DeFi Year-End Summary: 2021 Status, 2022 Outlook

The Block
2021-12-27 23:31:21
Collection
Predictive markets, non-dollar stablecoins, tokenization of real-world assets, governance transformation, and DeFi forks are worth our attention in 2022.

Source: The Block

Compiled by: Baize Research Institute

Summary of this section:

● The total value locked (TVL) in DeFi has exceeded $100 billion, with most allocated to lending platforms and decentralized exchanges. However, the performance of most DeFi tokens has lagged behind Ethereum.

● The amount of funds stolen in DeFi has increased eightfold compared to last year, with a total of 50 attacks amounting to $610 million.

● Regulatory pressure will fork and reshape DeFi. It is expected that more applications will impose KYC requirements and will need to enhance user trust in product developers.

1. The State of DeFi in 2021

Decentralized Finance (DeFi) is an open financial system powered by smart contracts and blockchain oracles, with the potential to replace decades-old infrastructure and opaque financial processes. DeFi provides users with permissionless and location-agnostic access to various financial tools without relinquishing control of their assets to intermediaries like brokers or banks.

The "DeFi Summer" of 2020 sparked a liquidity mining craze and opened up infinite opportunities for DeFi. This year, the total value locked (TVL) in DeFi protocols skyrocketed from $16.1 billion to $101.4 billion, with most funds allocated to lending protocols and DEXs.

DeFi Year-End Summary: 2021 Status, 2022 Outlook

However, after dominating the crypto market in the first quarter of this year, the performance of DeFi tokens began to fade. The "DeFi" index was 1.0% in January, peaked at 3.2% in April, and is now at 1.5%.

DeFi Year-End Summary: 2021 Status, 2022 Outlook

If we take the "blue-chip" DeFi tokens (UNI, AAVE, COMP, SUSHI, SNX, CRV, and YFI) as a proxy for DeFi tokens year-to-date, most of their prices have outperformed Bitcoin but not Ethereum. Since the first quarter, CRV is the only DeFi token that has surpassed Ethereum after explosive growth in the fourth quarter, while SNX, YFI, and COMP have recently performed the worst.

The significant increase in Ethereum's strength can be attributed to the majority of DeFi growth being concentrated on Ethereum. Uniswap is the most widely used DeFi protocol, with over 1 million active users in May, and on average, 45.7% of Uniswap's monthly active users are new users.

DeFi Year-End Summary: 2021 Status, 2022 Outlook

Uniswap also captures a significant portion of the total revenue generated by DeFi protocols, with monthly revenue reaching $2.2 billion. However, most recorded DeFi revenue is from the supply side, meaning fees that belong to protocol users (such as liquidity providers and lenders). Only 8.1% of the revenue generated by these DeFi protocols flows to protocol developers and their governance token holders.

Lending

Lending is one of the main pillars of DeFi, with the TVL witnessing unstoppable growth from $7.1 billion in 2020 to $46.8 billion in 2021, an increase of 559.2%. The top three lending protocols by locked value are Maker, Compound, and Aave, with TVLs of $18.3 billion, $12.8 billion, and $10.8 billion, respectively, and total outstanding debts of $9.1 billion, $7.7 billion, and $6.5 billion.

DeFi Year-End Summary: 2021 Status, 2022 Outlook

A common feature of these widely used lending protocols is that all loans issued must be over-collateralized. If a position is deemed to be at risk (when the position falls below a certain minimum collateral ratio), custodians can forcibly liquidate the collateral to repay the outstanding debt. In this way, loans can be withdrawn anonymously and trustlessly while reducing the risk of protocol bankruptcy in the event of borrower defaults.

Although established lending protocols have long dominated the space, the lending landscape is becoming more diverse as new lending platforms implement tweaks and target different niche audiences.

Alchemix and Abracadabra can use yield-generating positions as collateral, somewhat alleviating the inefficiencies of capital but introducing composability risks. Additionally, TrueFi is the first on-chain uncollateralized lending platform that maximizes capital efficiency for reputable borrowers.

Decentralized Exchanges (DEX)

In addition to lending protocols, Automated Market Makers (AMMs) can attract liquidity from market participants eager to deploy idle assets for yield.

Overall, the total monthly trading volume of DEXs peaked at $162.8 billion in May 2021, with the most significant month-over-month growth occurring in January, increasing by 137.3%. However, trading volume has not fully recovered from the market downturn in May, and the ratio of DEX to centralized exchange spot trading volume has remained below 10% throughout the year.

DeFi Year-End Summary: 2021 Status, 2022 Outlook

Curve has become the largest DEX with a locked value of $16.8 billion, accounting for 6.8% of the total DEX locked value. Curve is an AMM optimized for trading between like assets, achieving low-risk and sustainable yields due to its liquidity mining (LM) and adjustable pricing curves.

On the other hand, Uniswap continues to lead in trading volume. Uniswap v2 was the largest DEX by trading volume until it was surpassed by Uniswap v3 in June. During the peak in May, Uniswap v2's monthly trading volume reached $59.2 billion, but due to v3's concentrated liquidity design significantly reducing slippage, it pales in comparison.

DeFi Year-End Summary: 2021 Status, 2022 Outlook

However, as the number of DEXs increases, liquidity becomes increasingly fragmented, and users may prefer to trade through DEX aggregators. These aggregators optimize swap routes to provide better execution. Surprisingly, only an average of 13.9% of DEX trading volume comes from aggregators. More trading volume still belongs to DEXs or trading bots. 1inch is the leading DEX aggregator this year, with a market share of 64.9%, followed by 0x API (Matcha) at 16.8%.

DeFi Year-End Summary: 2021 Status, 2022 Outlook

Derivatives

Perpetual futures contracts have been the largest segment in the crypto industry, and while DEXs have become competitive over the years, the next step for growth is to expand into the derivatives market.

Perpetual Protocol led the derivatives market trading volume in the first half of 2021, setting a weekly trading volume record of $551.1 million during the week of the market downturn in May. Perpetual operates on the xDai sidechain and is built on a virtual AMM (vAMM) that parameterizes market depth. Using this model, the protocol can provide instant liquidity without counterparties.

DeFi Year-End Summary: 2021 Status, 2022 Outlook

dYdX made a comeback after launching its native token DYDX in August and initiating a liquidity mining program. dYdX relies on StarkEx, a zk-rollup (Layer 2) solution. It employs a hybrid infrastructure model that utilizes non-custodial on-chain settlement and an off-chain low-latency matching engine with an order book. Liquidity on dYdX primarily comes from professional market makers (e.g., GSR and Wintermute).

Perpetual futures typically operate independently of other DeFi protocols, sacrificing composability for improved capital efficiency.

Synthetic assets are tokenized derivatives. Synthetix is the oldest and largest synthetic asset issuance protocol to date. SNX stakers can mint synthetic tokens through over-collateralization and trade them with other synthetic tokens on the platform, which provides no-slippage execution based on oracle prices.

The trading volume on Synthetix primarily comes from forex (52.2%) and cryptocurrency (47.1%) synthetic tokens, with July being the month with the highest trading volume, reaching $1.6 billion. The average daily number of traders on Synthetix dropped from 167.5 in January to 13.8 in November, indicating its failure to attract trading users' interest. After its recent migration to Optimism, whether it can regain user favor remains to be seen.

DeFi Year-End Summary: 2021 Status, 2022 Outlook

On the other hand, the synthetic stock protocol Mirror on the Terra public chain mimics Synthetix's over-collateralization method but removes the no-slippage trading product, so synthetic tokens can only be traded on secondary markets. This shifts the burden of open contracts to the public market, causing synthetic tokens issued by Mirror to trade at a premium.

In recent months, the TVL of these two platforms has remained stable, with Synthetix at $1.7 billion and Mirror at $1.3 billion. Due to increasing regulatory pressure, their growth may be hindered, as the U.S. Securities and Exchange Commission (SEC) recently initiated enforcement action against Mirror.

DeFi Year-End Summary: 2021 Status, 2022 Outlook

However, not all types of derivatives thrived in 2021, as the decentralized options market has yet to mature into an effective hedging tool due to a lack of liquidity and overly complex mechanisms.

Structured Products

In recent years, the growth of DeFi has also been accompanied by increasing complexity in portfolio management, giving rise to numerous pre-packaged structured products that abstract the complexity of different financial instruments to save investors time and costs.

The first iteration of structured products is yield aggregators, which can automatically optimize yields for depositors. Convex is the largest yield aggregator by TVL. Launched in May 2021, it specifically enhances rewards for liquidity providers on Curve, the DEX with the largest TVL. With Curve's $16 billion TVL, Convex has surpassed the first yield aggregator, Yearn.

DeFi Year-End Summary: 2021 Status, 2022 Outlook

Other types of structured products have also begun to develop this year. For example, yield-tranching protocols like BarnBridge divide yields into several parts for investors with various risk preferences, while indices like DeFi Pulse Index provide holders with passive exposure to a basket of selected tokens.

On the other hand, automated liquidity provision (LP) managers like Charm and Gelato automatically balance LP positions on Uniswap v3, while automated trading strategy managers like Ribbon combine various derivatives with risk-adjusted returns. These products are still in their infancy, and whether they can achieve widespread adoption remains to be seen.

Liquid Staking

In December 2020, Ethereum launched the Beacon Chain, initiating the transition to a Proof of Stake (PoS) consensus mechanism under Ethereum 2.0. Users can stake ETH to become validators of the network and earn more ETH rewards. However, becoming a validator requires sufficient technical knowledge and funds, and the staked ETH cannot be withdrawn until Ethereum 2.0 goes live.

Liquid staking solutions allow staked ETH shares to be tokenized and "liquefied." Users who stake ETH in the Eth2 contract via Lido receive liquid tokens in the form of stETH, allowing participants to continue using them in other DeFi applications while engaging in PoS staking, similar to collateral on lending platforms.

Lido has become the top liquid staking platform for Ethereum 2.0, with an 86.6% market share and 1.5 million ETH ($6.6 billion) staked, equivalent to 1.3% of the current ETH supply. The TVL in liquid staking platforms will continue to rise as staked Ethereum cannot be withdrawn before the merge of the Ethereum mainnet and the Beacon Chain.

DeFi Year-End Summary: 2021 Status, 2022 Outlook

Decentralized Stablecoins

Decentralized stablecoins facilitate permissionless payments on-chain. Maker's DAI is the largest decentralized stablecoin, with its share of the total stablecoin supply rising from 4.1% to 6.3% in 2021. This year, the circulation of DAI surged from $1.2 billion to $9 billion.

DeFi Year-End Summary: 2021 Status, 2022 Outlook

DAI traded at a premium for a period in 2020, leading to the introduction of the Peg Stability Module (PSM), which stabilizes DAI's price close to its dollar peg. PSM allows users to exchange collateral for DAI at a fixed rate. 14.9% of the circulating DAI is backed by USDC or USDP sourced from PSM.

DeFi Year-End Summary: 2021 Status, 2022 Outlook

Similar to other areas, the landscape of decentralized stablecoins has become more diverse. Abracadabra's MIM is a stablecoin primarily backed by yield-generating positions, making it the second-largest collateralized decentralized stablecoin by market cap at $3.5 billion. MIM borrowers earn yield on their collateral, thereby enhancing capital efficiency.

Over the years, the "trilemma of stablecoins" has also been notoriously difficult to solve. The trilemma refers to the dilemma stablecoins face regarding three attributes: decentralization, capital efficiency, and price stability. A plethora of experiments with algorithmic stablecoins aim to address the aforementioned trilemma, but results have been mixed.

At the beginning of 2021, we saw many uncollateralized algorithmic stablecoins (e.g., Empty Set Dollar) collapse due to a lack of risk-free arbitrage opportunities when below expected exchange rates. However, other forms of algorithmic stablecoins that rely on partial reserves or native assets have begun to thrive, with four of them having market caps exceeding $300 million.

The UST stablecoin based on the Terra blockchain is the largest algorithmic stablecoin, with a market cap of $7.6 billion, minted using the native asset LUNA as a seigniorage share. Users can burn $1 worth of LUNA to create 1 UST, and vice versa. UST has benefited from explosive growth in Terra's DeFi ecosystem, as it is widely used on lending platform Anchor Protocol and synthetic asset issuance platform Mirror Protocol.

DeFi Year-End Summary: 2021 Status, 2022 Outlook

Low Volatility Tokens

Algorithmic low-volatility tokens, often referred to as "non-pegged stablecoins," have emerged as a new asset class that has garnered market attention this year. Their goal is to become decentralized reserve currencies, exhibiting lower volatility compared to most crypto assets and being less susceptible to long-term changes in purchasing power due to unforeseen monetary policies or economic conditions.

These tokens have feedback mechanisms that suppress price volatility by adjusting token supply in response to demand fluctuations. Olympus DAO's OHM, launched in March 2021, is the largest low-volatility token, currently valued at $4.1 billion.

DeFi Year-End Summary: 2021 Status, 2022 Outlook

OHM tokens are backed by collateral but trade at a premium. The artificially created demand incentivizes investors to stake OHM to earn more OHM tokens. The DAO accumulates more collateral by selling OHM at prices below the market, allowing the protocol to issue more OHM tokens backed by additional collateral. This creates a circular economy driven by speculative demand.

However, whether these tokens can generate demand beyond pure speculation remains to be seen.

"Wrapped Bitcoin" in DeFi

To some extent, Bitcoin is the first "DeFi" that allows holders to store and transfer funds permissionlessly. Despite the lack of a Turing-complete virtual machine on the Bitcoin network, Bitcoin has seen extensive use in DeFi applications on other blockchains. Given that BTC holds a 39.1% market dominance in the crypto space, this is not surprising. The number of "wrapped Bitcoin" on Ethereum has steadily risen from 140,000 to 316,600 this year, equivalent to 1.7% of the total Bitcoin supply.

Centralized custodians play a key role in transplanting Bitcoin's value into DeFi, likely due to capital efficiency and user-friendliness. WBTC is the most popular wrapped version of Bitcoin, accounting for 80.0% of the Ethereum market share, followed by HBTC at 12.6%, which surpassed renBTC in January 2021. The top three holders of WBTC are all lending protocols: Maker (20.8%), Compound (13.1%), and Aave (10.1%).

On the Binance Smart Chain (BSC), the circulation of BTCB surged from 530 to 10,500 during the same period, marking healthy growth in the BSC DeFi ecosystem. The top two holders are Tranchess, accounting for 19.8%, which is a structured product focused on BTC; and Venus, at 11.0%, which is the largest lending protocol by TVL on BSC.

DeFi Year-End Summary: 2021 Status, 2022 Outlook

DeFi Year-End Summary: 2021 Status, 2022 Outlook

Insurance

While most areas of the DeFi ecosystem thrived in 2021, DeFi insurance may be one of the few categories that declined. The insurance amount in leading insurance solution Nexus Mutual peaked at $2.3 billion in February, then fell to $688.2 million, a decrease of 70.0%.

DeFi Year-End Summary: 2021 Status, 2022 Outlook

IDO

IDO refers to token issuance through DEXs, which is currently one of the most popular methods of token issuance. However, token issuances conducted by creating liquidity pools on DEXs have attracted "scientists" and bots competing with ordinary users, significantly driving up market prices, after which they sell on the open market for profit.

Liquidity Bootstrapping Pools (LBPs), pioneered by Balancer, have become a more effective method of token issuance this year. The initial listing price of new tokens will start high to curb the rush. Prices will be adjusted based on real-time buying demand, algorithmically and over time. It resembles a Dutch auction but responds more sensitively to demand peaks.

On the other hand, Initial Bonding Curve Offerings (IBCO), promoted by the Hegic protocol, have become the preferred token issuance method for most Solana-based projects. Investors can deposit and withdraw funds during the sale, after which they can redeem tokens proportionally. The more funds raised, the higher the implied token valuation. Unlike LBPs, IBCOs offer the same settlement price for participants of any funding scale.

Some projects avoid using IDOs and prefer to distribute tokens for free to users of the protocol, known as airdrops, possibly due to regulatory concerns regarding token sales. Some users exploit this model, attempting to interact with protocols that have yet to issue tokens using multiple wallets, hoping to gain substantial returns in the future. However, whether such activities are ethical remains a topic of debate within the crypto community.

2. Summary of DeFi Vulnerabilities in 2021

The popularity of DeFi protocols in 2020 led to an increase in user numbers and TVL of projects. In turn, large protocols attracted not only investors' attention but also hackers, who stole over $77 million in user funds through vulnerabilities in 2020.

Public chains compatible with Ethereum EVM, along with smart contracts that cannot be quickly upgraded and are vulnerable, led to a repeat of fund theft this year. This year, the amount of stolen funds increased eightfold compared to last year, reaching $610 million, with a total of 50 attacks, of which about 60% ($355 million) were stolen by attackers through flash loans.

In another scenario, attackers may return part of the stolen funds to the project, which usually occurs when attackers agree to a bug bounty or their identity is discovered. Overall, 53% ($404 million) of the total stolen funds in 2021 were returned to projects, most of which were funds stolen from Poly Network.

While most vulnerabilities still occur on Ethereum, since April, hacking incidents on BSC, Polygon, and Avalanche have also emerged. About one-third of the stolen funds ($200 million) belonged to projects on BSC, occurring in May, which crypto users referred to as "BSC's Gray May."

It seems that DeFi developers must learn lessons, audit smart contracts, and take greater responsibility for user funds.

DeFi Year-End Summary: 2021 Status, 2022 Outlook

3. The Outlook for DeFi in 2022

Prediction Markets

Prediction markets are platforms where investors can bet on the occurrence of real-world events. It was one of the first concepts of decentralized applications implemented on the blockchain, such as Augur.

Despite starting early, it has failed to generate surprising trading volumes compared to other categories of DeFi protocols. Polymarket on Polygon was the leading prediction market in 2021, featuring hot topics, global major events (such as the U.S. presidential election), and crypto trends (such as Bitcoin prices and Ethereum upgrades). Surprisingly, sports events did not attract more crypto investors.

As the user experience of DeFi improves, the advantage of decentralized prediction markets lies in their ability to access more global hot events, allowing users to provide more competitive rates and deeper liquidity. Looking ahead, as prediction markets gain attention over time, the prediction process should utilize economically sound and corruption-resistant decentralized event oracles. Whether this can "settle" instantly is questionable, but it is certain that current prediction market platforms do not prioritize complete decentralization.

Non-USD Stablecoins

Most stablecoins are pegged to the U.S. dollar, as stablecoins are primarily used for trading cryptocurrencies settled in USD. While there are currently many stablecoins pegged to various fiat currencies, most of them lack demand and liquidity. Nevertheless, euro stablecoins are expected to gain adoption in the coming years.

First, the current euro is already the second-largest stablecoin group. There are two euro-pegged stablecoins in the DeFi space: sEUR, a synthetic euro from Synthetix with a market cap of $118.7 million, and STATIS EURO (EURS), a custodial euro stablecoin issued by Stasis with a market cap of $102.2 million.

DeFi Year-End Summary: 2021 Status, 2022 Outlook

Second, the EU's proactive attitude toward addressing regulatory issues surrounding stablecoins and other cryptocurrencies, along with a relatively welcoming stance toward the crypto industry, may bring more DeFi applications to Europe, with euro stablecoins playing a significant role. The "Crypto Asset Market Law" is a proposed regulation by the EU that will create a union-level licensing framework, providing regulatory clarity for various crypto service providers, including stablecoin issuers.

Tokenization of Real-World Assets

While cryptocurrencies as an asset class have developed into a $2 trillion market, they remain relatively isolated and disconnected from other industries. As the tokenized economy develops, everything of value, whether financial or cultural, will be tokenized in some way. Bridging the gap between real-world assets (RWAs) and DeFi can bring a significant amount of "old wealth" to the new digital economy and enhance the DeFi ecosystem.

Tokenized RWAs benefit from existing blockchain and DeFi infrastructure. For example, Centrifuge is an application chain that facilitates the tokenization of RWAs like NFTs and provides financing for different types of tokenized assets through DeFi. Tinlake is Centrifuge's RWA pool investment portal, holding over $44.4 million in TVL across 10 RWA pools.

Governance Transformation

The interests of governance token holders and protocol users are often misaligned. Only 7% of users belong to both categories. Token holders typically prefer to maximize short-term value extraction, even at the expense of the protocol's long-term sustainability. In contrast, protocol users prefer the durability and neutrality of the protocol.

Maker is a typical example of this governance dilemma. Token holders benefit from higher interest rates on DAI loans, while borrowers prefer the opposite situation. If users cannot rely on governance to make decisions that align with their best interests, it will drive them away.

Curve's locked voting scheme addresses this dilemma. Curve's native token CRV does not directly provide voting rights. However, CRV holders can lock their tokens to receive veCRV on a 1:1 basis, granting voting rights to veCRV holders. The longer the tokens are locked, the more veCRV (voting rights) they receive. This way, both token holders and users have vested interests in the development of the DEX. Additionally, liquidity providers on Curve can earn higher rewards if they lock their earnings directly, incentivizing users to actively participate in governance.

Locked voting may spread throughout the DeFi governance landscape in the future to realign stakeholder interests.

Forks in DeFi

Institutions are eager to deploy funds in the DeFi space but face numerous obstacles due to regulatory uncertainty (KYC/AML, securities laws). Some protocols have derived the concept of "permissioned DeFi," which can meet existing compliance requirements.

Some believe that such developments contradict the purpose of DeFi, undermining the principle of decentralization. Nevertheless, some applications still require trust in certain parties, such as borrowers of uncollateralized loans and custodians of RWA tokenization. Open finance should not only be decentralized finance but should also provide users with options and transparency.

These projects will be able to attract funding from institutional giants that have never engaged with DeFi. Some existing decentralized protocols are gradually expanding branches aimed at institutional clients, such as Aave Arc and Compound Treasury.

Nonetheless, most protocols will remain permissionless, and an increasing number of protocol developers will continue to remain anonymous. They will accelerate the process of complete decentralization and strive to avoid regulatory scrutiny. The threat of restricted access will also accelerate the development and adoption of privacy-enhancing DeFi ecosystems driven by zero-knowledge technology.

Today, many "decentralized applications" rely on centralized components, such as centralized hosted user interfaces and proprietary routing optimization algorithms. As regulatory pressure increases, they will be forced to take sides. Some protocols will comply with and enforce KYC processes or restrict users from certain jurisdictions; while others will remain anonymous and relinquish control over their front-end and smart contracts to achieve decentralization.

Regardless, forks in DeFi seem inevitable.

Finally, here is the Ethereum DeFi ecosystem diagram:

DeFi Year-End Summary: 2021 Status, 2022 Outlook

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