Ethereum transaction volume and usage continue to increase, and DeFi institutions are rushing into the market

In the second quarter of 2021, more financial analysts, media, politicians and entrepreneurs began to ask the question: What is DeFi and what are its benefits? After a year of vigorous development, all walks of life began to pay more attention to DeFi. Because DeFi is indeed solving an obvious contradiction, that is, decentralized currency should also be accompanied by decentralized services. The following is Consensys's review of the various DeFi sections on Ethereum in the second quarter of 2021, hoping to give everyone some understanding of the development of the DeFi ecosystem in the second quarter.

The State of DeFi

As of July 1, 2021, there are currently 161 million unique Ethereum addresses, up 10% from the end of the first quarter of 2021 and down slightly from the 12% growth at the beginning of the year. By the end of the second quarter, at least 2.91 million unique Ethereum addresses had interacted with at least one DeFi protocol, up 65% from the first quarter.

As community-driven education, simple user interfaces, attractive yields, and general awareness of DeFi best practices increased throughout the quarter, the number of new addresses also increased, but it is important to note that with wallets like MetaMask, it is easy to make multiple accounts, which means that addresses and users are not necessarily one-to-one. While this is a significant increase, active DeFi addresses only account for 1.81% of all Ethereum addresses.

Another measure of DeFi usage is the number of monthly active users on MetaMask, which exceeded 7.3 million as of June 1, 2021. This is partly due to the growth of DeFi applications on other Ethereum Virtual Machine (EVM) compatible networks that users can access through MetaMask, such as BSC and Polygon.

Stablecoin supply continued to grow rapidly in Q2 2021, with total issuance now approaching $65 billion, up more than 60% since the end of Q1 2021. USDT, issued by Tether, accounts for the largest proportion of stablecoins on Ethereum, at about 48%, down from about 58% of total supply at the end of Q1 2021. Since the regulatory issues of USDT have not been well resolved, perhaps this is one of the reasons why DeFi users are increasingly liking USDC and DAI for use in DeFi protocols. DeFi lending protocols such as MakerDAO, Compound, and Aave now account for about 23% of USDC supply.

Stablecoins such as MakerDAO’s DAI or Circle’s USDC are not only one of the important early foundations of DeFi, but also a way to hedge against crypto market volatility. Swaps between ETH and other ERC-20 tokens and stablecoins are one of the most frequently traded pairs that users access through MetaMask Swaps.

In addition to hedging volatility without having to convert ETH and other tokens to fiat on centralized exchanges, stablecoins are a fundamental building block for other DeFi options, such as lending. In mid-May, outstanding DeFi debt increased from $10 billion to an all-time high of $18 billion, followed by a collapse in the price of ETH and other ERC-20 assets, leading to a new record of $362 million in liquidations on May 18.

DEX

Decentralized exchanges, automated market makers, and token trading aggregators are technical descriptions of types of cryptocurrency exchanges that operate without a central authority, allowing users to trade peer-to-peer and maintain control of their funds.

Coinbase, which officially went public in Q2, identified DEX as one of the main threats to its business in its S-1. In Q2 2021, DEX trading volume reached its highest level ever, witnessing a whopping $173 billion in trading volume in May alone, with total trading volume in Q2 reaching $343 billion. This exceeds Coinbase's total trading volume of $335 billion in Q1 2021, as DEX only supports trading of EVM-compatible assets, and 58% of Coinbase transactions are Bitcoin.

So why not compare the trading volume of DEXs in the second quarter with that of Coinbase? The answer reveals another advantage of DEXs: because they are deployed on Ethereum as smart contracts, all real-time data can be viewed using open source services such as Dune Analytics, while Coinbase's data needs to wait for the company to release it. Now, decentralized insurance protocol companies like Nexus Mutual use Dune Analytics to maintain a real-time public platform of their financials, such as total supply, insurance costs, claims, returns, etc. It is expected that in the future, public real-time transparency will not only become a key differentiator for DeFi, but also a major advantage.

One of the big moments for DEXs in Q2 was Uniswap deploying its V3 version. Uniswap increased its market share of DEX trading volume from 60% to 74% throughout Q2. The main change in Uniswap V3 is to improve its capital efficiency, or concentrate funds in the price range where assets are most likely to be traded.

Because smart contracts on Ethereum are permanent, users can still use Uniswap V1 or V2. Currently, there is still more value in providing liquidity on Uniswap V2, but Uniswap V3 has more trading volume, which proves that this new way to improve capital efficiency is finding the best prices for users on various asset pairs.

Institutional Admission

Based on the data and analysis provided, it is no exaggeration to say that the entire financial system is being rebuilt from first principles with greater security, transparency, and composability. Financial innovation and growth have brought investment returns and opportunities, leading to an increasing influx of institutional capital into the space. Providing USDC liquidity on Aave currently yields an annual yield of 6.27%, with an average yield of 7.22% since inception. As protocols chase liquidity, providing sUSD liquidity on Aave to obtain yields of up to 32.5% is becoming increasingly the norm.

DAI yields for various lending protocols. Source: Codefi Compare

Most of these lending protocols have only been around for a few years, and while jurisdictions around the world are still determining how to advance existing regulatory structures with their new logic, new services have already begun to play an important role in facilitating institutional capital inflows. Generally speaking, larger financial entities have more onerous compliance and monitoring, reporting, and custody. This is why DeFi has been widely adopted among small and medium-sized cryptocurrency funds (less than $1 billion in AUM).

More regulated institutional investors are getting involved in the space, motivated by the desire to capitalize on investment returns, while also being able to do so from a regulatory and compliance perspective. PwC reports that 47% of traditional hedge fund managers (with $180 billion in AUM) are considering investing in cryptocurrencies. Intertrust found that hedge funds are expected to invest 7% of their assets, or $312 billion, in cryptocurrencies within five years. Investment firms will undoubtedly lead DeFi adoption, however, in order for these and other larger and more regulated institutions to cross the chasm, the required DeFi infrastructure must be built. Excitingly, this is exactly where the market is.

The requirements of institutional financing can be mapped through the capital allocation cycle - from research, pre-trade compliance and best execution to monitoring, reporting and custody. Products and services in all of these categories have exploded in the past 6 months, as capital has poured in to build the necessary DeFi infrastructure. For example, cryptocurrency custodians have raised significant funds, made strategic investments, and even been acquired.

Coinbase alone holds custody of over $90 billion in assets, while other custodians, such as Bitgo Custody, hold at least $16 billion in assets, and Gemini currently holds over $30 billion in assets. Additionally, custodians like Fireblocks have moved over $100 billion. Compliance, trading, and data analytics are attracting capital to build and expand institutional crypto access.

It’s not just the tools and infrastructure around DeFi that are being built. DeFi itself is also innovating to provide access to institutional financing. Private lending pools are ensuring that only KYC participants can access on-chain asset management, such as Aave’s permissioned pools. Compound Finance recently launched a new product, Compound Treasury, which allows institutions to earn a fixed interest of 4% per year, and leading fintech companies such as Current have begun working on integrating Compound Treasury into their products. More and more institutional-focused projects are entering the market to solve miner extractable value (MEV), create best execution protocols, and figure out decentralized identity.

DAO

As DeFi protocols and services continue to succeed, decentralized autonomous organizations (DAOs) have flourished as a means of protocol governance. Thousands of DAOs control large amounts of funds that can be allocated to various initiatives and new projects.

In fact, the top 20 DAOs alone hold over $6 billion worth of digital assets. While well-known DeFi projects like Compound and Uniswap control the largest DAOs, there are thousands of other projects, from media organizations like Bankless, social token communities like Alex Masmej, to public funding entities like Gitcoin, that use DAOs to coordinate and manage their finances. There are now over 190,000 DAO members across the crypto system.

There are over 1,100 DAOs using Snapshot for governance. Source: Snapshot

DAOs have been able to thrive largely because of an emerging tooling and development ecosystem that increasingly provides the necessary functionality to support these new organizational structures.

There are projects today that focus solely on DAO token services, governance, treasury, risk management, growth, community, operations, and development. As crypto projects continue to grow and distribute governance, DAOs will continue to grow in importance. Today, many projects have DAO structures, but are still often controlled by a small number of investors and the original team that built the initial product. Over time, DAOs will gain more relevance as real disagreements emerge between key stakeholders within the community that can only be resolved through voting campaigns.

DeFi Governance

Most major DeFi protocols are not only used for lending, but are also governed by token holders. Token holders vote on proposals ranging from proposals on how the protocol should allocate its treasury funds to more specific details. By paying attention to governance updates, users can clearly see major changes that are about to happen in DeFi protocols.

Synthetix

Of all the protocols, Synthetix has by far the most active governance. Multiple updates occur every week, changing various parameters related to synthetic assets. Additionally, Synthetix frequently changes the fees associated with issuing synthetic assets in the protocol. Due to market volatility, Synthetix has chosen to lower its target collateralization ratio. Finally, Synthetix can manually approve users to create synthetic versions of new assets, such as US stock indices, through the governance process.

AAVE

While Synthetix offers one of the most active governance systems in all of DeFi, Aave’s governance typically handles larger proposals, such as updating its native insurance system in the event of a shortfall event, known as the Aave Security Module. In addition, Aave voted to add the crypto-collateralized stablecoin Rai to Aave V2.

Airswap

AirSwap token holders can earn compensation by creating and voting for improvement proposals. After voting, participants can extract fees from the protocol fees collected based on the weight of their vote. In Q2, the community proposed and approved a vote to create a new token swap website, built around a streamlined, simple, and secure swap experience, established a new visual style for AirSwap website properties, and adopted a rewards system that allows additional activities outside of proposal creation and voting to be rewarded, such as creating analytical dashboards and technical improvements. The community also voted to adopt a governance "circle" where each member can allocate points to the contributors they work with based on their contributions at the end of each era.

Uniswap

Similar to Aave, Uniswap does not have a very active governance process. The lack of strong governance may be due to the fact that votes require 40 million UNI support to pass, and users must have 2.5 million UNI to submit proposals. That being said, Uniswap has passed two votes to lower the proposal submission threshold to 2.5 million UNI and fund a new DeFi lobbying organization aimed at informing regulators of the benefits of DeFi.

Yearn

Like Aave and Uniswap, Yearn does not have a very active governance presence, although the protocol's governance process has changed significantly over the past month. Additionally, Yearn set policy parameters for which teams should decide how to distribute the airdrops generated by Yearn. Lastly, Yearn proposed changes to their Multisig signers and adopted a new protocol governance structure. Multisig signers are like a board of directors for the protocol. They do not manage day-to-day operations, but are required to approve major decisions.

Compound

Like Synthetix, Compound also has a very active governance process. Major updates include moving to a new governance smart contract, support for new assets like LINK, and increasing the number of days users have to review proposals before voting, and the time they actually have to vote on them. Additionally, Compound chose to change their oracle system from primarily using Coinbase to using Chainlink’s oracle network. Lastly, Compound updated their cToken standard so that 2.8% of liquidations now go to their cToken reserve, reducing the risk of cascading liquidations that could lead to the protocol going bankrupt.

DeFi Expansion

Between April and June, the median gas fee price fluctuated greatly, ranging from 100 gwei to a maximum of 300 gwei.

Every DeFi user is afraid that the gas fee will be too high. On May 18, due to the decline in ETH prices, users rushed to interact with DeFi lending protocols to avoid liquidation, with the total cost of gas fees exceeding $100. Since June, gas fees have been low, hovering around 30gwei, which is $1.33 for a simple transfer and $12.65 for an Unswap transaction. Why is the gap so big?

The best answer is that EVM-compatible blockchains really took off in the second quarter, attracting users with lower fees and higher throughput. In fact, BSC and Polygon have recently surpassed Ethereum in transaction counts.

Layer2 aims to significantly reduce the cost and time of Ethereum transactions. Currently, there are more than 15 important EVM-compatible expansion projects, and there is controversy surrounding whether the network is Layer2, sidechain, or submission chain. The process of using a second-layer network on Ethereum involves several steps. First, you need to use a "bridge" to transfer assets such as ETH or USDC to the second-layer network, and then switch the network on MetaMask from the Ethereum mainnet to the specific second-layer network you will use.

Each of these steps carries risk, potentially locking funds in an insecure chain or being unable to withdraw those assets when the network is congested. As shown in the figure below, the value of assets locked in these second-layer chains is always variable as users try different networks and mostly similar users move assets between different networks.

In general, as more second-layer networks come online, especially rollups, we may see further redistribution of assets. The community is also looking forward to deploying Uniswap V3 on Infura and Truffle to see which one can achieve greater capacity.