What attempts have DeFi giants made to improve capital efficiency?

If everything goes as planned, there will be less than 15 days until Uniswap V3 is launched on the Ethereum mainnet. This means that the DeFi market is one step closer to the next "milestone" event.

In late March of this year, Uniswap released its highly anticipated V3 white paper for the first time, proposing to add "aggregate liquidity" and "range order" functions, and improve oracles. All of these designs are aimed at the same goal: to improve capital efficiency.

Although the public has mixed opinions on the V3 version, Uniswap's determination to improve capital efficiency is impressive. In fact, it is not just Uniswap, but also DeFi projects in other fields such as Aave that are constantly working to improve capital efficiency. After all, this is not only about improving user experience, promoting capital liquidity, and creating competitive advantages for itself, but more importantly, it may be about "going out of the circle" and challenging centralized traditional finance.

Based on this, this article will explore the reasons for the low capital efficiency of the DeFi market, sort out the attempts made by DeFi projects in the fields of spot trading, lending and derivatives to improve capital efficiency, and analyze the potential impact of these attempts on the cryptocurrency market.

1. The first hurdle in the DeFi market

Just as Ethereum urgently needs to improve scalability, DeFi projects also face urgency in solving capital efficiency. Before reviewing how DeFi projects can improve capital efficiency, it is necessary to understand the reasons for low capital efficiency, which will help us understand how DeFi teams improve and think.

Generally speaking, the reasons for the low capital utilization of DeFi projects vary depending on the track they belong to.

In the lending sector, low capital utilization is mainly manifested in over-collateralization. This is mainly because all financial activities in the DeFi world do not require KYC, and users’ loans are not endorsed by authoritative centralized institutions, which creates the risk that the borrower cannot repay the loan on time. Therefore, most DeFi projects "constrain" borrowers by over-collateralizing, which is equivalent to "changing credit to endorsement."

In the trading track, low capital utilization is mainly manifested in the fact that liquidity is not fully utilized. At present, most DEXs adopt the AMM model, where liquidity is evenly distributed along the x * y = k price curve, and the assets in the pool are used for all prices between 0 and infinity, which results in most of the funds invested by LP in the pool not being utilized.

For example, in Uniswap v2, only about 0.50% of the funds in the DAI/USDC pool are reserved for transactions between $0.99 and $1.01, and this price range has the largest trading volume and LPs can collect more transaction fees. Therefore, we can see that LPs can only collect fees for a small part of their positions.

At present, the problem of low capital efficiency is mainly concentrated in the trading and lending tracks, because the two constitute the basic layer of the DeFi market, and most financial activities are carried out on this basis. This article will also focus on sharing the improvements made by DEX and lending projects in improving capital efficiency.

2. How do DEX projects improve capital efficiency?

As mentioned above, in the DEX field, the AMM model is an important reason for low capital efficiency. Currently, spot and derivative trading platforms such as Uniswap, DODO and Perpetual have chosen to improve capital efficiency by improving AMM.

1. Improve AMM model

In terms of spot trading, Uniswap and DODO both start from the perspective of centralized liquidity to improve the utilization rate of LP funds. The former achieved this by launching the V3 version, while the latter improved the AMM model at the beginning of its design and created the active market maker model (PMM).

According to the Uniswap V3 white paper, through the "aggregate liquidity" function, LP can concentrate its positions in the price range where it believes the token has the most trading volume, thereby maximizing capital efficiency. For example, in the ETH/DAI pool, LP believes that the trading volume in the range of 1,000 to 1,700 US dollars is the largest, and it can allocate most of its funds to the price range of 1,000 to 1,700 US dollars, and a small part of the funds to the range of 1,000 to 2,000 US dollars.

The design concept of Uniswap is very similar to the PMM model launched by DODO, which uses the Chainklink oracle to obtain the latest market price of a certain type of crypto asset, and then concentrates the LP's market-making funds near this price to improve capital efficiency.

The derivatives trading platform Perpetual also chose to enter the market by improving AMM, and its design ideas are very interesting. We know that on the DEX platform, LP (equivalent to market makers) is the bearer of capital inefficiency. To solve this problem, Perpetual's method is to directly remove the role of market makers, and only traders exist on the platform.

Without market makers, how can traders' assets circulate freely? Perpetual proposed the concept of virtual market makers (vAMM). "Unlike traditional AMMs, which require liquidity providers to provide liquidity for the fund pool, the liquidity of vAMM comes directly from the smart contract vault outside the vAMM. The Perpetual team therefore pointed out that vAMM does not require LPs to bring liquidity, and traders themselves can provide liquidity to each other."

2. Leverage DeFi composability

Without talking about changing the AMM model, Balancer has taken a completely different path from projects such as DODO and Perpetual, and this path seems to provide ideas for improving capital efficiency for existing DEX platforms - using the composability of DeFi, joint lending agreements will fully mobilize "idle" funds.

Specifically, Balancer will jointly launch an asset manager with the lending protocol Aave, allowing unused assets in the V2 funding pool to be routed to Aave, thereby improving capital efficiency and generating returns.

It should be noted that Balancer's idea was not its first, Curve was the first to propose the plan. However, according to Balancer, compared with Curve's practice of encapsulating assets, its V2 version provides a new method for low-cost transactions without encapsulation. However, this version has not yet been officially launched.

3. How do lending programs improve capital efficiency?

In the view of the loan development team, since over-collateralization is the direct factor leading to low capital efficiency, lowering the collateral ratio or even going uncollateralized is the way to solve the problem.

1. Reduce the mortgage rate

The lending protocol Liquity is a practitioner of reducing the mortgage rate. The protocol was launched by Robert Lauko, a former blockchain researcher at the popular decentralized computing platform Dfinity.

According to Liquity's design, the minimum collateral rate it supports is 110%, which is much lower than MakerDAO's 150%, which means that users can get higher liquidity with the same funds. For example, if the liquidation line is 150%, Alice wants to deposit ETH to lend DAI. To prevent liquidation, she keeps the collateral rate at 300%, that is, deposit $300 worth of ETH and lend $100 DAI. At this time, if the ETH price drops by 50%, Alice will not be liquidated. But if the liquidation line is 110%, she only needs to deposit $220, and she can complete the loan with a smaller collateral rate and less capital investment under the same market conditions.

In addition to reducing the collateral ratio, Liquity's thinking on improving capital efficiency also involves the liquidation process. Liquity believes that MakerDaO's 6-hour auction process is too lengthy, and the value of the collateral faces the risk of further decline during this process. Therefore, the team designed an "automated instant liquidation" mechanism.

To put it simply, this mechanism is designed with three liquidation procedures: the first one is triggered by the "stable pool" (LP can deposit the Liquity stablecoin LQTY into the pool to participate in liquidation and earn the liquidation difference), which is equivalent to the "liquidation fund". After the asset's collateral ratio falls to 110%, the system will automatically start liquidation.

If the funds in the pool are not enough to pay off the debt, the Liquity system will automatically redistribute the remaining debt and related collateral to the borrower, which is the second procedure. Assuming the problem is still not resolved, the system will start the third procedure, global liquidation. The Liquity team said that global liquidation acts as a deterrent, motivating users to increase collateral assets to avoid liquidation.

2. Unsecured lending

In the traditional financial market, most lending activities are unsecured loans. The reason why unsecured lending is possible is that it relies on credit endorsement.

In the decentralized financial market, if DeFi projects want to achieve unsecured lending, they also need an intermediary layer that can prove the credit status of the lender. In this regard, Teller and Aave proposed two completely different concepts. The former chooses to rely on data provided by traditional financial institutions, while the latter is completed in a decentralized way through credit delegation.

On the Teller platform, if a user wants an unsecured loan, he or she needs to link a bank account after logging into the wallet. Subsequently, Teller will calculate the loan interest rate based on an open source credit risk algorithm and then lend the money. The essence of this method is to connect to the bank API, rely on the user's credit situation in the real world to measure their repayment ability, and ultimately lend the assets.

Unlike Teller's centralized approach, Aave's uncollateralized lending service is more "blockchain-spirited."

Flash loans and credit delegation are Aave's attempts at unsecured lending. Due to the frequent occurrence of flash loan accidents, we will not discuss them here, and we will focus on understanding credit delegation.

The credit delegation launched by Aave means that the depositor (who has not borrowed) entrusts his credit line to someone he trusts and earns interest by helping others complete the loan. This means that the borrower becomes the guarantor, and the credit of the two is bound, which can avoid the situation of being unable to repay to a certain extent.

However, compared with ordinary users, this solution is more suitable for institutional customers. At present, CEX platform karen has signed a contract with DEX platform Deversifi through the OpenLaw agreement to complete the unsecured loan. (Note: OpenLaw is a blockchain-based legal agreement development company that aims to integrate legal agreements with smart contracts to give them corresponding contractual status).

4. DeFi projects that are naturally born for capital efficiency

In addition to improving capital efficiency through self-iteration, there are also DeFi projects in the market that are naturally born for capital efficiency, such as the machine gun pool Yearn Finance.

When talking about Yearn Finance, we have to mention its founder, Andre Cronje (AC), who pursues extreme capital efficiency. Since launching Yearn last year, AC has been integrating other DeFi projects non-stop, and has launched new projects and announced new development ideas one after another, Deriswap being one of them.

Although Deriswap has not yet been officially launched, according to public information, "the protocol combines exchange, options, and lending into a single contract with high capital efficiency, allowing swaps, options, and lending interactions between two assets." AC is making every effort to pursue high capital efficiency.

In the DeFi market, projects that can provide high capital efficiency have always been the darlings of the market, and the success of Alpha Homora is an example.

At the beginning of the year, Alpha Homora grew rapidly, and its TVL ranked among the top ten in the market. The reason behind this is that it provides an integrated service of "leverage + machine gun pool + lending", which increases the possibility for users to obtain higher returns.

V. Conclusion

At present, whether it is a new or old DeFi project, its choice to improve capital efficiency as the main development direction is nothing more than solving industry pain points, helping users maximize their returns, and forming a competitive advantage. In the future, as more projects pursue high capital efficiency, the indicator for measuring the DeFi market may evolve from TVL to capital utilization.

In this process, DEX will inevitably attract more large market makers to enter DeFi by improving capital efficiency and creating more profits for LPs. This will not only reduce transaction slippage and impermanent losses, but also help DEX to form stronger competitive pressure on CEX.

At the same time, as unsecured lending matures, the DeFi market, which offers high interest rates, will attract traditional institutions to enter, ultimately increasing the liquidity of the entire crypto market.