2022 DeFi Review: Can DeFi, Lacking Innovation Momentum, Ignite the Next Bull Market?

Organizer: Biscuit, Runsheng, ChainCatcher

Recently, ChainCatcher and CatcherVC held a Twitter Space themed "Review and Summary of DeFi in 2022." We invited DoDo researcher Flame, Synthetix China regional head Errance, dForce founder Mindao, GoPlus Security partner manager Stan, and iZUMi Finance co-founder Jimmy to discuss the development of the DeFi sector in 2022 and predictions for the future of the industry. This sharing session gained significant attention due to the guests' insightful speeches. ChainCatcher has organized the content of this sharing and selected some of the highlights, but the entire session is worth listening to. You can click here to view the full version.

Host Kit: Looking back at 2022 DeFi, TVL dropped from a peak of 165 billion to 39 billion, evaporating by 76%. During this period, significant events occurred, from the collapse of LUNA and the liquidation of Three Arrows Capital's bad debts to FTX's misappropriation of funds, as well as smaller incidents like GMX oracle attacks for arbitrage and Mango's on-chain liquidation shorting. How do the guests deeply involved in DeFi evaluate this year's DeFi market? What were the expected and unexpected events?

Flamie:

DeFi in 2022 was relatively unremarkable, with a large number of copycat cases distributed across various chains, especially EVM-compatible chains. Most of the developments were updates to existing old projects, and new projects were mostly minor innovations. Of course, there were also very complex DeFi financial products. However, I believe that making DeFi more complex may be a misguided approach, as the entry barrier for users is too high, making it less user-friendly and not particularly attractive to draw in more users.

Perhaps the previous bull market has led to a relatively restless mindset among everyone, and the DeFi builders who entered later actually had few opportunities to attract attention. In the past two years, most of the things that could be done in the short term have already been done, such as moving from traDeFi directly onto the chain to create DeFi products.

The FTX collapse may have had early warning signs, as old users would notice the existence of margin calls. Additionally, withdrawal discounts could be exploited for arbitrage, but FTX did not discover this for several months, even close to a year, indicating that their risk control was quite poor. Recently, the sharp drop in TVL shows that there are not many real users and trading volumes based on the data, leading many to believe that DeFi is failing. Events like the FTX collapse have actually given us a boost of confidence; continuing to build in the DeFi space is definitely the right move.

Mindao:

From a surface-level perspective, the entire DeFi TVL has indeed dropped significantly, but I want to look at another indicator—the supply of stablecoins has decreased from 200 billion to over 130 billion, a drop of about 26%. In fact, stablecoins are the most critical indicator that can better express the penetration and robustness of the DeFi ecosystem. Most of the DeFi TVL is actually affected by the decline of platform tokens like ETH and wBTC and volatile major currencies, with the 76% drop roughly equivalent to the declines of BTC and ETH.

However, the decline in major currencies does not equate to a similar decline in usage at the application level. Recently, the trading volumes on chains like Optimism and Arbitrum have surpassed that of the Ethereum mainnet. In terms of transaction numbers and activity, interactions in DeFi have actually increased compared to before after the FTX collapse. From this indicator, DeFi in 2022 still appears quite healthy.

I had a certain premonition about the collective collapse of CeFi. Since the entire leverage began during DeFi Summer, it was evident that user assets were being used for various liquidity mining. For example, various stablecoin mining suddenly generated tens of billions of TVL, mostly from user funds. After DeFi Summer, the growth of off-balance-sheet leverage was very rapid, and all the known bankrupt lending companies emerged during that time. Although DeFi itself is on-balance-sheet, where its leverage can be seen—how much asset and collateral there is, and what the leverage ratio is—none of the CeFi lending platforms, including exchanges, can show their leverage.

What surprised me was the speed at which the entire CeFi collapsed—now basically all CeFi lending platforms have been wiped out. Another unexpected aspect is that mainstream DeFi projects are still doing quite well. I thought that such a significant event as the CeFi collapse would have some correlation and should trigger some explosions at the asset or protocol level in DeFi, but they have proven to be very resilient.

Jimmy:

At the end of 2021 and the beginning of 2022, when it was still considered the tail end of a bull market, many DeFi 2.0 and other conceptual layers emerged. Many institutions rushed in, raising funds for DeFi mining through various on-site financial products, or directly using users' principal for mining without issuing products. Before the Luna collapse, even Binance launched UST financial products, which was also a form of capital siphoning. Regardless of whether it was the overlay of 2.0 economic models, some unhealthy combinations, or the entry of off-exchange leverage, it all reaffirmed for the industry: "too big to fail" does not apply to the crypto industry. This was a problem that the entire industry had not anticipated before.

An interesting phenomenon is that, from the perspective of liquidity and trading on the entire chain, centralized exchanges play many roles as proxies for small coins, but some non-mainstream centralized exchanges do not have the capability to provide liquidity for these projects. At this point, DeFi becomes the settlement layer for these CeFi platforms, filling liquidity through bots purchasing on-chain. On the surface, it appears to be centralized market maker trading, but behind the scenes, it is actually moving on-chain liquidity to centralized exchanges, especially for tokens with poor liquidity on centralized exchanges but good liquidity on-chain.

This also inspires us to think: From the perspective of future on-chain liquidity, should DeFi be open to every individual? This question is closely related to the development of wallets. With better wallets, more trading behaviors, and more application scenarios, DeFi will become the first direct connection channel.

However, before that, DeFi has another role that has been overlooked: CeFi lending has collapsed, but DeFi has not; CeFi market makers have withdrawn, but DeFi's liquidity remains strong. DeFi could potentially become a transparent, trustworthy, and third-party-independent clearing/settlement layer aimed at institutional clients, which is very valuable for the entire industry. Although there are fewer retail users on-chain, if DeFi can capture some institutional clients that have sufficient trust in on-chain security, it can bring strong vitality and underlying returns to the entire industry even during bear market cycles. After this round of collapses, we can see this trend more clearly, which I did not anticipate at the beginning of 2022.

Stan:

From the perspective of the entire economic cycle, the decline in DeFi TVL is something that was expected. This round actually started from DeFi Summer, when the DeFi market was very hot, and TVL grew rapidly, subsequently driving the rapid development of NFTs, GameFi, and some public chain layers. Such rapid development will inevitably create a lot of bubbles, and there will certainly be a process of bubble deflation, which is a normal economic cycle. The industry has experienced several such cycles before; I estimate that the last cycle evaporated 90%.

Of course, there are also some external reasons, such as the pandemic and wars leading to inflation, and the Federal Reserve's interest rate hikes causing a global liquidity crunch. At the same time, many security incidents have occurred within the industry.

CeFi will always have trust issues, which is how to optimize the management of people. But DeFi itself is not a structural problem; it is a matter of continuously optimizing mechanisms. Through continuous development, I believe that it will definitely build market confidence better, and DeFi will continue to grow.

Errance:

There were quite a few interesting things in DeFi in 2022. Analyzing from the TVL data, since the DeFi Summer in 2021, it peaked around mid-May, then plummeted, and reached a second peak in November due to the prosperity of Layer 2 or EVM and non-EVM chains; around the time of the Luna collapse in May 2022, it reached a small peak again, then declined; finally, in November 2022, there was a small peak due to the prosperity of Layer 2. It can be observed that there is a small peak in TVL every six months.

For me, what was unexpected was that during a relatively bearish period, DeFi TVL experienced a 50%-60% increase from September to November 2022. Another unexpected thing is the issue of on-chain credit. Discussions about on-chain credit or credit lending have been ongoing for over a year, and various project parties or chains have conducted some research on this, but no institution has established a very effective bank credit lending model.

What was expected was the development of cross-chain bridges. In my view, cross-chain bridges will be the lubricant for DeFi's future development, as currently all DeFi liquidity is fragmented across different protocols and chains, including many non-EVM compatible chains and EVM compatible chains, where these assets cannot be directly exchanged.

Host Kit: Since AMM, it has been difficult to see disruptive native blockchain applications and models in DeFi. In 2022, with the popularity of Web3/gaming/NFTs and other applications, VC investment in DeFi has significantly decreased. What do the guests think is the biggest innovation in DeFi since AMM? Are digital bonds/insurance/credit derivatives considered innovations? Is the slowdown of VC investment and the lack of innovation in DeFi due to reaching a bottleneck?

Flamie:

Personally, I think that besides AMM, on-chain lending and related algorithmic stablecoin protocols are also worth paying attention to, as these protocols are second only to AMM in the entire bull market of DeFi. On-chain insurance or credit protocols can certainly be considered innovations; they combine with AMM to act as counterparties and utilize the composability of DeFi protocols, which I think can be considered a form of innovation. The biggest innovation lies in the layer-level innovation, which reduces friction in trading and increases efficiency, although it may also introduce some security risks.

Regarding capital cooling and lack of innovation, when I initially reviewed the entire DeFi space, I wanted to express the viewpoint of liquidity premium. The wealth effect of the bull market attracted many developers and financial talents into the crypto industry, and the influx of talent can reflect the prosperity of on-chain applications in the short term, which is why we saw many innovations in 2021, but 2022 was mostly "copy and paste."

There may be different innovations in the future. One track that I personally like is derivatives, utilizing block space to create financial derivatives, which are more native. I believe that some good things can be developed in the future.

Mindao:

I believe that the entire disruptive innovation of DeFi actually ended in 2019. This is my understanding of the different stages of DeFi, with the core being three axes: one is AMM, which was already created by Uniswap in 2019, and then there was Compound and decentralized stablecoins. In 2019, MakerDAO had already emerged, along with the pool model lending protocol Compound.

From 2019 to now, there have indeed been many minor innovations, such as DoDo introducing the market maker model and the introduction of oracle models, as well as Curve and Uniswap V3 creating aggregated liquidity, but I feel that these have not moved beyond the original AMM model of Uniswap.

In terms of lending, it is now difficult to determine what innovations have been made from Compound 1.0 to the current 2.0 and 3.0 versions, including Aave V3. These different versions essentially still follow the pool model, and the lending operations have not changed. The minor innovations involve adding some risk control modules to the pools.

Stablecoins are even more so. First, there was the over-collateralized MakerDAO, then the so-called 2.0 dual-token model, such as Rebase and Bond. Then came the algorithmic model of stablecoin 3.0, like the most extreme Luna, which was the so-called leveraged model. But in the end, the best performer remains MakerDAO, which is also an over-collateralized model. Although MakerDAO later added some innovations, such as introducing the PSM module and changing liquidity providers, all subsequent innovations have not moved beyond these three paradigms.

The current situation is very reasonable because traditional finance has only a few models. AMM exchanges correspond to traditional financial exchanges, such as stock exchanges and bond exchanges. Lending corresponds to banks, and stablecoins correspond to currencies. In fact, the abstracted models in traditional finance are just these few. For the on-chain insurance and fixed income protocols that emerged later in DeFi, I personally feel that those projects are more like icing on the cake in terms of functionality.

Regarding the reduction of VC investment in DeFi, I believe there are several reasons. One is that after DeFi Summer, the entire secondary market explosion allowed protocols to complete capital accumulation. For example, after completing private round financing, projects like DoDo and dForce went live on exchanges and no longer needed to raise funds in the primary market. Because the secondary market can provide good liquidity mining and has the ability to launch new products.

In the entire DeFi space, there are only those three types, and many segmented projects may not need to issue tokens. Therefore, since this year, very few new DeFi projects have launched on Binance, with only a few new category projects like GMX.

This also reflects a trend: existing DeFi projects that have already launched tokens are beginning to pursue vertical and horizontal integration. For example, dForce is also starting to do aggregated trading. Frax is also starting to do lending, while Curve and Aave are working on stablecoins, and Aave may next venture into DEX. When leading DeFi projects start integrating feature projects in the space, segmented tracks will have no opportunity.

Many minor innovations at the AMM level are insufficient to become independent projects; it is not necessary to issue tokens for operation. For example, a fixed income project issuing tokens may not necessarily be listed on Binance because such projects are too vertical, and many leading projects have already implemented these functions. Another example is the super-segmented track of weighted average AMM strategies, where users can complete repurchases at a market average price. Frax has already implemented this function without needing to issue additional tokens.

Therefore, I believe that the reduction of VC investment in DeFi is related to the development of DeFi into an integration stage. In this stage, although many segmented features emerge, VCs will not invest too much capital; giving $500,000 is already quite good. It is not that there are no innovations or opportunities in the DeFi space, but rather that innovations and opportunities have been absorbed by existing projects.

The recently popular GMX is focused on perpetual contracts, and its approach is similar to previous DeFi models. Additionally, GMX has begun to create modular DeFi combinations, aiming to establish its own matrix, but in the end, it may still move towards stablecoins and lending. Currently, the entire DeFi integration model is very clear.

To some extent, the leading protocols in the DeFi space are basically developing along this route. I believe that in the next three to five years, even if a bull market comes, there will be few emerging, vertical projects that can emerge. Just like in China's internet era, giants like Alibaba and Tencent monopolized major categories like social media, gaming, and e-commerce. I feel that DeFi has already reached this stage, which is a very interesting trend, and this trend is continuously strengthening due to high barriers of liquidity aggregation, technical security, and brand.

Jimmy:

Two points I want to add are that when any industry reaches the tail end of competition, the giants have already completed their land grab. If we want to drive the entire crypto industry forward, we need to improve the performance of underlying public chains and further reduce costs. Another aspect is the entry point for new users, including wallet users and institutional users entering DeFi.

In the previous cycle, infrastructure contributed significantly to user participation, from Layer 1 to after Layer 1 and then to Layer 2. Compared to Ethereum's block time of over ten seconds, the improved block time and reduced fees of Layer 2 have indeed provided many protocols with better opportunities.

If GMX had initially chosen to build on Ethereum, I don't think it would have achieved the same effect as launching on the Arbitrum project. Arbitrum allowed protocols like GMX to emerge because the network's block time was fast enough, and it could use oracles to adjust prices, minimizing the protocol's exposure to arbitrage or MEV losses. GMX then employed some extreme designs to avoid price delays as much as possible.

If the current block time could be reduced from one second to 0.1 seconds or if gas fees could drop another order of magnitude, I believe such technological innovations would definitely lead to the prosperity of upper-layer applications. Just as Layer 2 promoted GMX, innovations in underlying technology could also fill the landscape of the derivatives track in DeFi. This is an inevitable trend.

Another point is that when people talk about Web3, there are usually two perspectives: Web3 is sufficiently transparent and can access enough composability. This allows many protocols to integrate with others, unlike traditional internet giants that might block links to competitors. Conversely, when evaluating the value of a DeFi protocol, people will also consider the products and liquidity aggregated under that brand, which may be an important component of valuation.

Therefore, the future direction worth exploring in DeFi may align with what Mindao just mentioned, where everyone will improve their product matrix, but the ultimate decision of whether to build independently or integrate is a question worth discussing.

Additionally, compared to traditional finance or the internet industry, DeFi is still a relatively niche geek community. DeFi does not provide sufficient services and guidance for users. Centralized exchanges educate new users on how to open accounts, deposit funds, trade, and provide risk warnings. This is a very complete system.

From the early days, AC could manage so many projects because he advocated elitism and rapidly iterated based on community feedback. In the future, this aspect will also be stratified, where developers only need to focus on their protocols, and user onboarding and services can be entrusted to wallets or centralized exchanges as entry points. If DeFi wants to stand alone in the future, for example, to accommodate millions of new users, it must provide better user support services.

From the perspective of future profit distribution, taking Uniswap as an example, centralized exchanges (like Binance) may charge users a fee of 0.1%, regardless of whether the order is a take or make, so a completed transaction would cost the user 0.2% in fees. If it is a high-frequency market maker or a high-level VIP user, the fee could be reduced to around 0.05%. Additionally, market makers providing maker orders might even have negative fees.

Overall, the trading platform's cut of the entire fee is certainly at least half or more. This money, which should have been taken by centralized institutions, is actually fully distributed to users in DeFi protocols, which I think is one perspective.

Another perspective is whether DeFi needs to independently operate a service brand. For example, Binance collects fees to support a 7,000-person operation system, especially including user education, customer service systems, etc., to expand the entire market.

I think DeFi needs to consider whether to choose to act as a settlement layer connecting applications' traffic and users or to operate as an independent brand, potentially becoming a two-tier system with centralized exchanges. Especially considering that the incoming new users are not just OGs or Degens. After more new users come in, what kind of market positioning should be chosen?

Errance:

I might be a bit pessimistic. From my personal perspective, besides AMM and AMM-based LPs, there is no innovation in the entire DeFi space, and one could even say that there has been no innovation from the beginning.

DeFi is basically "copy-pasting" Web2 or traditional financial applications. We have not used on-chain cryptographic primitives as a basis to build some innovations. Such innovations require the emergence of true on-chain equivalents, that is, on-chain native stable tokens, which are genuinely accepted universally. The current stage of DeFi, whether in lending or projects like Synthetix, is essentially replicating Web2 models using blockchain, applying blockchain thinking to traditional applications.

Another point might be about liquid money, which is an interesting aspect in Web3. Synthetix should also be one of the earliest projects. People might think this is a DeFi innovation, but I personally believe it is merely a means to attract liquidity or a function; it cannot be called an innovation.

So I personally look forward to the emergence of true innovations based on Web3 and DeFi after solving the underlying public chain performance issues and the holy grail of on-chain equivalents. I am relatively pessimistic, so there are not many cases worth discussing at this stage.

Host Kit: Will DeFi still be a barometer for the next bull market? When blockchain technology combines again with traditional mainstream applications, can DeFi return to its previous peak? If you think it won't, please discuss what will be the barometer for the next bull market?

Flamie:

I personally believe that DeFi will still serve as a pillar track in the next round, with more segmented tracks like NFTFi or GameFi, which are essentially based on DeFi. Regarding the barometer, everyone may have different preferences. I think this needs infrastructure to drive it.

I am particularly interested in derivative projects of Block Space, as Block Space itself is a resource. Taking Ethereum as an example, all users have the willingness to increase gas to obtain faster packaging, which can be understood as a behavior of competing for resources to some extent. So if it can be treated like a commodity, we can create some derivatives based on these behaviors. Including Cosmos 2.0, they proposed rentable Block Space; for example, if there are many users on application chain A, causing network congestion, they can rent some network resources from application chain B to assist with packaging.

Mindao:

I believe that from the perspective of value capture, Layer 1, including decentralized storage and the infrastructure of Cosmos, is the easiest to capture value. However, when it comes to barometers, I think the entire crypto cycle has always been driven by applications. For example, the bull market in 2017-2018 was ignited by ICOs, which can be understood as a financing application. The bull market in 2020 was clearly driven by DeFi, which led to the prosperity of Ethereum and later new public chains like Solana.

In my view, public chain teams are relatively lazy. For example, we invested in Ethereum in 2014, and the originally designed POS roadmap was supposed to be implemented in 2016, but it has dragged on until now. Why? Because no one has pressured the public chain teams, and after entering a bear market, gas fees are not that expensive. Without applications, there will be no users for the space.

However, after DeFi Summer, it was found that there was not enough space, and Layer 1 also needed upgrades. This led to the emergence of new concepts like Optimism and zk. Even Cosmos did not previously mention the so-called ICS, which is the so-called secure sharing module, but it is essentially similar to Polkadot; it’s just that Cosmos may have done it more simply in terms of modularization.

So you can see that applications are driving the development of the crypto field. Why did dydx move from Ethereum to Starkware and then to Cosmos? The reason is that the Ethereum mainnet could not meet dydx's needs, and it had to implement it in the form of an App Chain. Therefore, I believe that the next bull market's barometer will definitely still be driven by applications.

Earlier, we talked about the three axes of DeFi: DEX, stablecoins, and lending. But I think there is still one axe missing, which is on-chain contracts. GMX may not be the final model; whether LP can cover profit risks remains to be seen. However, this model is at least understandable to us, and now the entire DeFi is replacing the business logic of CeFi.

Contract trading is a huge cake, and higher-performance L2s, whether Rollup, App Chain, or public chains, may take a bite out of this cake in the next cycle. The next bull market's barometer is likely to be applications that are closer to reality on top of DeFi. DeFi can already be clearly positioned as the underlying financial infrastructure, so as long as the application layer thrives, the underlying will definitely rise.

As long as applications like NFTs and GameFi take off, DeFi's TVL will definitely hit new highs. This is very clear; NFTs and GameFi cannot be separated from the DeFi infrastructure. You can see that recently Solana's entire TVL dropped by 98%, from last year's $10 billion to just over $200 million; the basic liquidity of each application is no longer sufficient to support it as a product. The funnel effect will direct the value of all applications toward DeFi and then to public chains.

However, from the perspective of barometers, I believe that new types of applications will emerge that surpass DeFi applications. The greatest possibility is NFTs and applications like GameFi that combine with consumption, which may bring about a new bull market.

Jimmy:

DeFi, as an infrastructure, has already proven its value. It is impossible to achieve an independent ecosystem on any chain without infrastructure. From this perspective, the next year of user onboarding and explosion may have two major logical lines:

One is that if Crypto users grow tenfold, it means DeFi will capture more CeFi scenarios. As a more transparent and trustworthy layer, after providing a better experience for users, it will become the main melody in the crypto field.

The other is the way users deposit funds and product experience. We can expect that in the next cycle, users will directly come to experience Web3 culture on-chain. In fact, NFTs have already proven part of this feasibility, as many NFT addresses use credit cards to purchase NFTs through MetaMask, with only ETH and NFTs in their wallets.

If these two directions can develop, it will greatly benefit DeFi.

Errance:

I personally think that SocialFi may see more development. As people's on-chain behaviors increase, data will gradually accumulate on-chain, allowing for more precise profiling of each user based on on-chain data. At this point, profiles can be used to find like-minded friends or communities, such as with Lens or Rss3 protocols.

Additionally, if using Web2 applications like Facebook, when I want to create a new account on Instagram or OnlyFans, it is difficult to directly migrate all my social connections from Facebook to the new social platform. However, achieving this in the Web3 space is very easy.

Another point is that as users' on-chain behaviors increase, they may develop certain constraints on themselves, which means they will not engage in behaviors that damage their address's reputation. This can also be referred to as credit accumulation, so some credit-based financial products may also develop.

DeFi may gradually sink to the bottom layer, and people will regard it as a financial tool or an investment target. Currently, almost all on-chain behaviors revolve around DeFi as the core, with DeFi users aiming to obtain greater returns and more governance rights, etc. In the future, DeFi may become a truly entertaining and social gaming space for users. Furthermore, after DeFi, it may shift towards SocialFi, where users can utilize social accounts to engage in more meaningful activities related to Web3, rather than just mining for monetization.