Analyzing the five major reasons for the current market crisis, the first is the pseudo-innovation of DeFi leading to market failure

Author: Solv Research Group

Author's Note: Exactly two years ago, on June 15, 2020, Compound launched what later became known as "liquidity mining" incentives, igniting the "DeFi summer" and subsequently a year and a half bull market in the entire crypto market. As before, this bull market also ended with a dramatic decline. By June 15, 2022, the total market value of the entire cryptocurrency market had dropped by 67.5% from its peak.

We believe that the main reasons for this market crash are five:

First, global central banks are tightening monetary policy.

Second, the lack of transparency in the operations of many centralized institutions in the crypto industry has led to the market's inability to timely and fully understand the internal accumulation of leverage risks, increasing the risk of sudden market crashes and panic.

Third, the products in the crypto economy are still primarily speculative digital assets, with very few services and products that have clear value and meet real needs; the transformation towards consumerization has just begun and has not yet become a stabilizing force for the industry's growth.

Fourth, since 2020, collateralized lending has become the main mechanism for liquidity creation in the crypto market, but this mechanism has not matured, leading to a death spiral of liquidity during market downturns.

Fifth, a large number of pseudo-innovations in DeFi have led to market dysfunction, misallocating a significant amount of capital and resulting in substantial losses.

The first issue mentioned is a macroeconomic problem, which is an external factor, while the other four issues are internal factors within the industry. We are preparing to write four articles to discuss these four internal factors and propose improvements.

This article discusses the market dysfunction caused by pseudo-innovation in DeFi. It should be noted that this factor is relatively minor in this market crash, but it is not to be overlooked for the DeFi industry.

DeFi's Extraordinary Plunge and Market Dysfunction

In this market crash, DeFi's performance was particularly poor. By June 15, 2022, while the total value locked in DeFi had dropped by 69%, roughly in line with the overall market, the market capitalization of DeFi projects experienced extreme collapse, with Uniswap's market cap losing 88.5%, Compound's market cap dropping by 94.2%, and many once-popular DeFi projects facing bleak prospects, with declines mostly exceeding 95%.

We believe that such a collapse in the DeFi market is abnormal. DeFi is the first category of purely on-chain applications with a clear profit model, and compared to CeFi in traditional finance and the crypto market, it offers better openness, greater transparency, and higher overall efficiency. Therefore, there was a time when people not only believed that DeFi's explosion was a given but also trusted that its success could be sustained, believing that DeFi could lead the bull market and withstand bear markets.

If that is the case, why did DeFi perform particularly poorly during this plunge?

One factor that cannot be overlooked is market dysfunction caused by pseudo-innovation, meaning that many DeFi projects, under distorted objectives, deliberately created complex financial assets, business logic, and incentive mechanisms, transmitting a large number of false price signals to the market, leading to significant misallocation of capital.

Market dysfunction is an economic term used to describe the failure of market mechanisms in resource allocation. In most cases, market mechanisms can guide participants to spontaneously adjust and optimize resource allocation through price signals. However, in certain situations, market mechanisms fail, and resources cannot be effectively allocated, leading to severe waste and inefficiency.

All economics textbooks will tell us that there are three main reasons for market dysfunction: first, products have externalities; second, market structures are inadequate; and third, there is information asymmetry. The primary reason for the dysfunction in the DeFi market this time is information asymmetry.

Information asymmetry can lead to market dysfunction. George Akerlof revealed this principle in "The Market for Lemons: Quality Uncertainty and the Market Mechanism." In the used car market, due to unavoidable information asymmetry regarding the actual condition of a car, buyers either overpay or, in a bid to avoid being scammed, only offer the lowest price, resulting in the loss of the price signal's function and the failure of the market mechanism.

The key role of blockchain and DeFi is to reduce information asymmetry. The two main characteristics of DeFi are its permissionless complete openness and its total transparency, where business logic and transaction records are fully transparent, allowing anyone to query and audit.

Given this, why do we say that the DeFi market is dysfunctional? Why do we believe that DeFi's extraordinary plunge is related to market dysfunction?

Leading projects that developed in the early stages of DeFi, such as MakerDAO, Uniswap, Compound, Aave, indeed positioned themselves with values of openness, transparency, and the elimination of information asymmetry. They are relatively simple and clear in logic, with complete documentation, and have been running long enough for the outside world to fully understand their business logic.

However, in the past two years, some so-called innovations in the DeFi industry have not only failed to leverage technological advantages to reduce information asymmetry but have also sought to create new information asymmetries inappropriately. These pseudo-innovations not only failed to solve real problems but also obscured the core highlights of DeFi, leading to severe dysfunction in the capital market under the deliberately created information asymmetry. In other words, in DeFi's financing and asset trading, investors, traders, and DeFi users allocated a significant amount of capital to the wrong places. Therefore, when the market adjusted and corrected, these misallocated funds suffered losses far beyond expectations, increasing market volatility and causing the market capitalization of DeFi projects to collapse.

Thus, we believe that viewing DeFi's recent plunge from the perspective of market dysfunction will be meaningful.

Four Manifestations of DeFi Market Dysfunction

The dysfunction in the DeFi market is caused by new, deliberately created information asymmetries, which sounds counterintuitive at first because DeFi is known for its transparency and trustworthiness. Proponents of DeFi often proudly claim that in DeFi, everything from transaction records to financial logic to implementation code is transparent, and as long as one is willing to study, they can have equal information and knowledge with the project parties.

In theory, this is indeed the case. DeFi has achieved mandatory transparency in its technical infrastructure. However, many DeFi projects, for various reasons, have recreated information asymmetries, intentionally or unintentionally misleading the market. Specifically, there are several scenarios.

The first scenario involves various whimsical financial pseudo-innovations that cover up fatal flaws through complex logic, code, and incentive mechanisms such as "liquidity mining."

Throughout hundreds of years of financial practice, many ingenious ideas have emerged, most of which have been eliminated by history due to serious flaws. After the explosion of the "DeFi summer" in 2020, a multitude of participants rushed into DeFi, many of whom lacked relevant expertise and knew little about financial history. Driven by the enthusiasm for gold mining and a bit of cleverness, they launched various DeFi projects. Many of these projects lacked rigorous theoretical derivation and did not conduct market testing; some even violated basic financial principles and had serious loopholes, relying entirely on rising token prices or the overall market. Once situations exceeded expectations, especially in extreme market conditions, they would reveal numerous flaws and be dramatically disproven.

However, these pseudo-innovations are often very adept at piling on complexity to create opacity, obscuring their defects. They often construct complex mathematical formulas to "add the finishing touch," claiming to produce miraculous effects, and then copy a large amount of code from mainstream protocols, mixing, modifying, and stirring it into a pot of incomprehensible smart contract code soup. During that phase, we encountered and studied many projects, many of which had bizarre ideas and complicated code. Even for experienced smart contract developers like us, it was impossible to quickly understand their entire logic and discern their authenticity.

Faced with such complexity, the market lacked the capacity to identify and assess it, leading to significant venture capital being misallocated to pseudo-innovation projects. Many of these projects secured funding and once achieved high market capitalizations. However, after a period of testing, the vast majority of them have been disproven by the market, resulting in nearly total losses for the capital allocated to them.

Worse still, in the competition for capital and traffic, almost all such projects established very complex mining incentive mechanisms, often including three or more assets, a multitude of intertwined complex rules, and highly arbitrary, ever-changing governance models. Even relatively simple businesses, under the chaos of such incentive models, completely lost transparency and predictability, making it impossible for anyone to evaluate them.

For such projects, value investors naturally keep their distance, and project parties can only create highly speculative Ponzi structures to attract gamblers, such as deliberately obscuring the functions and rights of governance tokens, creating cascading nested "two pools," "three pools," condoning leveraged bribery, and inducing participants to engage in multi-layered cycles, continuously increasing nominal yields. Of course, the high yields offered by the project parties are unsustainable, and miners are well aware of this. Thus, one side tries to maximize the market through Ponzi structures, while the other side, like a school of sharks, comes and goes swiftly, drawn by the scent of profit, with both sides hoping to gain from each other before immediately discarding one another, forming a highly malignant, deceitful game structure that is contrary to the original intention of DeFi projects.

In this factually fraudulent game structure, misleading becomes a deliberately pursued goal, and information symmetry is as elusive as a mirage, making it impossible to discuss; how could the market not be dysfunctional?

The second scenario involves treating "governance tokens" as stocks, misleading many funds into making incorrect allocations by treating the total value of governance tokens as the project's market capitalization.

To avoid being classified as securities, most DeFi projects describe their governance tokens as having only voting rights, governance rights, and other "political rights." However, we all know that these governance tokens are rarely used for voting and are mainly traded. This creates a dilemma: how to value the votes? This is, of course, impossible to clarify, resulting in the actual value of these governance tokens becoming very difficult to assess and exhibiting extreme volatility.

We do not criticize this situation itself, as it is an inevitable result under uncertain regulatory environments. In fact, whether there is information asymmetry regarding such assets is worth discussing. Because both project parties and traders know very little about the actual value of these assets, in this sense, these assets are opaque but information symmetric. Therefore, a more accurate description would be that there is price speculation on an asset whose valuation logic is unknown to everyone. This in itself is not problematic; Bitcoin is a representative of such assets.

The problem is that a misleading narrative has emerged in the DeFi market, equating "governance tokens" with project stocks to calculate the project's market capitalization. This narrative has misled many funds into being allocated to governance tokens, even to leveraged assets based on governance tokens, resulting in unexpected losses. In fact, this has also led to an imbalance between rights and responsibilities for project parties: they can enjoy the benefits brought by market cap bubbles during bull markets but have no obligation to support the price of governance tokens with real business income during market downturns.

For example, at the lowest point on June 15, Compound's TVL still exceeded $4 billion, with good interest income. However, the market cap of COMP was only $212 million. If one were to value the Compound project, many would likely assign a higher value, but the relationship between COMP as a governance token and the value of the Compound project is unclear, and Compound's operational income cannot support the price of COMP.

Such misleading narratives have led many investors to believe they are investing in DeFi projects themselves, while in reality, they are merely investing in a value-ambiguous voting right. When the market crashes, the healthy profit situation of these projects cannot be transmitted to governance tokens, nor can it provide market support.

The third scenario involves creating assets that are nominally safe but actually high-risk through complex nested structures, transmitting false interest rate signals to the market.

Many DeFi projects after 2021 are not genuinely solving any financial problems but are instead focusing all their energy on constructing assets with false risk-return structures. Compared to the first scenario, these "innovations" do not create information asymmetry through code complexity but utilize the open infrastructure of DeFi to create very long financial structure chains, often including several third-party protocols and dozens of assets, with layers of nesting and complex combinations, resulting in even more opaque assets. Regardless of how they are packaged, these assets are fundamentally constructed on high-volatility assets with leverage and thus inherently belong to high-risk assets. However, due to their complex construction, very few people, if any, can fully penetrate and understand their mechanisms and dynamics. As long as a pretty story is added, these assets can be packaged as high-yield, low-risk innovative financial products, attracting a large amount of capital. As long as this continues for a sufficient period, it can shake people's rationality.

This approach also has a particularly detrimental effect: it transmits false risk-free yield price signals to the market, leading to price chaos in both primary and secondary markets: a significant amount of capital is misallocated to high-leverage assets disguised as safe assets without awareness, while many quality startup projects fail to receive sufficient funding due to their inherent high risks.

We have all seen the fate of such assets. When the market undergoes systemic adjustments, these so-called risk-free assets collapse rapidly and unexpectedly. Many investors who thought they could lie on a safety net to collect high interest suddenly find that not only are the interest rates illusory, but they also lose everything.

The fact that a large amount of capital is misallocated to high-risk assets without awareness, only to cry foul when they crash or even go to zero, is one of the significant characteristics of this market crash and has not happened before.

The fourth scenario involves, under competitive pressure, forcibly incentivizing pseudo-demand through liquidity mining and high yields, leading to false prosperity and transmitting erroneous signals to the market.

Since Compound successfully launched liquidity mining, almost all DeFi projects have introduced their own liquidity mining incentive mechanisms. It should be noted that when used appropriately, this mechanism can help projects rapidly expand their user base and create network effects. However, the use of liquidity mining incentives should be limited to real business objectives and serve to promote genuine business growth. Once detached from this goal and high yields are used to incentivize pseudo-demand, it will accumulate enormous risks and lead to malignant game structures.

For example, some complex derivatives protocols did not have real demand during the early stages of DeFi's development. However, project parties, in order to quickly increase trading volume, constructed special incentives to create short-term false prosperity. Since there was no real demand, once the incentive intensity weakened, a collapse occurred immediately.

A typical example is that many DeFi protocols split Aave's approximately 4% APY into priority and subordinate, then incentivized governance tokens to offer APYs of over 10-20% to create the illusion of high trading volume. However, such a game structure is clearly unsustainable; these protocols, after offering a large amount of governance token incentives, were ruthlessly dumped, unable to establish a loyal user base through the initial massive incentives, nor could they accumulate the funds needed for survival, leading to immediate project death when yields could not be maintained.

Learning Lessons from the Crisis

Our suggestion: Return to simple, clear, principle-based innovation.

DeFi is destined to be a great innovative movement that changes human finance and economics. This movement has entered a new cycle amid the brutal downturn of 2022. In the last cycle, many once-renowned tricks and trendy concepts revealed their true nature in the unexpected market winter. However, in the metaverse of financial markets, which infinitely amplifies human flaws, they are destined not to die but merely to hibernate. In the next warm spring of the crypto market, they will surely re-emerge, transformed. Although by then the stars of market innovation may have changed to Web3, DeFi will still be the central character as an indispensable core infrastructure of Web3. We can be certain of two things: first, DeFi will shine brightly once again, and second, various monsters will return.

The DeFi industry should learn lessons from the crisis and avoid repeating past mistakes. We propose the following recommendations:

First, advocate for a new DeFi innovation philosophy that is clear, simple, principled, and core-focused. The market should cultivate an atmosphere that rejects all cumbersome, complex gimmicks and refuses to amplify and manipulate human greed and fear, treating tricks that obscure the essence with complexity as one would disdain a fraudster.

Second, explain the significance of DeFi innovation using economic principles. As the latest technological tool of the free market system, all blockchain and DeFi innovations should conform to basic economic principles, solve real problems, create actual value, and improve real efficiency, rather than merely being a trick to divide the cake. Such innovations should be able to explain their value creation mechanisms using basic economic theories, such as promoting the refinement of division of labor, expanding the scale of collaboration, reducing transaction friction, increasing transparency, lowering entry barriers, and improving regulatory enforcement efficiency, etc.

Third, oppose pseudo-innovations that do not create actual value, such as "Ponzi mining," "circular staking," and "leveraged bribery."

Fourth, create more transparent assets with clear valuation logic, such as debt-type assets, correct the misleading narrative of treating governance tokens as stocks, and reduce the active and deliberate layering of leverage on opaque assets like "governance tokens."

Fifth, establish industry-level stress testing mechanisms, such as creating simulated markets on testnets, advocating for and even requiring DeFi projects to conduct stress tests within them to examine their performance in extreme market conditions.

We know that the crypto and DeFi markets can never escape the foolish behaviors driven by human greed and fear, but we also believe that DeFi will not stand still. As the development of this crypto industry over the past thirteen years has proven, as long as we can honestly face the problems and learn from the lessons, we can achieve real progress and do better next time.