After Major Crypto Sell-Off, Why Did DeFi Stay So Sticky?
A look under the hood shows DeFi users are more prone to use platforms for income rather than leverage.
According to the data, decentralized finance (DeFi) users might not be that degenerate after all.
Amid the dozens of introductory posts and explainers on DeFi from mainstream media outlets over the past year, a general consensus has emerged: While promising, DeFi is currently primarily utilized to speculate on crypto prices, using tools like lending platforms as a form of leverage.
Indeed, this line of thinking has been trotted out in The New York Times, Bloomberg and CNBC, among dozens of others. Likewise, Twitter traders wear the badge “degen,” short for “degenerate,” with pride, adding to a consensus that the field is a wild west of gamblers and speculators.
A look under the hood shows the majority of depositors are playing it safe, however – sometimes even safer than meatspace finance. DeFi is a wide swath of smart-contract-based applications that serve bank-like functions on the internet using decentralized blockchain tools.
Last weekend, a pullback across crypto markets ravaged spot prices and wiped out leveraged traders on centralized exchanges. Bitcoin (BTC) fell as far as $42,000 from $57,000 before a relief bounce, while ether (ETH) plummeted as low as $3,500 from $4,600.
DeFi’s closely watched total value locked (TVL) figure remained comparatively unchanged, however, dropping from $270 billion to just $260 billion, and maintaining a range the sector has held since November.
In interviews with CoinDesk, a number of industry experts said the outperformance is in part attributable to DeFi users being more cautious than some would expect – and, if DeFi were ever to experience prolonged outflows, that relative conservatism would be to blame.
Leverage vs. income
For derivatives traders on centralized exchanges, last week’s dip was one of the most violent in history.
As CoinDesk reported, price action early in the week washed out over $187 million of positions. Futures open interest (OI) in particular dropped nearly 25%, wiping out $5.4 billion in OI from a $22 billion total.
Given that leverage traders and derivatives speculators were so thoroughly routed on centralized exchanges, it would be easy to assume that DeFi would suffer a similar pullback.
On-chain data, however, tells a different story.
Liquidations across DeFi’s top lending platforms, including Aave, Compound and Maker, topped just over $66 million in the trough of the pullback, according to a Dune Analytics dashboard – a tiny fraction of the space’s current $280 billion in TVL. Additionally, the liquidations account for just .01% of Aave, Compound and Maker’s combined $42.37 billion in TVL.
Ashwath Balakrishnan, director of research at investment and research firm Delphi Digital, said that part of the reason why is that DeFi loans are often even less leveraged than real-world ones.
“The loans that you see on Aave and Compound, they’re a lot more prudent than the ones you’d see even at a bank mortgage,” Balakrishnan said. “At a bank you can get a mortgage for a loan-to-value of anywhere between 60%-80% depending on your credit score. But if you look at Aave and Compound, the larger loans that go through the loan to value is between 10% and 15% to 50%. That’s playing it super safe.”
Additionally, he said that tracking users borrowing stablecoins shows the majority of loans aren’t being used to trade, but instead to provide liquidity to protocols like Curve.
“I would disagree with the notion that a lot of it is being used to margin trade or that the leverage is unhealthy,” he added.
Daniel Khoo, a researcher for analytics platform Nansen, likewise noted that during the drawdown inflows to platforms like Beta Finance and Lido’s stETH showed that DeFi yield farmers continued to work the fields in spite of market action.
Khoo told CoinDesk in an interview that DeFi TVL might outperform spot prices in part because they simply provide attractive income opportunities difficult to find in other financial products.
“The ability to earn a good yield, risk-adjusted, causes capital to be more sticky and thus TVL to be more resilient. This is often compared to parking capital in 0% interest rate savings accounts or even bonds (which might or might not have a better risk-reward ratio),” he said.
While this analysis challenges the prevailing narrative that DeFi is primarily used for leverage and speculation, experts say a prolonged drawdown in spot prices could eventually lead to a flight from DeFi and a severe reduction in TVL.
According to the pseudonymous founder of data website DeFi Llama, 0xNGMI, DeFi’s deposits have built-in resiliency due to dollar-pegged stablecoins, and users favor battle-tested smart contracts that are seen as less risky.
“There’s a tendency for crypto natives to keep their assets in crypto so if a bear market comes and most people shift their portfolios to stables, you’ll end up with a bunch of money in the hands of people comfortable with smart contracts and of which a portion of them will keep it in DeFi,” 0xNGMI said.
However, a large portion of the yield in DeFi relies on froth: depositors to Uniswap liquidity pools, for instance, make money on trade volume, and froth increases their returns.
According to pseudonymous eGirl Capital contributor CL207, eventually the returns could drift low enough that perceived smart contract risk – the fear that a platform might be hacked or exploited – will outweigh the returns, and a prolonged dip could “nuke” DeFi as users seek income elsewhere.
“I called [DeFi TVL] like some sorta alternative OI because it is direct data to show there is $ participating in some sorta play, where risk is higher than normal,” CL told CoinDesk in a Twitter message. “Futures [are] higher risk than spot, yield farming on chain [is] higher risk than just lending USDC out on FTX. Similar logic.”
It remains to be seen how acute a drawdown in TVL could be, but DeFi Llama’s 0xNGMI believes that deposits could prove sticky.
“TVL is highly correlated with time-weighted froth, and APRs will be crushed in bear, but I don’t think TVL will be reversed because there’s a barrier to adoption that only needs to be crossed once,” he said.
He compared the phenomena to depositors learning how to “bridge” to other chains over the summer – while Polygon, one of the first sidechains with a real ecosystem, took time to build up steam, Avalanche expanded rapidly as users were accustomed to bridging from Ethereum.
“I believe that also applies to putting your money on smart contracts,” he added.
Ultimately, however, these risk-reward calculations on the part of depositors are far different from the ones made by leverage or derivative traders, and DeFi’s TVL chart reflects that.
“I think this notion of DeFi as a haven of leverage is false, and it’s provably false,” said Delphi Digital’s Balakrishnan. “If you ignore the narratives from the detractors and actually look at the data, you’ll see it yourself.”
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