Bull-Bear Cycle: Is the DeFi Narrative Over?

Original source: Dragonfly Research: "DeFi's (non)Progress This Cycle"

By Celia Wan

When people start to question everything they believed during the bull market, we know it is the end of a cycle.

This round of the crypto cycle began with Compound launching COMP and bringing the concept of Yield Farming to the masses, and officially ended with Terra being killed by Anchor’s promised 20% yield and over-inflated LUNA.

The crash has raised a series of introspective questions about the effectiveness of other DeFi projects:

“I don’t see a clear difference between Terra and more standard DeFi protocols. Until DeFi fills a real economic need (i.e. something to get financed), isn’t this just a different style of putting your money before someone else?”

Even questioning Bitcoin:

“Over long enough time frames, Bitcoin’s mechanism design is just as flawed as Terra’s.”

Usually, when a trend collapses, the bubble evaporates. Take Terra, once the biggest success story of DeFi and L1, for example. Its failure meant that liquidity mining lost its luster, expectations were reassessed, and prices were adjusted.

Although many coins are now trading at all-time lows, the market is now converging on new prices that are less based on hype and more based on a realistic view of how far we have come in the last cycle. The crypto winter is a great time to look back at where we have been and how far we have actually come.

Source: DeFi Llama (excluding double counting, staking, pool 2, and borrowing)

To put the last price cycle in context, we benchmarked the current prices of some of the most notable DeFi and L1 projects against their all-time highs and prices on November 1, 2020. The latter date was chosen because it was at the beginning of the cycle, when things were starting to look good for DeFi and L1, but the bubble was still small - Uniswap launched its token two months ago, but the price has not recovered at this time; DeFi's TVL is about to break the $10 billion mark, but has not yet seen exponential growth; projects such as Avalanche, Solana, and Terra have not yet launched their respective liquidity mining programs and are rarely discussed.

These price points can reveal insights into: 1) the maximum return an investment in a project could have generated since the start of the cycle; 2) the ability of the project to retain its value at the end of the cycle; and 3) the drawdown a token experienced from its ATH to the end of the cycle.

It turns out that both DeFi and L1 have underperformed Ethereum and Bitcoin in terms of drawdowns. This is not surprising, as ETH and BTC have the strongest market consensus, and this consensus is less affected by the ebbs and flows of the market. For the same reason, Ethereum and Bitcoin have worse maximum returns than most DeFi and L1 tokens.

Data as of June 28, Coingecko

Meanwhile, in terms of maximum returns, L1s are the clear winners of this cycle. The top two projects, Solana and Polygon, have become famous in this cycle through generous ecosystem funds and liquidity mining incentives. They each posted a maximum return of 5 figures, far exceeding other L1s such as Avalanche and Near.

Overall, L1 outperformed DeFi as a whole. DeFi blue chips overall lagged (though still posted impressive 4-digit gains). COMP and SNX performed even worse, but this is likely because their price cycles don’t match the ones being discussed (SNX launched in 2018, COMP ran until November 1, 2020).

This pattern tells us one thing - DeFi has not generated much alpha on top of L1 beta in past cycles.

Jason Kam (@mapleleafcap) has a great framework for thinking about this argument. In the summer of DeFi in 2020, he asked a rather pointed question - if ETH is similar to an energy commodity for building a petrochemical value chain (DeFi), then "Is it better to invest in oil or petrochemical/industry chain stocks?

Looking back at what we have achieved in past cycles, I think the answer to this question is clear - the risk-reward ratio of the underlying token is better than any application built on it, at least for now. Over the past two years, blue-chip DeFi tokens have experienced similar drawdowns as L1 when the market fell, but have shown less upside potential than L1 when the industry took off.

Heuristically, this is easy to understand. So far, most of the hype around DeFi is because it can bring "users" and "liquidity" to L1. However, when users do come to L1, most of the time they are attracted by liquidity mining incentives, and they quickly find that these incentives are the only thing they can do on the blockchain. Then, when the returns decrease, they will move to other L1s with higher returns.

In this relationship, L1 adds no value to DeFi. DeFi exists to make L1 look good - it is a means to end TVL and user growth, which then leads to "adoption" of L1. However, many DeFi projects themselves do not benefit from building on different blockchains, and some are even hindered by chains that are incompatible with the EVM and poor development documentation.

Therefore, these DeFi projects lack the intrinsic motivation to maintain their market value. Not only is their growth highly dependent on the expansion of L1, but their advantages are also limited by the ecosystem they belong to.

The most telling numbers that reveal this vicious growth pattern come from comparing the token prices of these projects now to the prices at the beginning of the cycle. Refreshing the numbers, these numbers show how much value DeFi and L1 projects can retain after most of the bubble is washed away by the LUNA crash.

Data as of June 28, Coingecko

The results show that DeFi has not outperformed Ethereum or L1 in terms of value preservation , despite almost all tokens having achieved more than double-digit growth during this period (except COMP, 1INCH, and SNX). Take UNI as an example, its return from November 1, 2020 to today is 128.22%, while Ethereum's return is 208.26% (UNI has also recently received additional price increases due to the acquisition of Genie and the new NFT roadmap). In other words, if you had some Ethereum at the beginning of the cycle and held on to it, you would have outperformed DeFi at this time ("holding on" is important because Ethereum's maximum return is lower than UNI). The same is true for many other DeFi tokens.

This observation is a sobering look at what these projects leave behind at the end of their cycles. The old model of attracting users to DeFi with liquidity incentives and airdrops no longer works. DeFi brings users to L1 without caring about what exactly those users do. The end result is that DeFi, which is essentially part of a service industry, can only serve itself - users participate in DeFi to participate, not to use it for other activities. This kind of self-interest sometimes degenerates into a Ponzi scheme.

Of course, price is not the only important factor. In the past cycle, some real innovations have also occurred in DeFi, and its progress cannot be quantified by token prices. For example, the pioneering centralized liquidity feature of Uniswap V3 has opened up a huge design space for the emergence of new applications; the increased demand for block space has inspired a series of block space financialization protocols, such as Flashbots and Alkimiya.

Finally, there are some DeFi protocols that launched their tokens late in the cycle and have not had the opportunity to reach their full potential. For example, projects such as Lido, Ribbon, and dYdX all have multiple products or industry updates coming soon that will further drive their growth.

Lido will see a huge boost to its TVL once the Ethereum merger is complete. Ribbon offers a ton of structured products that are well suited for an on-chain composable environment but are currently untapped. dYdX and some other derivative protocols still have a huge untapped market to capture, especially when comparing their volumes to their off-chain peers.

The fact is that while L1s were able to outpace DeFi in the last cycle, none of them will be able to grow further if we can’t figure out where new users are coming from.

DeFi will become exciting again when new categories emerge that can bring real users to the blockchain, users with real financial needs that DeFi can serve. And the rise of NFTs and Web3 in the second half of the cycle has demonstrated a different demand than over-leveraged tokens. These categories will attract new users and reconnect them to DeFi, which will be the story of the next cycle.

Until then, there are still many questions to be answered and teams working on important research for DeFi. The bear market will provide them with the much-needed time to focus on their products rather than rushing into a token-based listing.