Ponzi schemes, DeFi is built on a casino-like trend mixed with economic structures that would make Bernie Madoff (the largest fraudster in U.S. history) rise from his grave.

After the collapse of UST and the Anchor Protocol, TVL disappeared from Terra, leaving Ethereum with about 65% dominance in DeFi, while Binance Smart Chain and Tron did not follow closely behind. How did this happen, and why, despite Ethereum's gas fees and fierce competition from alternative L1s like Solana, Avalanche, and Polygon, does funding continue to flow back to Ethereum? The answer is not so simple, and the fact is I don't have many answers. My best guess involves the notion that DeFi was created on Ethereum and is more or less destined to spend its lifecycle on-chain to outpace all other chains. Ethereum has seen its L2s like Arbitrum, Optimism, zkSync, and Starknet become increasingly popular and utilized, which somewhat explains the almost inevitable possibility that DeFi TVL will ultimately remain 100% concentrated in the internet casino.

Currently, DeFi TVL is represented by some quite reputable protocols (see: the aforementioned top five), and if you only look at the top 25 or so, it appears quite responsible. In the past, we began to see real Ponzi schemes emerge. If you have searched any defillama in the past few weeks, you would notice that many protocols are experiencing extreme TVL fluctuations. Inflows of 25% one day, outflows of -40% the next day, and -65% outflows over the past 7 days—anything you can mention can happen in DeFi. While those hoping for long-term (possibly) gains lack opportunities, the current situation looks quite bleak. If lucky, many protocols have stable yields in the range of 3-6%, after running in double digits for several consecutive months. If we cannot provide liquidity for our precious stablecoins, what else can we offer?

I believe DeFi will tilt towards the following categories in the coming year:

• Lending
• Structured Products
• Derivatives
• Cross-Chain

"But you can borrow using protocols like Aave or Compound, then------"

No, this is different. If we want to attract institutional capital from big players, we must market ourselves to them.

Lending

I think we will see significant growth in TVL for protocols like Maple, Goldfinch, and Clearpool, as trust among more crypto-native protocols declines after the unfortunate Terra events. Yes, I am saying that DeFi will become less decentralized. This is bad, but if you have a "glass half full" perspective, it might be good. Maple has outperformed many peers in terms of TVL strength, token price, and relatively eye-catching (a metric I made up) indicators, while many protocols have been scrambling to reclaim their precious TVL. Goldfinch and Clearpool are also in this category, but Maple is simply doing better. By the way, you can still earn double-digit stable yields on Maple.

The lending market is huge because many people have a lot of money but cannot always use it—borrowing against your collateral is one way. The growth of Aave and Compound is driven by the inherent demand for crypto whales to acquire more funds, with deposit incentives initially attracting these magical funds. This pattern has largely contributed to the current state of DeFi, as 99.9% of protocols must first launch LP incentives to attract any traction/attention/deposits. This is not always a bad thing, but it does prevent much of the junk in cryptocurrency from being removed, as farming and junkyard games can occur quite frequently. Aside from making some people money, some people a lot of money, and many people no money at all, DeFi currently lacks a real primary use case. This may be due to impermanent loss, poor token economics, lack of PMF, or some combination of the three, along with many other qualitative factors. Oh, TradFi has trillions of dollars, and only 1% of its followers have entered DeFi, and we will all become rich. Let’s move on.

Structured Products

Structured products are an interesting story, mainly because of how they have been marketed in DeFi so far. Everything in DeFi is about yield, and structured products are fundamentally designed to provide high yields, but it's hard to make them stick. Sure, you can use one of these protocols and see theoretical yields of 42% for ETH cc or csp—but why do that in such a volatile market, where if it drops or limits your price, you are obligated to buy a significantly higher upside? Yes, I know these products are primarily used for hedging, but crypto is still in its early stages, and over time, these will become more important. Regardless of their utility, it is evident that they do occupy a place in the current market. If you cannot get the yield you need from anywhere else, structured products might become your friend.

We may not see a large number of overly degraded structured product strategies, but the probability of seeing them is still quite high. If crypto enters the next cycle and structured products are still around (tired of entering structured products every ten seconds), there will be many opportunities to combine Ponzi economics and theta into a devastating weapon for millions of retail investors. Imagine if a DeFi founder sells his project next month for > $20 million && < $25 million while simultaneously selling CSP on the project token, hoping that large funds rescue user funds at the same time—this possibility is conceivable.

This is often quoted by the casino GCR—embrace it.

Some protocols working hard in this space include Ribbon, Friktion, and Timeless; of course, there are many others. I believe that if these protocols can survive and maintain a high-quality product offering + consistent TVL inflow, they will one day become very large. Structured products are also very important on Solana, partly because I am so bullish on L1 as the #2 choice behind Ethereum. The only issue I see with Solana is its network outages, the current poor token economics of many old competitors, the high hardware requirements for validating chains, and this relative centralization. Derivatives are also very important on Solana, which will be discussed next.

Derivatives

Crypto has been struggling to see many of its on-chain options protocols take off in terms of usage and TVL, leading to a revival of protocols like GMX, dYdX, and Drift. Despite the market downturn and general lack of liquidity, GMX has seen a crazy influx of new users. Look at this chart; it is actually trending upwards:

GMX is not alone in this regard, as perpetual trading volumes have been doing well, and I won't extract all the data here.

On-chain business is not proceeding as usual, but the tokens of these perpetual trading platforms have remained strong, despite the chaos surrounding most other competitors. Projects like dYdX have very poor token economics and good usage, which means not buying the token could become quite foolish, as it is likely to be acquired by larger players as a "value" play. We have DeFi blue chips; why not perpetual blue chips? Protocols like Drift, Perpetual Protocol (its name), and 01 Exchange are all very interesting and have garnered significant interest; they need to maintain their trading volumes, keep users satisfied, and ensure they do not go bankrupt.

Looking at other derivative protocols, there are some under our radar, like Cega, Vega, and Zeta (I know these names are silly). Many relatively new on-chain derivative platforms do not compare in usage to some of the big brands I mentioned, but they offer some very cool, valuable, and unique products for users willing to venture into the unknown. For example, take a look at this image from Cega Finance documentation:

Referring to the above, I think it is fair to assume we will see more such products in the cryptocurrency space. This leans more towards structured products, but it is a derivatives platform, and derivatives are associated with structured products—hold on, this won't fundamentally change the structure of the article—I hope you get the point. Returning to my point about options, there is not enough funding in DeFi to achieve this satisfactorily at scale. Market makers have little reason to take the other side of trades, as there are usually more monetarily attractive ways to make money in markets without decentralized options protocols. Does this mean we will never see options for our precious on-chain gems? No, it will not happen immediately as we want.

From both qualitative and quantitative perspectives, Perps seem to be king. They are relatively easy to understand, and leverage is something everyone loves, even if they lose 9.9 times out of 10. Perp trading volumes are expected to continue rising and moving to the right.

Cross-Chain

I decided to include a section related to cross-chain in the article (very brief, leaving most of the content for future articles) because it directly aligns with the growth of DeFi. During 2021, we saw the "competitive L1 season" play out time and again. Seriously, the same script ran 10 times with almost no failures. Ethereum's dominance in DeFi TVL was further eroded as the combination of upward L1 tokens, ecosystem funds, and bullish VCs led to a rapid rise in TVL across all areas from Avalanche to Fantom.

While many of these chains have now been knocked back to their roots (see: Fantom), there are still plenty of reasons to be optimistic about a multi-chain future supported by protocols like Synapse, LayerZero, Wormhole, Axelar, and many others I don't want to list one by one. Many of these have made a lot of money in exchange fees, hold significant TVL, and provide services that are crucial to crypto in its current state—there's not much to dislike about bridges and the ability for dApps to build natively on bridges. Not to mention that many of these cross-chain solutions plan to transition to their own chains at some point in the near future, leading to a potential "competitive bridges/cross-chain as an undervalued L1 season" (yes, of course, I made that up), which could send some of these tokens and future tokens of these protocols in a manner similar to competitive L1s. But this is one of my major dreams, and I hope we can all share it.

When you consider the future of DeFi and where it might ultimately head in terms of mass adoption, a chain agnostic future makes a lot of sense. When we interact with payments in the meat world, we do not know which underlying services are powering and processing our transactions—we just do it as usual. This could become the case for DeFi, far beyond the time when all 7 billion people in the world are gambling on UBI in DeFi Ponzi schemes, with DeFi TVL dwarfing today's TradFi. But I digress.

Looking Ahead

I hope this article has provided you with some much-needed insights. I believe that no matter how much we have lost, we should strive to remain optimistic because the future is very bright. If you particularly feel that crypto or DeFi has been disenfranchised, I suggest you read some science fiction to help you imagine all the crazy ways we might ultimately spend money on Ponzi schemes in the future.