Bankless | Is DeFi Heading Towards Death? What Causes the Significant Decline in TVL?

Amidst the market downturn and rumors of legal investigations and liquidations involving Celsius and Three Arrows Capital, the performance of the DeFi market has also been lackluster compared to six months ago. Is DeFi heading towards its demise? What are the reasons for the significant decline in its TVL? Analyst Ben Giove from the crypto research firm Bankless shared his views on these questions.

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The Current State of the DeFi Market

Assessing the current position of the DeFi market and the extent to which liquidity and on-chain activities have contracted since the bear market using some on-chain data metrics.

Total Value Locked (TVL)

The total TVL of multi-chain DeFi is approximately $621 billion. This is a 66.5% decrease from the historical high of $1.868 trillion reached in December 2021. The significant decline is attributed to a widespread drop in integrated assets like ETH and wBTC, and the decrease in yields leading to capital outflows.

Decentralized Exchange (DEX) Trading Volume

DEX trading volume is far below the peak of $3.086 trillion reached in November 2021, with Ben Giove estimating a June volume of around $1.033 trillion, a 66.2% decrease from the peak. This trend may be attributed to the weak market trends of the past few months as trading behavior is highly correlated with price increases.

Borrowed Amount

This data measures the value of outstanding debt in lending protocols, currently around $51 billion. This is a 75.3% decrease from the peak of $211 billion in December last year, indicative of a typical feature of a bear market - a decline in leverage demand.

Stablecoin Supply

The current market value of stablecoins is approximately $1.567 trillion. This is a 17.1% decrease from the peak of $1.889 trillion in May 2021. The decline is primarily due to the collapse of UST, which had a market value of around $18.7 billion at its peak, leading to a contraction in the supply of other stablecoins as holders redeemed assets in a panic.

Token Prices

The chart below shows the price trend of the DPI DeFi Pulse Index, a market-weighted index tracking the performance of the entire DeFi asset market. It has dropped 90.3% from its peak of $656.49 to the current price of around $63.45.

In addition to market consolidation and weakness, the inflation of token rewards has exacerbated the decline of DPI. Many constituent tokens of DPI offer liquidity mining programs, but these incentive measures are less attractive in the current market conditions.

From the data above, it is evident that capital is leaving the DeFi ecosystem, with reduced user trading activities and declining borrowing volumes. Billions of dollars in stablecoins are also being exchanged for fiat. All of this is happening as the market value of DeFi tokens continues to depreciate, signaling a broader and more severe bear market, with DeFi clearly entering a contraction phase.

Exploring Reasons for Price Declines and Data Declines

The DeFi industry has entered a contraction phase for the first time since its development. Ben Giove believes this is mainly due to the following reasons:

1. Dual-sided nature of yields

As the crypto market rebounded post-2020, protocol utilization, liquidity, and leverage ratios surged. The increase in usage led to higher yields, allowing liquidity providers to earn more fees, deposit rates in the lending market rose, and the value of incentive measures denominated in tokens also increased.

During this period, DeFi protocols offering APRs in the 4 to 5 digits were quite common, attracting a significant influx of funds.

However, as prices fell, on-chain activities also decreased. The decline in yields led to a diminishing appeal of deploying funds in DeFi, resulting in capital outflows.

For instance, deposit rates on stablecoins on Compound and Aave range from 0.7% to 1.7%, even lower than U.S. treasuries.

2. Overreliance on Liquidity Mining

DeFi degens may view liquidity mining as gamifying finance, a significant win for DeFi, but the growth caused by this monetary incentive system is not sustainable and needs improvement.

While liquidity mining is quite helpful for the initial growth of protocols, once rewards start to decline, funds flow out of DEXs or protocols. Additionally, liquidity mining exerts downward pressure on the prices of reward tokens, which are typically the governance tokens of the protocols themselves, as they need to be sold to realize profits.

This method also depletes the capital of DAO treasuries since protocols often allocate a significant portion of their native tokens to these reward programs. This not only reduces the funds available for protocol development but also makes them less flexible in utilizing capital under adverse macroeconomic conditions.

3. Protocol Explosions and Exploitations

As the market continues its downturn, many events have damaged trust and highlighted the inherent major risks in DeFi.

One of the most severe incidents to date is the Terra event, where the death spiral of UST and LUNA led to losses of billions for investors. Not only that, but other protocols in the Terra ecosystem were also affected.

DeFi hacks have also significantly impacted investor sentiment, with over 20 hacking attacks in 2022 resulting in user fund losses exceeding $1.4 billion, surpassing the total losses for the entire year of 2021. The frequency and scale of hacking attacks could lead to a sharp decline in on-chain activities, coupled with reduced yields, making the risk-return profile of deploying capital on-chain less attractive than before.

Catalysts for the Revival of DeFi

Having understood the reasons for the decline in DeFi prices and reduced on-chain activities, Ben Giove shared key factors that could help the DeFi industry return to growth:

1. Introduction of Scaling Solutions

Despite reduced on-chain transactions and falling prices, Ethereum's gas fees remain at a certain level, making it unable to effectively onboard potential users. This not only limits the types of DApps that can be built on it but also prompts users to riskier positions and portfolio management with these DApps.

For example, to save on gas costs, users with only a small amount of funds are forced to concentrate their funds on fewer protocols, unable to adjust as freely.

This situation is expected to improve as scaling solutions mature. While this technology is still in its early stages, meaningful adoption and significant transaction volumes have already appeared on these Layer2 networks. User transaction costs will be significantly reduced, and transaction confirmation times will decrease, helping bring in a new wave of DeFi users.

2. Real-world Adoption

While billions are currently locked in DeFi today, a significant portion comes from whale users. Limited expansion of the user base is due to the lack of easy entry points and regulatory issues.

However, there are increasingly more avenues now, through which a more diverse user base can be brought in, injecting more capital.

For instance, protocols like Maple Finance, Clearpool, and TrueFi provide institutions with a compliant way to access collateral loans using DeFi. This allows institutions to operate over the chain, reducing transaction costs and improving efficiency.

Aside from institutions, decentralized lending protocol Goldfinch has provided over $102 million in loans to businesses operating in markets like Nigeria, Southeast Asia, and Mexico.

By expanding the user base and introducing new capital, not only does this help showcase the value of DeFi, but it also contributes to its sustained growth.

Conclusion

Ben Giove stated that the collapse and liquidation crisis of UST, Terra, Celsius, and Three Arrows Capital Terra's venture capital institutions were not accidental. The flawed structures and mechanisms, discovered within a few days, led to fatal consequences from the protocol to the related organizations. However, these projects are not built on Ethereum and are not DeFi protocols. The transparent and open values of DeFi have been demonstrated in various events.

With the emergence of Layer2 scaling solutions and increasing use cases by institutions and more businesses, Ben Giove remains positive about the future of DeFi.

"Yes, DeFi may be bad. But it's certainly not dead. In fact, DeFi is doing well," said Ben Giove.