DeFi Year Ahead

In this report, we look to highlight some key opportunities and challenges for DeFi and spell out the reasons we remain optimistic that DeFi will thrive. But before that, let’s take a look at how the industry has fared.

Broadly speaking, DeFi tokens have had a tumultuous year. Ethereum DeFi, which is the largest DeFi ecosystem, saw some of its highest-rated coins take a beating.

The past six months saw crypto as a whole get shaken up, with several key players taking large losses or blowing up entirely. Despite DeFi’s mechanisms protecting users from this fallout, DeFi tokens didn’t manage to scrape through unscathed.

While TVL has fallen almost 75% from its peak, DeFi still accounts for a large portion of capital in on-chain products. Compared to the broader finance industry, DeFi is still a drop in the pond. The highest traction products are DEXs and money markets.

Skipping to the present, we’ve had five straight months of declining DEX volume leading up to November 2022. But the hidden silver lining is that despite this massive fall from grace, DEXs on Ethereum still did about $30-40B in monthly volume — no small feat.

1. All DeFi products with traction are speculation-based primitives (we’ll explain why this is a necessary first step later).
2. Onboarding new users is a cumbersome process, requiring deep education.
3. Retaining users sustainably is a challenge in itself (as is the case with all new products/applications).
4. The overall UX of the space is far from ideal.
   
   

DEXs like Uniswap, 0x, Curve, dYdX, and GMX have stood tall in light of recent events. Seeing more crypto native participants move from centralized exchanges to self-custody could entail higher volumes on DEXs going forward. In all honesty, DEXs being a saving grace is a fairly obvious takeaway. But given the massive difference in UX between CEXs and DEXs today, it’s unlikely we will see this materialize in a big way anytime soon unless that gap narrows considerably.

Will a meaningful exodus of market making capital from CEXs prove to be a valuable opportunity for orderbook DEXs? Perhaps.

Keep in mind, neither 0x nor dYdX run fully on-chain stacks. 0x relies on a number of market makers hosting their own orderbooks, while dYdX currently uses a centralized orderbook and matching engine.

2022 was a brutal year for DeFi blue chips, but these projects still dominate their respective sectors. Since value will likely gravitate to the application layer over time, it seems worthwhile to explore the blue chip rebound thesis. If and when fundamentals start to actually matter, this theme will be even more salient.

At a glance, Synthetix may have the most romantic use case of any OG DeFi dApp. The promise of a full-stack, permissionless derivatives platform that democratizes access to the $630T derivatives market propelled SNX to a $4B market cap in early 2021. Progress has since slowed and expectations have waned, but Synthetix has quietly been fostering a healthy ecosystem on Optimism.

The launch of Aave v3 in March headlined an incredibly eventful year for Aave. Aave is once again taking a leadership role in pushing crypto forward, with a complete disregard for token price. The launch of its institutional DeFi platform Aave Arc, the development of decentralized stablecoin GHO, and the incubation of decentralized social graph Lens Protocol signal a focus on business development and long-term thinking.

Speculation primitives have ample runway for progress in 2023. The lack of convenient, capital-efficient access to leverage has been problematic for a while now. Users are forced to utilize makeshift techniques such as recursive borrowing in order to fully capitalize on opportunities that call for spot leverage.

Forex is a massive market that is highly gated in traditional finance. Despite ideal conditions, attempts at bringing forex to DeFi have failed, suffering from low demand and poor design.

• Synthetic assets utilizing the oracle model: Gains Network and GMX offer the easiest way to get leveraged exposure to synthetic assets. These projects have to implement creative solutions to mitigate tail risk, which are accompanied by various drawbacks. Still, this model is easy to implement and is already demonstrating the growing demand for forex in DeFi. Forex trades made up the majority of Gains Network volume in September and October. With GMX’s much larger user base and impending launch of synthetic assets, we could see forex volume explode in 2023.
• Collateralized stablecoins pegged to various currencies: Collateralized stablecoins would benefit from composability within the broader DeFi ecosystem. Existing attempts such as Iron Bank Fixed Forex and Handle.fi have struggled due to the limited utility of spot foreign-currency exposure. The lack of convenient ramps prevent personal finance use cases, and the inaccessibility of spot leverage pushes users towards synthetic perps for trading. This is a great example of the Synthetix and Gearbox value-adds discussed above. Without liquidity pools consisting of synthetic assets, peg stability must be hard-earned through incentives and arbitrage. Oracle-fed prices for synthetic assets can shoulder this burden for forex stablecoins through liquidity pools. Gearbox’s credit accounts allow for potential utility beyond non-levered trades on Uniswap. With additional improvements in complementary dApps and on/off-ramps, this more organic avenue for on-chain forex adoption could start to gain traction.
  
  

Default risk is the most obvious, given the unsecured nature of these loans. Counterparty and concentration risk are a close second. For example, Maple’s design is one in which a pool delegate decides who to loan lender capital to. If too much is given out to one party, lenders in that pool are exposed to greater counterparty risk. This is all the more important in the case of Clearpool, where each pool is exposed to a single borrower and therefore has higher inherent concentration risk.

For this report, the core focus is why this could turn out to be an important part of DeFi. We can all agree that liquidity is the lifeblood of a well-functioning market. When used correctly, leverage is a powerful tool. Unsecured lending remains the easiest way to unlock capital efficiency for professional investors and traders in crypto.

You’re probably familiar with the blow ups of institutional lenders like Celsius, BlockFi, Hodlnaut, and Babel Finance, as well as the potential ill-fate awaiting the likes of Genesis and several others. Traditional lenders run opaque operations. There’s no transparency to lenders as far as how much and to whom their money is being lent out. Capital providers to these lenders cannot evaluate concentration risk to a single borrower, and apparently they can’t rely on the lending intermediary to act with caution and diligence. Borrower concentration was what wiped out a number of lending books.

An example of this happened just this week. Last week, Auros missed a repayment of its ~$3M loan from Maple’s platform, triggering widespread concern. The situation only escalated from there.

Lyra Finance’s Avalon update brought the first delta-hedged AMM to DeFi. The ability for an AMM to hedge its obligations has been a game changer for LPs since launch. Delta hedging is extremely difficult to implement, but more delta-neutral AMMs and sustainable yield projects are starting to emerge.

Using GammaSwap, users can borrow an LP position and separate the tokens, gaining positive exposure to impermanent loss. Liquidity borrowers pay a funding rate to GammaSwap LPs, which results in a payoff structure that beats the vanilla LP position in all scenarios.

DeFi sits upon a few transparent infrastructure legos. Ethereum, Solana, Avalanche, and Arbitrum are a few examples of those base layers. These networks are home to non-custodial networks, where the highest degree of custody you would be subjected to is smart contract custody. And even in that case, every user has control over when they can deposit/withdraw funds.

As explained in the introduction, DEXs have seen the greatest degree of product-market fit thus far. And thus, DEX aggregators have been successful. In the future, as DeFi grows, we expect to see liquidity aggregation expand further than DEXs. Aggregators for borrowing, lending (or yield in general), options, perpetual swaps, and other products are bound to pop up. The large number of protocols facilitating each of these activities necessitates this.

For newer crypto users who use their own wallets to trade, UX aggregators offer some cool benefits. For starters, access is limited to protocols deemed to be “safe” from rug risk. Zapper is unlikely to integrate some new farm spitting out a 4-digit APY with a high risk of the team pulling off a rug. More savvy users who understand the risks of these farms will have no qualms occasionally visiting a new front end to indulge their inner degen. However, since the entire experience is non-custodial, there is a large degree of autonomy. For example, one could still swap into high-risk tokens using a UX or liquidity aggregator by overriding the warning that pops up. You get warned, and that’s it. Nobody stops you from doing anything.

VeTokenomics burst onto the scene with Curve’s yield farming frenzy at the tail end of DeFi Summer. The ensuing Curve wars fortified Curve’s position as DeFi’s liquidity moat. Today, dozens of other projects are starting to embrace veToken designs. There is now over $10B TVL in projects that have implemented or plan to implement some form of veTokenomics.

Typically, mature veToken structures such as CRV, CVX, FRAX, and BAL result in around 50% of token supply being locked – an undeniable benefit for token holders. When applicable, steep emissions elegantly charge a funding rate to token holders that provide no value to the project. Theoretically, long-term thinking by ve-lockers drives additional value. This benefit breaks down as individual users are outdone by aggregators which further separate incentives.

Once veCRV was launched, Convex created a liquid wrapper called cvxCRV. Convex allowed users to stake their Curve LP tokens to enjoy boosted yields without the veCRV commitment. This accelerated Convex’s accumulation of veCRV, as individual users tended to avoid the unnecessary sunk cost. Users who locked CVX for 16 weeks in exchange for vlCVX controlled the gauge votes of Convex’s veCRV and avoided the linear decay. This separation of veCRV’s utility allows vlCVX to wield massive voting power, with 1 vlCVX controlling over 5 veCRV. Individual veCRV holders are diluted, with veCRV’s utility spread too thin by comparison.

Since Convex requires users to lock CVX for vlCVX to steer gauge voting and earn bribes, the need for an additional liquid wrapper is born. Redacted Cartel’s Pirex creates liquid wrappers for locked-token schemes such as vlCVX. Pirex allows for the auto-compounding of rewards and the tokenization of future voting events. It will soon incorporate GMX along with – ironically – its native revenue-locked BTRFLY.

During Votium’s early rounds, bribers were able to steer over $5 in CRV emissions per $1 spent on bribing. This situation is particularly convenient for projects like Frax, who own a significant amount of CRV and CVX while using bribes to direct emissions towards their pools. vlCVX ownership offers a rebate for bribe expenses, as Frax essentially pays themselves. Emissions per $1 spent on bribes are now around $1.40, and will likely settle at or below $1.

As additional aggregation layers continue to emerge, users will opt for the outermost layer rather than deciphering the convoluted mess of unlock schedules and who controls who. Frax-like ownership at the metagovernance layer will be less practical, as NAV will be made up of unrelated businesses. Bribe markets will resemble native token dumping as a service as the increasingly transactional shadow market is relegated to the back end. As we are already starting to see with sustainable yield and principal-protected products, the market will squeeze everything it can out of these high FDV gauge tokens to support compressed yields.

Apart from new names like Rage Trade, there isn’t much design-level innovation happening with decentralized perpetuals. Because of this, a few of us on the Delphi DeFi team have begun to suspect that on-chain orderbooks will see strong traction.

To expand on the “incentivize market makers” point from above, all of these platforms basically rent liquidity from Deribit. Since on-chain options haven’t taken off, structured products create deals with market makers to get the liquidity they need. Market makers will, for example, buy calls from Ribbon depositors at a certain price, then sell an equivalent amount of calls with the same specs (expiry, strike) to hedge. By doing this, they capture a spread — essentially the difference in the price they buy from Ribbon at and sell on Deribit.

We got on-chain options-based structured products before on-chain options, which is peculiar to say the least. This makes the saturation even more surprising.

Selling options is not free money. Far from it. In fact, some of the most experienced and knowledgeable options traders think selling options is overrated from a yield-generation perspective. Many use the old analogy of it being akin to picking up pennies in front of a steamroller. In this context, the steamroller is the notion of tail risk — which is far too common in crypto.

One bad week can erase months of steady gains. Look no further than the performance of covered calls. This is precisely the kind of tail risk selling options entails.

But if you think about it logically, it does make sense that we saw mass outflows in the aftermath of market-wide contagion driven by the Terra and 3AC collapses. But on the flipside, once this tail risk had played out and the market had quieted down a bit, these vaults likely showed a healthy return, since the “black swan” had played out and price stagnation started to settle in.

• Simple swaps via DEX aggregators.
• Staking ETH via Lido/Rocket Pool.
• Access to automated liquidity-provisioning services.
• Relatively safe yields and access to low leverage using Aave/Compound.
• Higher and riskier yields using Yearn, Ribbon, Maple Finance, TrueFi, etc.
• Maybe even perpetuals trading on dYdX for users in accepted jurisdictions.
  
  

• Sybil resistance: An individual cannot beat us more than once.
• Incentives, game theory, and crypto-native recourse: The proportion of individuals that choose to hurt us will be below a sustainable threshold.
• System architecture: An individual cannot beat us too badly.
  
  

Biometric authentication is highly accurate, scalable, and versatile. Biometrics offer permanent, portable authentication that traditional passwords cannot provide. Biometrics can utilize numerous physical and behavioral features to verify identity with a high degree of confidence.

Social graph analysis is easier to fool in one instance than biometrics, but offers strong resistance to large-scale attacks. Compromising an entire social graph would take an enormous amount of time, capital, and coordination.

• Gating of financial privileges via credit scoring. The threat of being locked out deters malicious behavior.
• Punishment and/or repossession of assets. This threat is backed by the state’s monopoly on force.
  
  

Securitization and tranching will be crucial in the manipulation and repackaging of risk into more palatable chunks. The social graph will supercharge predictive analytics and allow for highly creative slicing of risk buckets. Alpha hunting and on-chain sleuthing will grow to encompass finding mispriced risk factors based on demographics, lifestyles, geographic locations, behaviors, etc.

Users progress through a tier-based system, gradually earning a longer leash as the protocol allows itself to become more vulnerable to default. This stepped-program will stagger the progression of user cohorts, allowing a beta test-like diagnosis of any weak points.

• Status quo on Aave/Compound/Euler.
• Payday loans:
• Due to the low time-lag of payday loans, they would carry relatively low risk. Coinbase supports direct deposit and has made strides towards this type of infrastructure.
• Experimentation with payroll custody is currently limited to prepaid debit cards. More progress needs to be made here.
• Payday loans could be amortized by payment streams via Sablier/Superfluid. This would dramatically lower borrowing costs, providing a credit card-like experience for those with no access to credit.
• Low probability of default allows capital-efficient use of credit delegation for guarantors. Aave’s seldom-used credit delegation feature that was introduced in v2 would find product market fit.
• 110% LTV capped at $ or % of net worth with guarantor.
• Removal of guarantor, progressively increasing LTV and borrow caps.
  
  

1. Sell an overpriced derivatives contract.
2. Borrow cash to construct an offsetting basket of securities.
3. Calculate profit X, borrow X net of interest to get paid today.
   
   

• Flash loans.
• Buy low/sell high, hold to maturity. Capital is tied up for the duration of the contract, and profit is realized at maturity.

Aave’s GHO stable coin is very promising. One overlooked aspect of its potential is facilitator #3: delta-neutral positions. There are some exciting possibilities for this in the future. Aave’s portal feature and incredibly deep liquidity are ideal for facilitating the settlement of multi-currency cross-chain offsetting derivatives contracts. The synergies between Aave’s lending business and crypto’s immature derivatives markets are tantalizing.

Today, typical arbitrage for crypto options may look something like the above. Buy low, sell high, hold to maturity. This is inefficient due to the collateral required to short an option. For arbitrage purposes, options must be fully collateralized. Otherwise, the setup is exposed to the price action of the underlying and no longer offers risk-free profit.

The options protocols are getting the most value from this arrangement, so it is in their interest to create a palatable situation for the lending platforms. Options platforms would receive much more efficient pricing and liquidity, likely making significant headway in their battle against CEXs. The lending protocol would gain utility for its idle reserves and product-market fit for its stablecoin (without expensive liquidity-mining programs).