In just 8 months, DeFi has attracted more than $100 billion in funds into the contract . These contracts not only contain traditional financial elements, but also express new financial elements. These innovations provide individuals with opportunities to truly own their own assets, participate in global capital coordination, trade through decentralized exchanges, use the lending market, and so on.
In this article, we will explore the current status of DeFi built on Ethereum and study its growth and availability indicators.
DeFi upgrade
DeFi is both a technology and a sport . Teams of researchers and engineers have joined forces to reimagine financial services. From the early smart contract innovations, such as raising funds through ICOs, early NFT experiments, such as CryptoKitties, and the initial DEX implementation, reflecting the decentralized future of finance, these projects have come a long way.
The above chart shows the explosive growth of user base and value in the DeFi ecosystem . What we have seen is a storm of innovation and the spirit of innovation behind finance. The entire community has been guided by participating in the DeFi protocol. Incentive measures urge users to move toward products, effectively increasing and retaining users and capital.
In 2019, Synthetix conducted the first DeFi experiments in liquidity mining to incentivize and guide the sETH/ETH Uniswap pool. This later inspired a wave of yield farming projects in 2020, most notably after Compound Finance enabled COMP token liquidity mining in its borrowing and loan markets.
The introduction of incentives for lenders and borrowers to earn COMP popularized the agreement-the total value of the agreement jumped from $100 million to $500 million in a week.
The key innovation here is actually a social innovation, that is, participants who provide liquidity and use the agreement will be rewarded by the protocol governance token, so attracting users and liquidity has become the name of the game for the DeFi protocol.
Measuring DeFi adoption
The growth of DeFi can be expressed in many ways, the most intuitive is to measure active users. Since the early days of the DeFi experiment, the growth of users has been explosive. Since the beginning of 2018, more than 2.1 million addresses have interacted with Ethereum DeFi in some way .
If every Ethereum address is part of (TAM), so far, DeFi has penetrated less than 3% of Ethereum addresses with non-zero balances (approximately 58 million addresses). With the increase of Ethereum applications, the potential TAM of DeFi applications is also increasing .
A metric called “Total Value Locked” (TVL) has become popular to describe the total assets deployed in smart contracts. Locking, depositing, storing, sending, lending, and providing all have the same meaning in the context of TVL. In the exchange, we can treat these assets directly as liquidity, and in the loan agreement as collateral .
The relevance of TVL varies from protocol to protocol, and it should always be considered in conjunction with utilization, transaction volume, and other usage indicators . Utilization rate describes how much liquidity of the supply side of an agreement is effectively utilized by the demand side. Take the lemonade stand in classic economics as an example.
- Suppose I produce 100 glasses of lemonade every day. This is the 100 cup supply available to the demander.
- Now we assume that the demand side buys and consumes an average of 70 cups every day. That is 100-70=30 cups of lemonade are not used. We can assume that as a supplier, I might start to make fewer cups every day to meet demand more closely.
- But, wait if the local government comes and say they will subsidize my lemonade stand and buy these 30 extra cups of lemonade every day, regardless of usage (this is roughly equivalent to the liquidity mining reward provided by the agreement)? We now have a rational lemonade manufacturer to continue supplying 100 cups of reason.
Therefore, although $124 billion of TVL may exist in the system, this is a nascent market, and capital will flow to where it expects the best risk/return. If users are scarce, but liquidity incentives are strong, rational actors will flow to these opportunities. However, in order to determine whether these agreements are developing a loyal user base, we must dig deeper into indicators that describe the stickiness of end users and liquidity providers .
Adopted by DeFi protocol type
Borrowing and lending market
The explosive growth of lending agreements because users are attracted.
- Earn interest for their tokens
- Gain leverage and the ability to short on-chain
- Obtain the liquidity of other tokens without the need to sell the tokens they currently hold
Maker introduced the first DeFi lending market, allowing users to generate DAI with ETH deposits. Over time, there will be more types of collateral.
Compound popularized a wider range of asset lending and provided more token lending. When lending a position, the lender receives cTokens on behalf of his deposit. These cTokens can be used as the basis for other protocols .
Aave began to compete with Compound, providing different economic models, using users’ collateral to borrow up to 75%, and providing a larger selection of tokens for borrowing/lending.
In each agreement, we have a separate currency with different interest rates and utilization rates. The following are examples of compound interest and Aave. Utilization rate = 1-(free flowing funds/market size). If there are US$1 billion in deposits and US$100 million in loans, the utilization rate will be 10%.
In these markets, interest rates change according to the utilization curve. As the overall market utilization rate increases, interest rates also increase to encourage more lenders to enter the market and borrowers to withdraw. Conversely, as the utilization rate decreases, the interest rate will also decrease to encourage more borrowers to enter. In the chart below, we notice how the current utilization rate affects the interest rate in the DAI market of compound finance .
Markets with higher utilization rates reward lenders with higher yields to attract more liquidity. It also becomes more expensive for borrowers.
These markets have been growing steadily since their inception, and the stablecoin market has the highest activity and utilization rate. As we can see in the figure below, stablecoins are balanced in terms of borrowing and lending, with the average utilization rate exceeding 75% in most cases. Volatile assets like ETH and wBTC are usually rich in collateral, but few borrowers.
Arbitrageurs will transfer their deposits and borrowing capital to any place where they can find superior interest rates/risks and returns. There is a risk premium for participating in low-liquidity markets. Interest rates tend to smooth and normalize, as shown by the USDC interest rate between Compound and Aave over time. The new liquidity mining plan and other effects will bring new interest rate fluctuations .
Liquidity incentives and lenders attracted by attractive yields channel liquidity, and borrower adoption follows. This continued liquidity and utilization has led to attractive interest rates and continued adoption by borrowers and lenders.
Decentralized exchanges (DEXs)
The use of DEXs has exploded in the past year. Although borrowing and lending have obtained the most liquidity, DEXs have gained the most users with a great advantage. Among the 2.1 million users interacting with DeFi, 1.53 million users have used Uniswap at some point (about 73%) . In comparison, 316,000 users interacted with Compound at a certain point in time (about 15%)
Liquidity providers deploy capital to earn a share of transaction fees and liquidity rewards . Users are attracted to the platform through market depth and the availability of tokens they are interested in. A positive feedback loop is created, more users create more fees, and more fees attract more liquidity. When the liquidity reward expires, enough users and income from fees keep liquidity in the agreement.
As far as the actual demand side of these products is concerned, the trading volume has always been strong. The 12-month trading volume is 420 billion U.S. dollars, and the 30-day trading volume is 67 billion U.S. dollars. Among all Ethereum DEXs, the daily trading volume is in April. At its peak, more than $3 billion . In addition, so far, 1.98 million unique addresses have interacted with DEXs.
Measure the relationship between liquidity and users, we can get an interesting point of view, that is, which exchanges can meet the stickiness of the supply side and the demand side. The holy grail adopted is when a DEX can attract strong and continuous liquidity and trading volume for a long period of time .
Although in the case of Curve, their liquidity seems to be inflated relative to transaction volume and fees, Curve focuses on stablecoin pairs with much less volatility. In addition, Curve invests the assets in the liquidity pool to Compound and Year Finance to obtain additional income in addition to transaction fees. They are an example of DeFi projects benefiting from composability; projects such as Yearn use their platforms as the basis for stablecoin swaps and liquidity mining.
We can also measure the health of an exchange through user retention rate. Some exchanges insist on using incentive schemes to maintain strong liquidity, but their user retention needs to be improved .
In the breakdown below, we see that Uniswap lost 240,000 addresses in April, while retaining, returning and creating 615,000 users. We saw that Sushiswap lost 18,000 addresses, while retaining, returning and creating 31,000 users. This makes Uniswap’s net retention rate + 375,000 users, and Sushiswap’s net retention rate + 13,000 users.
Collateralized stablecoin
The use of stablecoins has become a core tenant of DeFi, and the centrally issued and reserve-backed tokens USDT and USDC dominate the market share. Stablecoins have become the base currency for most DEX pairs and lending markets .
The biggest attempt to design a decentralized stablecoin is DAI, which maintains a soft peg to the U.S. dollar through market arbitrage and has no central reserve. DAI is the currency of MakerDAO, backed by collateralized debt positions in ETH and other tokens. MKR tokens are used as the last asset and can be used to repay the lender in the event of any bankruptcy. In order to incentivize MKR token holders, when debt holders repay the stability fee, MKR tokens will be burned, which is similar to the interest rate that keeps the system stable.
Although USDT and USDC are clearly dominant, the growth of DAI as a stablecoin is still impressive. Since its inception, its circulating supply has reached more than 3.6 billion U.S. dollars .
DAI has historically maintained a relatively stable peg to the US dollar. Although the issuance is managed by MakerDAO, traders often try to profit from arbitrage opportunities, short DAI above $1 and long DAI below $1. This kind of transaction can additionally deposit ETH to mint DAI, or conversely repay CDP to withdraw collateral.
To prove this, we can see which DEX liquidity providers have established the deepest liquidity pool centered on DAI of about $1.
We also noticed the use of DAI in various DeFi protocols. Keeping a hook is good, but actual usage in top DeFi projects is more important.
In the lending market, DAI is the stablecoin with the second most collateral in Compound , followed by Aave. Considering that the total outstanding supply of DAI is less than 10% of the total supply of USDC, USDT and DAI, this is quite healthy.
In a decentralized exchange, a look at the supply side of DAI will reveal healthy liquidity. DAI claims on Uniswap to have about 19% of stablecoin liquidity.
On the demand side, DAI’s trading volume accounts for approximately 15% of the daily trading volume of Uniswap including DAI . USDC and USDT each account for approximately 43%.
Stablecoins are one of the most used assets in DeFi. The strength and stickiness of stablecoins in DeFi are marked by some key characteristics.
- USDC, USDT and DAI represent the dominant DEX trading pairs
- Stable coins provide sufficient liquidity and strong utilization in the lending market
- DAI remains pegged and its adoption continues to increase without the need for reserves backed by US dollars.
Users lock their assets in the Year’s vault and automatically allocate funds among various strategies . The basis of these strategies described in the Yearn document is this.
- Use any asset as working capital.
- Use liquid funds as collateral and manage the collateral through algorithms to avoid defaults.
- Borrow stablecoins.
- Use stablecoins for liquidity mining and/or earn fee income.
- Reinvest returns and create compound interest growth.
For example, DAI Vault utilizes a complex strategic network and interoperable agreements to create revenue for depositors. This level of complexity and strategy is too complicated for ordinary users, so Year provides users with a single-click solution that does not need to fully understand the complexity of how their funds are invested in work . They directly charge 2% management fee and 20% performance fee for their own efforts, which is different from typical hedge funds 2 and 20.
The increase in user trust in the Year system is due to relatively few smart contract vulnerabilities, the ability of developers and strategists, and the continuous competitive rate of return provided by automatically finding and transferring deposits to the highest revenue source.
Yield aggregators have been adopted by individual DeFi users and projects as a key part of the infrastructure. Users go to Year to find a simple way to participate in DeFi opportunities, while minimizing gas costs, complexity and liquidation risks. The project integrates Year into its key infrastructure for the project-Badger DAO and Alchemix each have deposited more than $300 million in Year, and more projects continue to add Year.
With the strong growth so far, capital continues to accumulate in Year and other aggregators, with little sign of slowing down .
Conclusion
Decentralized finance has changed from a niche area of cryptocurrency to a leading area in less than 12 months. Although the locked-in total value ($124 billion) is an effective indicator to measure the overall DeFi adoption, it hardly explains the true adoption and the full scope of the product market. On the contrary, more useful indicators can be used to understand the overall picture of the supply side (liquidity) and the demand side (number, users, utilization, retention rate, etc.).
In just 12 months, DeFi has been reached.
- More than 2 million users
- Locked in value of more than 120 billion U.S. dollars in all DeFi-related smart contracts
- On decentralized exchanges, daily trading volume often exceeds $20
- The utilization rate of stablecoins on lending platforms often exceeds 80%, with liquidity exceeding US$10 billion
- A decentralized stablecoin (DAI) has a circulation of more than 3 billion U.S. dollars and revolves around the stability of its soft peg.
The most exciting thing is that this is just the beginning of the future development of the financial industry.