Research report | After the DeFi crash, the potential crisis has not yet been exposed

Source: Hashpai

Author: LucyCheng

1. Overview

In the first half of 2020, Bitcoin halved, slightly rekindling market enthusiasm; in the second half of the year, the decentralized financial market unexpectedly became popular, setting off the entire crypto community in one fell swoop. Since June, DeFI projects such as Compound, yearn.finance, and Sushiswap have taken turns to launch, and the related tokens have shown a growth trend of several times or even dozens of times in price.

The rise and fall of the total market value of DeFi projects in the past year (data source: DeBank)

The market is growing wildly, aggregated DeFi projects are emerging one after another, and capital users are flocking in; but most of the participants who enter the carnival have not yet realized that these high-yield financial projects with superimposed functions have invisibly integrated multiple risks. With the recent failure of the YAM project and the cashing out of the founder of Sushiswap, DeFi tokens have collapsed one after another, the field has lost its popularity, and the market has reached a new turning point. In this article, Hashipai will analyze decentralized financial projects and observe the huge risks hidden behind the wealth-creating effect of the DeFi market.

2. From the surge in June to the plunge in September, the popularity of DeFi has declined rapidly

From 2018 to early 2020, the total market value of DeFi projects only grew by about 92%; as of January 1, 2020, the figure reached $1.53 billion, less than one percent of Bitcoin's current market value. The market trend remained unchanged in the first half of this year, with the total value of DeFi still hovering around $1.5 billion. It was not until early June that a turning point appeared and it entered an exponential growth mode. According to data from DeBank, in just three months, the total value of the DeFi market jumped sharply from $3.3 billion to $17.1 billion, a cumulative increase of more than 446%. During the same period, the total locked amount of DeFi also showed a straight-line soaring trend, doubling tenfold to around $10.5 billion.

Changes in the total locked amount of DeFi projects from July 2017 to the present (data source: DeBank)

The market surge in June is inseparable from the credit of the lending protocol Compound. Since the project announced on June 16 that it would produce the governance token COMP through liquidity mining, the secondary market that provides trading of the currency has quickly spread from decentralized exchanges to centralized exchanges. More than 70 trading platforms including Poloniex, Coinbase, and Binance have successively added support for COMP, and the output of tokens has increased by more than 3.29 times in less than a week. In the following month, Compound has attracted more than $1 billion in locked positions, and the growth value of related data is 48 percentage points higher than the total locked position of the entire DeFi market at the beginning of 2020.

Compound's on-chain lock-up situation over the past year (data source: DeBank)

Similarly, Balancer, following in the footsteps of Compound, also showed a strong growth trend, contributing $1.38 million in locked-up amount when the total locked-up amount of DeFi projects doubled in June. Although the prices of the two projects have been sideways since July, Compound, which was the first to launch lending mining in the DeFi field, set off a wave of yield mining in the market. Following closely, DeFi "foods" such as sweet potatoes, salmon, corn, pearls, kimchi, etc., which focus on liquidity mining, have been launched on public chains such as Ethereum and Tron, and star projects such as YFI, YAM, and SUSHI have successively detonated the market.

Yearn.finance launched liquidity mining and governance tokens on July 18. The price of the token surpassed Bitcoin within one month of its launch, and reached a peak of $39,894 on September 13. The YFI market was unprecedentedly hot, attracting media coverage, and the controversy over additional issuance has set off a wave of DeFi project forks in the market.

YAM, which uses the YFI mining distribution model, forked AMPL and soared 260% within 24 hours of its launch. Sushiswap, which also uses a similar YFI mining mechanism, was forked from Uniswap, which did not issue coins. In less than four days after its launch, it absorbed more than 75% of Uniswap's traffic, with a total value of locked assets exceeding US$700 million. The project token was just launched on the exchange on September 1, and it rose from US$6 to US$16, an increase of more than 166 percentage points.

Sushiswap lock-up situation (data source: DeBank)

Sushiswap's strong ability to attract attention and money has pushed market sentiment to a climax. On September 1, the total value of the decentralized financial market reached a peak of 17 billion US dollars, and DeFi tokens including SUSHI, DF, KIMCHI, etc. set new highs in the following days. However, four days later, as the founder of Sushiswap was exposed to cashing out, the project team ran away and other problems emerged one after another, many once popular DeFi tokens began to avalanche and plummeted, and SUSHI, which was the first to bear the brunt, was directly cut in half.

The rise and fall of tokens of DeFI projects focusing on liquidity mining in September (data source: Coinmarketcap; deadline: September 25, 2020)

Although there have been positive news such as exchanges entering DeFi, new coins being mined, and SUSHI buying back tokens at $1,400, the market is not as hot as before. Since the beginning of the month, except for YFI, YFII and COMP, all DeFi projects focusing on liquidity mining have not escaped the fate of price cuts, with the highest single-day drop of related tokens reaching 82%.

Total locked positions of DeFi projects in the past three months (data source: DeBank)

From the perspective of the secondary market, the scale of the DeFi market has shrunk significantly, and the trading volume has gradually slumped; but returning to the primary market, the funds entering the DeFi project do not seem to have obvious signs of exiting. According to DeBank's data, the total locked-in amount of DeFi experienced a sharp drop in the first few days of the month, and soon turned from a decline to an increase; although the growth rate has weakened, the current total assets have returned to the level of tens of billions of US dollars. Among them, after the announcement of the issuance of the coin, the total locked-in amount of Uniswap, the largest decentralized exchange in the field, continued to rise and broke through the 2 billion US dollar mark on September 19, setting a record high.

3. DeFi is a hot topic this summer. It all comes down to the temptation of money.

Before Compound launched liquidity mining, the project's locked-in amount was only 90 million US dollars; and before Balancer launched liquidity mining, there were less than 1,000 users. Today, the number of users of these two projects has soared dozens of times, and the locked-in amount has also increased to hundreds of millions of US dollars. According to DEFIPLUS data statistics, the locked-in amount of projects that have currently launched liquidity mining accounts for more than half of the total locked-in amount of DeFi protocols.

Growth of DeFi users (data source: DUNEANALYTICS)

The siphon effect formed by the DeFi project's opening of liquidity mining is related to the incentive mechanism for distributing governance tokens. In theory, users can passively obtain governance tokens in the process of participating in project transactions, mortgages, quotations, etc., and use them to vote on future changes and developments in the protocol. However, judging from the crazy surge in tokens of various DeFi projects, users value the immediate benefits that can be earned by selling them in the secondary market rather than participating in community governance.

In liquidity mining projects, the price of tokens usually rises with the number of platform participants and the increase in injected funds; in turn, the rise in token prices will continue to stimulate more funds to enter the market. In order to chase the rewards of project tokens, a large number of investors actively provide liquidity to DeFi protocols, thereby further pushing up token prices and forming a positive cycle.

Yearn.finance’s locked-in amount and price changes in the past three months (data source: DeBank)

Taking yearn.finance as an example, on August 13, 2020, yearn's locked-in amount on Curve was $140 million; two weeks later, as of August 31, 2020, the relevant data increased to $870 million. The expansion of the project's locked-in amount has driven the price growth of its governance tokens, with YFI soaring from $5,354 to $35,060 during this period.

For liquidity providers of DeFi projects, selling project tokens in the secondary market is the fastest way to make a profit. Not only can they earn high returns while token prices are high, but they can also pass on the risk of holding tokens to investors who buy governance tokens. As long as there are people willing to take over in the secondary market and token prices remain high, the size of the DeFi market will continue to expand under the effect of a positive feedback loop, and even give rise to an illusion of false prosperity.

4. DeFi overturns at high speed, and the Lego structure faces a domino-like collapse

Liquidity mining has brought a large number of new entrants to the DeFi market. However, in the context that the scalability issues of public chains such as Ethereum have not yet been resolved and the project entry threshold is still very high, there are very few users who have real demand for the lending and trading functions of decentralized financial projects themselves; among the participants pouring into the DeFi system, the proportion of speculative users is far higher than the proportion of those with real usage needs.

For example, according to the original design of Compound’s liquidity mining, both borrowing and lending can get COMP rewards, which led to the emergence of a large number of pure arbitrageurs in the early days of the platform. They made a lot of project tokens by constantly lending and repaying loans. For this reason, for a period of time, nearly 80% of COMP output was taken away by a few BAT big players.

Changes in Ethereum network transaction fees (data source: Etherscan)

With the FOMO sentiment in the market, the liquidity of DeFi projects continues to increase, but the primary market needs the support of token prices to maintain prosperity. What should be vigilant is that the secondary market has long been reduced to a fool's game of passing the parcel in a positive feedback loop. In theory, if you do not participate in community governance and have no intention of participating in the project for a long time, these exponentially growing tokens will have no practical effect and real value in the hands of entrants. Investors are willing to buy at high prices in the secondary market because they assume that more blind speculators will take over from them at a higher price. Once the token price falls and the secondary market speculators exit, this fool's game will collapse in an instant, and the "dig-withdraw-sell" wealth-making model of income farmers will gradually become ineffective.

However, in the DeFi field, where the total market value is less than one-tenth of the total value of the Bitcoin market, any unexpected event may cause an avalanche in token prices. Moreover, the field has just started, and there are many unknown risks in each project, both in terms of system security and team personnel. For example, YAM, whose locked-in volume exceeded US$400 million on the day of launching liquidity mining, was directly declared a failure after the team revealed that there were serious vulnerabilities in the smart contract within 48 hours of its launch; Sushiswap, whose annualized mining income was once as high as 9,500%, was reported by the founder to be selling for cash just five days after its launch, and the project token plummeted by 80% overnight.

Comparison of the total market value of DeFi projects, Bitcoin and Ethereum (data source: DeBank, Coinmarketcap)

What’s worse, many current DeFi projects are composed of different decentralized financial protocols, which increases users’ profit opportunities while also amplifying risks accordingly. Take YFI for example, its income is affected by AAVE, AAVE’s income is affected by COMP, COMP’s income is affected by MKR, and MKR’s income is affected by ETH. For this kind of Lego-like decentralized financial project, as long as there is a thunderstorm in one link, the risk is likely to spread to the entire building block, causing a domino-like collapse of the market.

When the token price collapses, investors in the secondary market will face a direct blow, and the related assets will shrink significantly; and the liquidity providers (LP) in the primary market will not only see a reduction in cash-out income, but also have to bear the risk of impermanent loss. Unlike Compound, which simply issues coins by subsidizing mining, a large number of liquidity mining projects now also integrate DEX mining mechanisms. Simply put, LPs deposit two tokens in proportion to provide liquidity for the platform's fund pool and earn transaction fees; when the unilateral price of the trading pair fluctuates significantly, the LP's deposited principal shrinks, resulting in impermanent losses.

Currently, the currencies supported by the liquidity pool are not limited to mainstream currencies such as ETH and USDT. In order to increase the yield, most projects have added non-mainstream trading pairs and even DeFi token liquidity pools. This means that when the DeFi market plummets, LPs that provide liquidity for related currencies will lose a lot of principal.

5. Liquidity gradually dries up and the market will end in a death spiral

Without price support and the greater fool investors in the secondary market, a large number of liquidity providers will leave the market. Judging from the data of DeBank, the current decentralized financial market is not as hot as before. Although the locked-in amount has recovered the earlier decline, after the market avalanche in early September, the growth rate of DeFi pledge has slowed down significantly, and can even be said to be stagnant. Taking Uniswap, the largest DeFi market, as an example, after the project announced the issuance of tokens on September 17, the locked-in amount gradually rebounded to the current level of US$1.97 billion; but compared with the turning point on September 5 when the locked-in amount turned from rising to falling, it has only increased by eight percentage points.

Changes in the total market value and total locked volume of DeFi projects in the past year (data source: DeBank)

The stagnation of locked-up volume means a decline in market liquidity, and the decline and sideways movement of DeFi token prices means a decrease in the amount of hot money entering the market. If there is no new impetus to stimulate the market for a long time, secondary market speculators attracted by the positive feedback loop will gradually leave the market; without the existence of buying speculators, these DeFi tokens issued at almost zero cost will continue to fall or even crash directly.

The secondary market weakened, the high-yield model of LP "deposit-withdraw-sell" collapsed, a large number of speculative users withdrew, the project liquidity gradually depleted, further accelerated the decline in token prices, and the market gradually fell into a death spiral. When the meager income from liquidity mining cannot support the high fees required during the operation, speculators will all disperse, leaving only a small number of DeFi enthusiasts who really want to use it.

Although the current DeFi secondary market has not collapsed, the prices of tokens of leading projects, led by YFI, have slightly recovered; but the "lemon market" in the field has already formed, and the risk of market collapse is gradually increasing. Since many decentralized financial projects are open source, the cost of plagiarism is extremely low. Driven by the get-rich-quick effect, the market has spawned a bunch of "lemon" projects; for example, the Sushiswap imitation projects KIMCHI.finance and YUNo.finance, which are now close to zero, and the Jade EDM whose founder ran away early. These emerging inferior projects have invisibly plundered the liquidity of high-quality projects. As they collapse one after another, the process of the DeFi market entering a death spiral will also be greatly accelerated.

VI. Conclusion

Hashepa believes that the rapid surge in the decentralized financial market from June to August is due to the wealth-creating effect brought about by liquidity mining. DeFi projects with superimposed functional combinations have linked the entire decentralized financial field, attracting users to flock to it; but the rapidly expanding market is fragile, and prosperity supported only by prices can easily collapse. Recently, with the frequent collapse of projects, the secondary market has gradually returned to rationality, and the craze caused by liquidity mining has gradually faded, which will eventually lead to the depletion of liquidity in DeFi projects.

Of course, the decline of liquidity mining does not mean the end of DeFi development. From another perspective, the bursting of the bubble is actually a healthy cleansing for the entire decentralized financial industry. However, for speculators who are still immersed in the DeFi money-making effect, if they do not recognize the risks as soon as possible, they are likely to become the participants with the heaviest losses in this carnival.