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An Update on DeFi Markets

Sep 17, 2021 · 8 min read

By Ashwath Balakrishnan, and Kevin Kelly, CFA

Market Update

With L1 szn taking hold of crypto markets, DeFi coins have fallen out of favor over the past few months. Coupled with May’s chaotic downturn, it’s easy to see why sentiment for DeFi has been so poor since.

When crypto assets set a local bottom in late July, investors turned their attention to DeFi, but this was quickly overrun by L1s. Last week, we saw yet another swift yet sharp correction in the crypto market, albeit not as extreme as May. Since then, DeFi tokens have found a new lease on life, with blue chips like CRV and SNX leading the bounce. When we examine DeFi performance since August, however, ALPHA stands out against other tokens.

One interesting finding is that the majority of DeFi tokens have underperformed FTX’s DEFIPERP index. And this is because DEFIPERP, while initially curated to track the state of Ethereum DeFi, has evolved into an index for Solana and Ethereum DeFi tokens. The index includes SOL as well, which introduces some inconsistency as it isn’t exactly a DeFi index.

According to independent research by 0xSisyphus, SOL’s weighting in the index grew from 1% to over 22% between Oct. 2020 and Sep. 2021. This essentially means the DEFIPERP is no longer an accurate benchmark for DeFi — and it explains why its outperforming individual DeFi tokens in light of SOL’s stellar rally.

Speaking of Solana DeFi, these tokens have performed well on the back of SOL’s rally. RAY is up over 270% since August while SRM lags, but is still up 150% over the same time period. HOLYPERP, which is an index of SOL, FTT, SRM, and RAY has outperformed individual coins with the exception of SOL and RAY. FTT isn’t a DeFi token, but we included it in the comparison since it’s a “Sam coin.” Others like MERC and OXY have underwhelmed, but their performance is on par with Ethereum DeFi blue chips.

Zooming into the state of Ethereum’s DeFi assets, there are fairly strong correlations across the board. Notably, their correlation to ETH is extremely weak, and this is because we are measuring YTD correlation. ETH had it’s monster rally earlier this year while DeFi lagged, which explains this phenomenon. DEFIPERP also has strong correlation to DeFi prices despite not being an accurate benchmark anymore. It’s important to note that positive correlation means they move up and down together. But the extent of price moves could vary a lot.

Since we’ve established DEFIPERP isn’t the best benchmark, we analyzed DPI’s (another DeFi index) sensitivity against BTC and ETH. Using the last year of data, we found that DPI’s beta against BTC is just 0.32. This means for every 1% move in BTC, DPI moves just 0.315%. Against ETH, it has a beta of 0.57, implying a 0.57% move for every 1% ETH moves.

There’s a prevailing narrative that holding DeFi coins is like owning a higher beta ETH, but the last year of data disproves this. However, there are some caveats with this analysis. DPI only includes select blue chip tokens, so it suffers from the same flaws as any benchmark. Further, the date range for this analysis (Sep. 2020 – Sep. 2021) is biased towards sectoral trends in ETH and BTC, and ignores the massive DeFi rally in mid-2020.

However, the ultimate point still remains true: most investors were better off holding ETH and BTC rather than playing the passive allocation game in DeFi. 

L2’s Get the Ball Rolling

L2s are expected to be one of the most important catalysts for Ethereum. As more transactions get settled on rollups, Ethereum’s base layer will be relieved of its congestion while total throughput actually increases. Rollups account for 1%-1.5% of all gas consumption on mainnet Ethereum after the recent increase in usage. That figure is set to increase significantly over the next year.

StarkEx, Optimism, and Arbitrum are all live and settling transactions on Ethereum mainnet. dYdX’s ZK rollup on StarkEx had over $200M a month ago. With the announcement of their token in late Aug, this shot up to nearly $380M as people attempt to game the rewards distribution.

Arbitrum’s launch a few weeks ago was met with blazing enthusiasm, causing TVL and transactions to soar at a startling pace.

Arbinyan, a speculative “fair launch” farm, was responsible for over $1.7B of Arbitrum’s TVL at one point. With the exception of a few protocols, most of the activity on Arbitrum is basically degenerate speculation. But, if anything, this is a testament to the open nature of Arbitrum and how anybody can deploy a contract on the L2 now — which is in contrast to Optimism’s gated launches that prioritize security.

However, there are legitimate products that have already launched on Arbitrum. MCDEX is a platform for futures and perps trading, and the project is currently running a transaction mining campaign to rebate 200% of trader fees in MCB. It currently has $8.1M of liquidity in its ETH and BTC perps and facilitated $5.8M of volume in the last 24H.

DeFi Protocols and Their Traction

Decentralized exchanges have, by far, seen the highest degree of product-market fit relative to all other sectors of DeFi. A blow-off top on DEX volume makes the chart look rather ugly. But if we consider May’s volumes to be an anomaly, DEX growth has been strong and consistent across the entire year.

Uniswap still commands over 60% of market share, but there’s a possibility this changes as L2 narrative takes a hold of the market. Sushiswap is starting to deploy their DEX and introduce mild incentives across L2s in a bid to emulate the “franchise model” and set up shop in every relevant ecosystem. Uniswap, on the other hand, has deployed on Arbitrum and Optimism, but is likely to concentrate on their Optimism deployment — and direct incentives there — given the team’s ties.

Overall, Uniswap is banking hard on Optimism to become the liveliest L2 while Sushiswap is relatively agnostic and focusing on getting their DEX to any and every L2 they can.

Speaking of DEXes, a relatively newer sector in DeFi to pop has been derivative DEXes. Perpetual Protocol has been posting solid numbers for a few months now, but with the DYDX token announcement, dYdX exchange volume has gone berserk.

dYdX accounted for less than 40% of its joint volume with Perpetual Protocol. However, in the last few weeks, that number has shot up to over 85%. One day it even broke into the high 90% ‘s as dYdX settled almost $2B of daily volume. Derivatives are a huge segment in global markets, and DeFi is unlikely to be a stranger to this phenomenon. Several competing products like MCDEX, Futureswap, Vega, and Mango Markets are cropping up across DeFi to fill the gap for futures/perps.

Derivatives require low latency and high throughput, making them an ideal candidate to lead the L2 push. Now that we finally have functional L2s, this sub-sector looks more attractive.

DeFi money markets are as strong as they ever have been. The total amount of loans issued looks nothing like DEX volumes (re: the blow off top) and has been consistently growing even during times of poor sentiment.

Aave and Compound are pretty much neck to neck in loan issuance, as Compound catches up to the phenomenal growth on Aave earlier this year. Utilization ratios, which track the amount of loans issued vs the amount of deposits that can be borrowed against, are between 40% and 50% for Aave and Compound.

Maker has seen a sharp increase in its utilization ratio, largely due to the growth of its Peg Stabilization Module (PSM). With the PSM, anyone can deposit stablecoins like USDC or USDT and mint DAI against it in a 1:1 ratio. This eliminates the over-collateralization component that is otherwise employed on Maker and other money markets. The vault asset mix on Maker has been a tad concerning too, becoming heavily skewed towards centralized stablecoins.

Lido Finance has been at the forefront of staking since it launched late last year. But it only started to see exponential growth in the past few months. Lido has established itself as the primary liquid staking solution — not just in DeFi. It now accounts for over 16% of total deposits made to the Ethereum 2.0 contract.

Ethereum 2.0 isn’t even live and has $27B of ETH staked (Lido has approx. $5B). There’s a lot of uncertainty around how the rollout will go down, which is likely stoking some fear amongst people who want to stake but are waiting for a smooth launch. The market for staking ETH will increase as Ethereum 2.0 proves it works. Lido is optimally positioned as the top liquid staking provider — an advantage that will prove difficult for competitors to overturn.