DeFi Minsky Moment: Stress Testing and Insights

Author: AC Capital Research

The digital asset market fell into a liquidity crisis in May this year, with token prices plummeting leading to on-chain position liquidations. The liquidity crisis had a very serious impact on the DeFi ecosystem. According to DeFi LIama data, the total value locked (TVL) dropped sharply, retracting more than 70% from its peak. Many well-known DeFi protocols faced issues such as payment difficulties, management chaos, and loss of trust during this crisis. This article aims to review this liquidity crisis, exploring the fundamental reasons behind its occurrence and the impact of the bear market environment on the development of the DeFi ecosystem.

1. The Beginning and End of the Liquidity Crisis

Bittracy will first review this liquidity crisis: In May 2022, the Terra ecosystem was attacked by short sellers, and LFG's rescue efforts failed, causing the $10 billion market cap LUNA to go to zero. Institutions like Jump Capital, Three Arrows Capital (3AC), and Celsius faced huge paper losses due to their large LUNA positions. Due to the high "stacking" nature of the DeFi ecosystem, "Finance Contagion" quickly occurred among crypto institutions, marking an important turning point from bull to bear market. In June, Bitcoin's price fell below $20,000, a 50% drop from the May peak. The significant liquidity loss from 3AC's LUNA holdings put considerable pressure on its capital, and with substantial holdings in GBTC, ETH, and other digital assets, the poor market performance further exacerbated 3AC's situation, leading to a sell-off of its investment tokens. Almost simultaneously, the lending platform Celsius was exposed for concealing losses, and to meet customer withdrawal demands, Celsius sold off its digital assets for liquidity, causing sETH to depeg.

The drastic fluctuations in digital asset prices led to a liquidity crisis in DeFi: lending protocols implemented liquidations on under-collateralized positions, and massive sell pressure triggered a spiral sell-off, causing further price declines. Meanwhile, the exchange pool price differences of stablecoin projects widened; uncollateralized and semi-collateralized protocols began to face bad debt risks. This decentralized financial ecosystem, once widely trusted by investors, appeared somewhat at a loss when facing the liquidity crisis. As of the time of writing, Bitcoin's price has risen above $20,000, and the impact of this liquidity crisis on DeFi is worth reflecting upon.

2. Fundamental Reasons for the DeFi Liquidity Crisis

From the entire process, the collapse of Terra seems to be the starting point of the market crash, but could the bull market have continued without Terra? In fact, the overall market cap of stablecoins stopped growing in April, and issues with risk management at Celsius and Babel have persisted. So what are the fundamental reasons for the liquidity crisis? This article will analyze the fundamental causes of the liquidity crisis using an "Up to Bottom" approach.

1) Macro: Tightening of the dollar depresses the valuation of digital currencies, and liquidity tightening increases pressure on the market

After the outbreak of the COVID-19 pandemic in 2020, global central banks initiated monetary expansion to stabilize the economy, with the growth rate of the US base money exceeding 300% year-on-year. The overflow of liquidity rapidly pushed up financial asset prices, with the Federal Reserve's balance sheet expanding from $4.16 trillion before the pandemic to $8.92 trillion, more than doubling. By 2021, the global economy gradually returned to normal; however, monetary expansion led to significant inflation, with the US CPI rising to a 40-year high. Starting in November 2021, Powell decided to tighten the scale of bond purchases and began tapering in June 2022. According to the balance sheet reduction path announced by the Federal Reserve on May 4 (reducing assets by $95 billion per month), by the third quarter of 2025, the Fed's balance sheet will fall below $6 trillion. The marginal tightening of liquidity has put significant pressure on overvalued assets.

US Treasury rates have long been referred to as the anchor for global asset pricing, and the rise in benchmark rates has reshaped asset valuations. In 2021, the overall market cap of digital assets first exceeded $1 trillion, and Bitcoin transformed from a value consensus among a small group into a truly significant asset class. In the macro context of liquidity contraction, the crypto market, which is highly sensitive to liquidity, naturally bore the brunt, which is a macro factor leading to the DeFi liquidity crisis.

2) Changes in the cryptocurrency market cycle: The end of the Bitcoin halving rally, exhaustion of Dapp innovation, and decline in new address numbers

From a mid-level perspective, we analyze the market changes in the second quarter from the viewpoint of the crypto world:

Historically, this Bitcoin halving rally has reached its end. Given Bitcoin's significant role in the digital currency world (with a market cap ratio around 70%), I reviewed the historical performance of Bitcoin after its previous three halving events. We can see that the halving of Bitcoin's block rewards is a unique cycle in the crypto market, and the reduction in block rewards raises Bitcoin mining costs, driving market trends. Referring to the past three halvings, each rally lasted about 22 months. On May 12, 2020, Bitcoin began its third halving, marking the start of this bull market. By May 2022, this bull market had lasted over two years, and the momentum from the Bitcoin halving is gradually waning.

From a technological advancement perspective, developer innovation shows signs of fatigue. In 2020, thanks to the innovative development of smart contracts by technical personnel, the decentralized world became vibrant: the "DeFi Summer" of Q2 2020; the GameFi wave of 2021; the rise of Layer 1. As we entered the second quarter of 2022, new Dapps were mostly replicas and optimizations of existing models, with fewer groundbreaking innovations. As an investor, Bittracy finds it challenging to identify promising investment targets. In an environment of "declining prices + lack of innovation," the market began to shift towards "narrative-driven" NFTs, gradually consuming market liquidity. Starting in May 2022, due to weak endogenous growth, the number of new addresses began to decline, and the crypto world’s attractiveness to external users was diminishing.

3) DeFi Mechanism: Downward price fluctuations easily lead to liquidity shrinkage and increased trading risks

• Price declines amplify Impermanent Loss, causing stakers to withdraw funds: When crypto prices rise or fall, there will be some Impermanent Loss. Due to the asymmetry of Impermanent Loss, when prices fall, stakers suffer more severely. Regarding the performance of Impermanent Loss in the face of market fluctuations, Pintail provided a detailed explanation in the article "Uniswap: A Good Deal for Liquidity Providers?": If the token price fluctuates significantly, it may lead to stakers' Impermanent Loss far exceeding their returns. Therefore, when the market shows signs of crisis, stakers often choose to withdraw their funds, creating a negative feedback loop that tightens DeFi liquidity, causing the total value locked (TVL) to shrink sharply in a short period.
• Large trades amplify AMM slippage: The AMM mechanism is the core foundation of DeFi, but it cannot avoid the price shocks caused by large trades. When the market declines, users often have an urgent need to redeem funds, and when large-scale trading occurs in a short time, the staked funds within the Swap cannot meet users' trading needs. First, in the DeFi ecosystem, the scale of staked funds in Swap Protocols is roughly equivalent to that in Lending Protocols, and during large-scale liquidations, the Swap Protocol cannot provide sufficient depth for liquidations. More importantly, under the AMM trading mechanism, large trades significantly impact market prices (a single large-scale liquidation can greatly affect the position of the trade on the fixed product curve), causing price deviations. Igor Mikhalev and Zoia Mandrusova demonstrated in "Agent-Based Modeling of Blockchain Decentralized Financial Protocols" that their research results show a positive correlation between trade size and slippage, with single large trades disrupting trade prices. The depegging of UST on the Curve protocol is the best example. On May 7, a trade exchanging $85 million UST for USDC in the STw-3CRV Curve pool directly led to the depletion of UST liquidity, showing that DeFi based on AMM struggles to cope with market crises.

Summary: Under the pressure of the macro environment, the digital asset market's poor performance affects not only DeFi but also CeFi and even traditional financial institutions, which are facing crises as well. The Federal Reserve's balance sheet reduction and the withdrawal of excess liquidity will tighten the financial environment and raise risk-free interest rates. The spillover effects of the Federal Reserve's policies will elevate global interest rate centers, exerting varying degrees of pressure on global financial markets, especially impacting some overvalued risk assets. Meanwhile, blockchain innovation has stagnated, and the industry's endogenous growth momentum is insufficient, leading to a decline in its attractiveness to the outside world. More importantly, due to the operational characteristics of DeFi trading mechanisms, the on-chain financial system's situation becomes even more precarious in the face of market adjustments.

3. Impacts of the DeFi Liquidity Crisis

1) DeFi enters a stock market, and concentration among top players may increase

Firstly, a declining market will directly lead to weaker on-chain trading volumes and decreased lending demand, intensifying the competitive environment in DeFi. Trading fees and interest spreads are the main sources of income for DeFi, and in a bear market, trading volumes and locked amounts will significantly decline, shrinking market space. For a long time to come, DeFi developers will have to face a stock or even shrinking market. The intensified competition is not friendly to newly launched DeFi Dapps.

Compared to the bull market, new protocols will find it harder to acquire liquidity in a bear market, and the market share of leading DeFi protocols may significantly increase. As risk appetite decreases, investors are losing interest in participating in new mining opportunities. Specifically regarding market-making mechanisms, DeFi protocols generate income by selling tokens upon launch, incentivizing market makers and users with tokens: using arbitrage costs (impermanent loss) and token rewards as functions of trading fees, determining the reward amounts for liquidity providers. However, in a market environment with low liquidity, the likelihood of users engaging in FOMO decreases, making it more challenging for new protocols to guarantee market makers' profits (maintaining token prices).

Investors should be aware that leading protocols are encroaching on the survival space of other protocols. Curve announced in July that it would launch over-collateralized stablecoins. Meanwhile, the lending protocol AAVE also plans to release its stablecoin GHO and provide corresponding Swap services. Against the backdrop of gradually weakening on-chain trading, leading DeFi protocols are entering other sectors, leveraging their advantages to expand growth space. Therefore, Bittracy believes that in the next two years, there is a logic for increased concentration in DeFi.

2) DeFi protocols need to optimize governance structures and improve governance efficiency

The "oligarchic governance" of DeFi protocols has not been resolved to this day. To put it bluntly, project teams and investors have strong control over the protocols, leading to a high risk of moral hazard. In the face of this pressure test, those organizations claiming decentralized governance (like Celsius and Terra) chose to sacrifice customer interests and engage in violations to seek self-preservation, leaving users' rights unprotected. In reality, the governance structure issues in DeFi have always existed; during the bull market, users turned a blind eye to them, but it was too late when the crisis occurred.

How to optimize DeFi governance has become a widely discussed topic among investors. Recently, in roadshows involving DeFi protocols, ensuring the interests of all parties in the face of market pressure has become the most discussed topic. In the early stages of project development, centralized governance is needed to ensure efficiency, and the community should establish effective mechanisms to prevent project teams from engaging in misconduct and avoid repeating past mistakes.

Earlier this year, I wrote an article about governance: "2022, Where Will DAOs Go?" In that article, I discussed that DAO governance methods are not suitable for all scenarios, and that centralized governance, when used appropriately, can ensure the effective operation of protocols. DeFi protocols should choose appropriate governance mechanisms based on their business nature to promote the long-term sustainability of the protocols.

• Innovation Direction: Asset security is gaining attention, with development opportunities in insurance and privacy sectors

In 2020, DeFi built a financial system for the decentralized world, laying the foundation for the industry's vigorous development. As the market strengthened, DeFi evolved towards higher efficiency and better returns. We saw semi-collateralized and even uncollateralized algorithmic stablecoin protocols (UST); uncollateralized lending protocols (TrueFi, Maple Finance); and higher-yield staking protocols (Alpaca Finance, Lido). Such liquidity innovations improved capital utilization efficiency and helped users enhance their returns. Among these, some protocols sacrificed liquidity for high returns, while others used higher leverage to obtain Farming Yield. However, due to the composability of DeFi, once the economic system experiences liquidity contraction, the highly stacked financial system can easily fall into crisis. Therefore, during market downturns, we witnessed the collapse of LUNA, the depegging of sETH, large-scale liquidations, and the chaos among Dapps.

Looking ahead, risk management should be prioritized by practitioners. Establishing an effective risk management system in the decentralized financial ecosystem should become a key focus for developers. After a flourishing period of liquidity innovation in DeFi, I personally look forward to the emergence of various "safety tools" in the DeFi world. For example, Gauntlet, as a decentralized risk management platform, aims to help DeFi protocols control risks while enhancing capital efficiency. The protocol provides guidance on capital utilization efficiency for DeFi protocols through sensitivity analysis in different scenarios, aiming to offer more direct incentives for market makers and users. Currently, Gauntlet has already collaborated with AAVE, Compound, MakerDAO, Sushiswap, and Balancer. Meanwhile, Gauntlet works with DeFi Pulse to assess the "economic security level" of different funding platforms. For instance, users deposit funds into Anchor to earn a 19.5% interest rate, yet even seasoned players may not know the risk levels they face. Gauntlet can serve as a rating tool on the consumer side to help users quantify risks. From a practitioner's perspective, we must acknowledge that risk management is currently a shortcoming in the DeFi ecosystem. Therefore, insurance and security sectors may welcome a promising development window.

4. Conclusion

As an important foundation for the development of the decentralized world, DeFi's returns during the bull market stemmed from the excessive inflation of governance tokens and the leverage that ignored risks, which are clearly no longer reliable in a market downturn. In a bear market, protocols need to earn their survival space through actual transaction fees and interest spreads. However, this is a good thing, as DeFi's development will align more closely with the essence of finance, and development teams will provide reliable business models and stable products for the market; more balanced governance models, more solid revenue methods, and safer risk management will be the fundamental logic for the future development of DeFi.