Dragonfly Investors: Analyzing the DeFi Cycle Narrative and Why It Lags Behind L1?

Written by: Celia Wan, Dragonfly Capital

Compiled by: TechFlow intern

When people start to question everything they believed during the bull market, you know it's the end of a cycle.

This crypto cycle began with Compound launching COMP and bringing the concept of single-asset staking to the masses, and it officially ended with the death of LUNA, which was overinflated and promised a 20% yield by Anchor.

This collapse triggered a series of reflective questions about the validity of all other DeFi projects—even Bitcoin:

Typically, when trends collapse, bubbles also evaporate. Take Terra, once the biggest success story in DeFi and L1, for example; its failure meant that single-asset staking lost its luster, expectations were reassessed, and prices adjusted.

Although many tokens are now at historical lows, the market is now converging on new prices that are not based on hype but are more grounded in a realistic view of the achievements made in the previous cycle. The bear market is a good time to reflect on last year and the actual progress we made.

To connect with the previous price cycle, we compared the current prices of some well-known DeFi and L1 projects with their historical peaks, as well as with the prices on November 1, 2020. This period was chosen because it was at the beginning of the cycle, when the situation for DeFi and L1 began to clarify, but the bubble was still small—Uniswap had launched its token two months prior, but prices had not yet rebounded; DeFi's TVL was on the verge of crossing the $10 billion mark, but it had not yet seen exponential growth; projects like Avalanche, Solana, and Terra had not yet launched their respective liquidity mining, and few were discussing them.

These price points can reveal some patterns:

1) The maximum returns that investment projects may have generated since the cycle began;

2) The ability of projects to retain value at the end of the cycle;

3) The drawdown experienced by tokens from ATH to the end of the cycle.

It turns out that DeFi and L1 both underperformed Ethereum and Bitcoin in terms of drawdowns. This is not surprising, as ETH and BTC have the strongest market consensus, which is less affected by market fluctuations. For the same reason, Ethereum and Bitcoin had worse maximum returns compared to most DeFi and L1 tokens.

At the same time, in terms of maximum returns, L1 is clearly the winner of this cycle. The top two projects, Solana and Polygon, gained fame in this cycle through ample ecosystem funding and liquidity mining incentives. Their maximum return rates exceeded five digits, far surpassing other L1s like Avalanche and Near.

Overall, L1s outperformed DeFi, and DeFi blue chips lagged overall (though they still achieved impressive four-digit returns). COMP and SNX performed worse, but this may be because their price cycles do not match the price cycle being discussed (SNX launched in 2018, while COMP started running before November 1, 2020).

This pattern tells us one thing—in past cycles, DeFi did not generate much alpha above the beta of L1.

Jason Kam has a good framework for thinking about this issue. During the DeFi Summer of 2020, he posed a rather meaningful question—if ETH is akin to an energy commodity that builds the petrochemical value chain (DeFi), then "is it better to invest in oil or petrochemical/industry chain stocks?"

Looking back at the achievements we made in past cycles, I believe the answer to this question is clear—the risk-return profile of underlying tokens is better than any applications based on them, at least for now. Over the past two years, blue-chip DeFi tokens experienced drawdowns similar to L1 during market downturns, but the upside potential they showed when the industry took off was not as strong as that of L1.

From a heuristic perspective, this is easy to understand. So far, most of the hype around DeFi has been because it can bring "users" and "liquidity" to L1. However, when users actually come to L1s, they are often attracted by staking incentives, and they quickly find that these incentives are the only thing they can do on the blockchain. Then, when yields are low, they will migrate to other L1s with higher returns.

In this relationship, L1 does not add value to DeFi. The existence of DeFi is to make L1 look good—it is a means to achieve growth in TVL and user numbers, which makes L1 appear "adoptive." However, many DeFi projects themselves do not benefit from different blockchains, and some projects are even hindered by chains that are not EVM-compatible and poor developer documentation.

As a result, these DeFi projects lack the intrinsic motivation to maintain their market value, their growth is not only highly dependent on L1's expansion, but their advantages are also limited by the ecosystems they belong to.

The most compelling numbers for this vicious growth pattern come from comparing the current token prices of these projects with their prices at the beginning of the cycle. These numbers indicate how much value DeFi and L1 projects can retain after the LUNA collapse washed away most of the bubble.

The results show that although almost all tokens gained double-digit growth during this period (except for COMP, 1INCH, and SNX), DeFi did not surpass Ethereum or L1 in terms of retention rate.

Take UNI as an example; its return rate from November 1, 2020, to today is 128.22%, while Ethereum's return rate is 208.26% (UNI recently also received an additional price boost due to the acquisition of Genie and a new NFT roadmap). In other words, if you had some Ethereum at the beginning of the cycle and held onto it, your performance would now surpass that of DeFi (holding is important, as Ethereum's maximum return rate is lower than UNI), and many other DeFi tokens are similar.

This is a sobering view of the value these projects leave at the end of the cycle; the old model of attracting users to DeFi with liquidity incentives and airdrops no longer works. DeFi brought users to L1 without caring about what those users actually did. The end result is that DeFi is part of a service industry that can only serve itself—users participate in DeFi to participate, not to utilize it for other activities. This self-service can sometimes devolve into a Ponzi scheme.

Of course, price is not the only important thing. In the past cycle, DeFi also saw some genuine innovations, the progress of which cannot be quantified by token prices. For example, Uniswap V3's groundbreaking concentrated liquidity feature opened up significant design space for the emergence of new applications; the demand for block space spurred a series of block space financialization protocols, such as Flashbots and Alkimiya.

Finally, some DeFi protocols launched their tokens later in the cycle and did not have the opportunity to fully realize their potential. For instance, projects like Lido, Ribbon, and dYdX have multiple products or industry updates coming soon, which will further drive their growth.

After the Ethereum merge is completed, Lido's TVL will receive a significant boost. Ribbon offers a wide range of structured products that are well-suited for the on-chain composable environment but have yet to be developed. dYdX and some other derivative protocols still have a massive untapped market to capture, especially when comparing their trading volumes to off-chain peers.

The fact is, while L1 was able to surpass DeFi in the last cycle, neither can further develop if we cannot figure out where new users are coming from.

When new categories emerge, DeFi will once again become exciting, as these categories can bring real users into the blockchain, users who have actual financial needs that DeFi can serve. The rise of NFTs and Web3 in the latter half of the cycle has already indicated a demand different from over-leveraged tokens; these categories will attract new users and reconnect them to DeFi, which will be the story of the next cycle.

Before that, many questions remain to be solved, and teams need to commit to important research in DeFi. The bear market will provide them with the much-needed time to focus on their products rather than rushing token listings and promotions.