STATE OF DEFI - MAY 2024
Hannes Detlefsen
Deutsche B?rse Digital Exchange | Blockchain Association Schleswig-Holstein
Disclaimer: The views expressed in this article are my personal views and do not reflect the views of any organization with which I am affiliated. In addition, readers should not rely on this article as a source of financial, legal, or other advice.
While the financial sector is still digesting the success of the Bitcoin ETFs, which saw record inflows in the first weeks, even more exciting developments are taking place in the onchain sector that deserve attention. While easy access to Bitcoin is undoubtedly a milestone, idealistically speaking, we are taking a step backward by reverting to fixed trading hours and traditional securities accounts, instead of embracing the openness, self-determination, and 24/7 transferability that crypto and decentralized finance offer today.
This article takes a peek behind the curtain - at the redesign of financial services and the emergence of new products and mechanisms with the digital age in mind.?
"Ethereum has taken what was a four-function calculator of a programming language in Bitcoin and turned it into a full-fledged computer." - Fred Ehrsam
Refresher:
Blockchain enables a shared version of network state, based on rules collectively determined and enforced by algorithms. While Bitcoin only enables simple transactions and has limited capabilities for smart contracts, Ethereum has evolved into a network enabling business models that were unthinkable of just a few years ago. Tokens, digital representations of assets or usage rights, are issued on this technical foundation and can vary in various dimensions like the issuer, associated rights, sector, function, or built-in value accrual.?
Although the use of tokens or tokenization is not a new concept, the new functionalities and mechanisms are enabled by the global computing network - independent, decentralized, with equal access, and verifiable in real-time.
The result: Things we didn't realize were assets, programmed in a way we couldn't imagine.
But what's really happening onchain? Let's take a closer look.
Disclaimer: This article covers Ethereum and its ecosystem, which arguably provides a good overview with a market share of 60% and three times as many developers as the next largest competitor. However, there are also exciting developments in other ecosystems such as Solana or Cosmos, which are gaining significant market share. Please don't blame me for being a maximalist - we will talk about them in another article :)
When talking about Ethereum, it's important to distinguish between the protocol and its associated asset, Ether (ETH). Ethereum, with its Ethereum Virtual Machine (EVM), provides the infrastructure that enables the onchain economy. ETH serves as the settlement token within the ecosystem and coordinates the various stakeholders involved.
In Q1 2024, Ethereum generated a profit of $369.08 million. But how?
For the use of Ethereum, whether for simple transactions or interacting with applications, users pay transaction fees. A portion of these fees, about 80%, is burned, or taken out of circulation. This is akin to a share buyback in the traditional markets. At the same time, new ETH is issued with each new block, leading to dilution. However, if the amount of ETH burned is greater than the amount issued, this results in positive earnings for the protocol and thus for passive holders of ETH.
To maximize the value appreciation, token holders can either individually or with the help of (liquid) staking providers actively validate the network. This allows them to receive a share of the newly issued ETH and transaction fees as a reward for their contribution to the network.
Despite the emergence of competitors that are faster, more efficient or easier to use, Ethereum remains the leading open and decentralized global settlement network with over 1 million validators. At the application level, open architecture encourages competition, and competition leads to innovation.
Speaking about competition - let's dive into the first topic of today: Stablecoins
Stablecoins are tokens whose value is pegged to a specific underlying asset, whether it's a fiat currency or liquid (re-) staking positions, such as stETH or rsETH. In this context, we'll focus on fiat-denominated stablecoins. Using blockchain technology, these tokens can be sent and settled across jurisdictions within seconds, 24/7, at a fraction of traditional fees, offering huge potential for the payments industry.
The supply of fiat-denominated stablecoins currently stands at over $145 billion, and over 334 million transactions have been made using stablecoins in the last 30 days, with a volume of $2.5 trillion.
But not all stablecoins are the same. Beneath the surface, stablecoins can differ significantly in design, with a need to solve a trilemma - balancing Stability, Capital Efficiency, and Decentralization.
Stability means the token should maintain a stable value against the referenced asset. Capital efficiency means ideally being able to mint a stablecoin against collateral in a 1:1 ratio. Overcollateralization is less capital-efficient but can be suitable in decentralized environments. Undercollateralization is possible but can easily lead to a depeg of the stablecoin in times of market volatility. For global usage, decentralization is crucial for a stablecoin. In the sense of DeFi, such a token should be independent of any central authority. However, a certain degree of centralization is often necessary to ensure the scalability of the stablecoin.
Let's focus on the two most common structures of stablecoin design.
The simplest mechanism involves having a centralized issuer who holds at least a 1:1 collateralization for each issued stablecoin, usually in the form of cash and cash equivalents such as short-term US Treasury bills. They are capital efficient and stable, but not decentralized, and therefore issuers are responsible for complying with applicable regulatory obligations.
Tether is the largest issuer in this category, with its stablecoin USDT, now holding a market share of over $110 billion. Through interest income from backing and the appreciation of other investments in gold and Bitcoin, Tether recorded a net profit of $4.52 billion in Q1 2024.
The second most common mechanism is Collateralised Debt Positions (CDPs) - the DeFi native stablecoins. Here it is possible to mint a stablecoin against collateral (crypto assets or real-world assets). However, every dollar minted is overcollateralized. If the collateral falls below a certain threshold, the user is liquidated to ensure the stability of the stablecoin. This provides decentralisation and stability, but is less capital efficient.
The largest CDP stablecoin is DAI, issued by MakerDAO, which now has a market capitalization of over $5.3 billion. DAI is supported by a diversified backing consisting of 36.8% other stablecoins such as USDC, 20.1% real world assets such as US Treasuries and 43.1% crypto assets. Due to its deep liquidity, strong integrations and long track record, DAI is widely used within DeFi.
MakerDAO captures almost 40% of all DeFi profits on Ethereum, generating more fees than most Layer-1 and Layer-2 protocols.
Fun fact: Maker's revenue from stETH-based loans exceeds the revenues from Lido's entire stETH supply.
MakerDAO's annual revenues currently stand at nearly $480 million, with 77% of revenues coming from crypto-backed loans and 20.6% from public credit. A portion of the fees is distributed to users through the DAI Savings Rate for staked DAI, while another portion is used to buy back and burn the protocol's native token MKR - similar to a share buyback.
With the introduction of the lending protocol Spark - an Aave V3 fork - and the DeFi services platform Summer.fi, MakerDAO is currently expanding vertically and is in an optimal position to continue gaining market share in the long term. The "MakerDAO Endgame" involves a complete rebranding, including a new governance token and a new stablecoin, with the aim of attracting non-DeFi natives as customers through gamification and yield-bearing stablecoins.
A completely different approach is pursued by Ethena and USDe - the new kid on the block.
USDe currently has a market capitalization of $2.3 billion and maintains its peg through staked ETH - and more recently also BTC - as well as derivatives that generate quite some yields.
But what is behind the concept of the so-called Synthetic Dollar?
Users mint USDe by depositing a liquid staking token (LST) or a stablecoin into the protocol. The deposited token is exchanged for an LST, which represents the value of the underlying ETH plus the proportionate staking rewards. Ethena then opens a perpetual future, where they short the same amount of ETH on a centralized exchange, creating a delta-neutral position. These futures include a funding rate, which ensures that the price of the future is based on the price of the spot underlying. If there are more long traders than short, the longs pay a funding rate to the shorts and vice versa. Due to the bullish sentiment and the speculative nature of crypto users, the funding rate is typically positive, especially in bull markets, leading to longs paying up to over 20% in funding fees to the shorts. Ethena captures this funding rate and distributes it to USDe stakers as returns. Additionally, USDe or sUSDe (staked USDe) holders receive Shard Points, which can be exchanged for ENA, Ethena's native governance token, after a fixed period known as an epoch.
The trade-off is as follows: Either the user does not stake their USDe and receives no funding rate but 5x Shard Points, or they stake their USDe and receive only 1x Shard Points but the funding rate. Whether or not a user stakes depends on the payout of the funding rate and the future value they place on the governance token ENA. Currently, the ratio between USDe and sUSDe is 0.133, indicating that users are primarily speculating that the ENA allocation will yield higher returns than the funding rate strategy.
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But as always, there are also some risks involved:
Ethena and USDe are certainly an interesting concept and a novelty in the DeFi sector. However, only time will tell whether the insurance fund is sufficient in turbulent times and whether the protocols incentives are right.
Since we're already deep down the rabbit hole, let's get even more degen - with Pendle Finance:
Pendle Finance is another emerging player in DeFi, introducing a new innovation: Yield Tokenization, or for those from the traditional finance world, interest rate swaps.?
With a Total Value Locked of $4.38 billion, Pendle is now ranked seventh by TVL. But what makes Pendle so successful?
In DeFi, there are many different assets that provide income, such as stETH, GLP or USDe. However, future payouts are often uncertain, especially in the context of airdrops where the actual value is not yet known. This leads traders to seek a hedge against uncertainty. In DeFi, yield derivatives offer greater flexibility and stability than traditional yield farming methods. Users can access a wider range of yield-bearing assets and participate in future returns without the volatility.
This is made possible by the following mechanism:
After a user's deposit, Pendle first wraps the yield-bearing tokens into standardized yield tokens (SY) and then splits them into a Principal Token (PT) and a Yield Token (YT).
Let's take the example of USDe:
PT-USDe represents the principal amount of USDe minus the yield the token would generate in a fixed time period. At maturity, the user receives the full amount of USDe back.
YT-USDe, on the other hand, represents only the yield component and the token is worthless at maturity. However, the user will receive all the yield that USDe has generated during this time.
The prices of PT-USDe and YT-USDe diverge depending on the expectations of the users. PT-USDe can be purchased at a discount, providing a fixed return after the maturity, for example, 20% p.a. However, if a trader believes that USDe will generate more than a 20% yield p.a., they can buy a bunch of YT-USDe and increase their exposure to the yields.
The tokens can be traded in an AMM specifically designed by Pendle, allowing the trading of assets with time-decaying properties by adjusting the AMM curve and thus the exchange ratio over time. This prevents time-dependent losses for liquidity providers.
With the current hype around Airdrops and integrations with protocols like Ethena, Pendle Finance has grown into a real powerhouse, stimulating Layer-2 ecosystems within weeks through targeted incentive programs.
But enough of the new protocols, let's take a look at the old DeFi stalwart, Uniswap:
Uniswap, the AMM pioneer, continues to lead the way. The current TVL of $5.52 billion is impressive, and the total number of users through the Uniswap interface has more than doubled in the past year, currently standing at 7.25 million. Unlike platforms like Coinbase with limited token pairs, Uniswap provides a user-friendly interface for a wide range of tokens to exchange. Users can simply enter the tokens they want to exchange and receive the desired tokens directly into their self-custodial wallet - all in just a few clicks. And DeFi users love it - Uniswap recently surpassed $2 trillion in total trading volume.?
Of all new wallet transactions through the interface, around 55% of these users are making their first swap ever. A further 25% made their first swap on Uniswap within one day of their first Ethereum transaction. The number of new wallets on the interface each day is also significant, with around 35,000 new wallets swapping through the interface each day (spiking during volatility and token launches). While this doesn't necessarily translate into 35,000 new users every day, there is still a large subset of users who are net new.
In terms of product offering, Uniswap continues to evolve - from UniswapX to Limit Orders, Browser Extension or soon Uniswap v4 - Uniswap Labs delivers. In addition, they now have their own wallet solution that allows users to buy crypto directly into self-custody. By integrating payment providers such as Coinbase Pay, Robinhood Connect or Moonpay, users can onboard directly through the Uniswap app without ever having to enter a centralized exchange. Onboarding as it should be.
And that is just the tip of the iceberg. There's much more to discover beyond the topics already discussed. Airdrops like W or EIGEN, other protocols like Frax Finance or chains like Berachain - these will be covered in another article.
Thank you for your time and see you soon!
Ressources:
Perhaps complementary: https://youtu.be/px38kFsVOXM?feature=shared