Bankruptcy projects are scattered around the 2022 crypto market plunge. Cryptographic investors are facing tough times, coupled with difficult macro conditions. DeFi was hit badly as well, but its key protocol worked surprisingly well, in contrast to the performance seen in the last market shock when the Covid pandemic struck in March 2020. ..
There is a third intrinsic factor that made the fall even worse — Extensive leverage of the system.. How do you measure if this is really happening?
The most direct measure of capital allocated on a DeFi is usually the Locked Total Value (TVL). Both Ethereum prices and DeFi are down about 75% on a dollar basis from record highs. It makes sense to consider that as the price of assets locked in DeFi goes down, so does the TVL metric.
Decrease in price DeFi, as well as decrease in TVL metric:
DeFi configurability allows capital to be deposited in several protocols, resulting in an overestimation of the dollar by the TVL metric.
For example, an investor can lend $ 1 million to Compound’s ETH, borrow 500K DAI for liquidity in Curve’s DAI pool, or lend to Compound. TVL will account for $ 1.5 million, but investors brought only $ 1 million.
⍺ DeFi Alpha: Yields on stablecoins supercharged by concentrators and Fiat DAOs
As the price of ETH falls, compound positions begin to increase the risk of liquidation, allowing liquidity to repay the loan, leaving a $ 1.5 million capital outflow.
This creates a cycle in which liquidity is removed from the set of protocols when the price violates the assembled position. This mainly happens when there is a significant price cut on crypto assets. why?
DeFi is essentially a long-leverage machine
The main use cases of idle capital in DeFi are those who are trying to trade two assets (by providing liquidity with DEX) or those who are trying to position long / short with leverage (deposit with lending protocol). Is to provide liquidity (by doing). Leveraged ones are usually longer. This is unique to DeFi, as the transfer of capital to the protocol is for holding crypto assets in the first place and therefore has a positive outlook for the assets held.
The provision of the DeFi protocol supports this behavior. The top protocol by TVL is MakerDAO, and besides USDC, ETH is the most prominent asset. Depositing ETH and renting DAI is the same as being exposed to ETH for a long time. If the price of ETH goes up, you can borrow it, but if ETH goes down, you need to add collateral or repay the loan. The same thing happens with lending protocols such as Compound and Aave.
They lent out a large amount of stablecoin, but they are mostly idle while these depositors are not borrowing ETH or BTC, and are described as shorts to these assets.
This imbalance in long / short positioning causes a feedback loop that rapidly deflate the TVL in nominal terms when prices begin to fall, requiring crypto assets to be sold to repay the loan.
As borrowing capacity is amplified, higher prices allow for more leverage. The best measure of this type of activity is in the fees paid by lending protocols such as Compound and Aave.
Leverage protocol as the primary tool for leverage
The rates paid when lending stablecoin come from long leveraged crypto assets. For this reason, it is especially interesting to see how stablecoin rates fluctuate over time, depending on the price performance of ETH, the most lent asset. Here you can see the loan rate generated after depositing DAI with the composite protocol.
The inflow of capital into DeFi was large from 2020 to 2021. That alone can explain how yields have been reduced overall over the last two years.
As marked in red, There is a certain correlation between the bear market and lower yields.. In other words In a bull market, yields tend to stay at that level.. The reason for the sharp drop in APY is due to the de-leveraging process described earlier.
A similar situation occurs with DEX such as Curve. The past APYs of the most popular pools are: 3pool (composed of DAI, USDC, USDT):
As seen in the green, yields were maintained at around 12% -6% in the first bull market and 2% -5% in the second bull market. What is shown in red is that as soon as the price of ETH went down, the yield fell as a result.
The capital introduced into Curve is not used for long leverage, but it makes sense to follow the yield from the lending market. This happens because both yields are arbitrage traded. If a new investor is willing to invest capital in Stablecoin and the yield on the curve is high, it will expand to the curve before the compound and decrease as the yield on the curve increases.
The same thing happens in the opposite case. This is a slightly simplified vision because the risk of each option is different and balances the risk / reward profile of each protocol.
Many bulls and a few bears
In a bull market, going long is expensive. At the peak of the bull market, borrowers paid more than 10% each year to make available to BTC or ETH in these lending protocols. In the current bear market, stablecoins can be borrowed for less than 2% per year. It’s cheaper to open a long position.
The opposite happens with a short circuit. At the top, shorting BTC or ETH was relatively cheap. This is because BTC or ETH borrowing rates were not very high, but you have to deposit stablecoins, which are paid 5-10% each year to get a loan.
Therefore, in the future, a key indicator of DeFi’s bull market could be an increase in stablecoin lending yields among most lending protocols. Similarly, when the borrower pays a lot for the stables in most lending protocols, it can be inferred that DeFi is on track in a very leveraged cycle as well. This helps assess when precautionary measures such as exposure reduction and hedging are needed.
As shorts in DeFi become more common, the described imbalances are reduced and the over-leverage clearing cascade is significantly reduced. A possible solution is when traditional financial funds, which are not always primarily long cryptos, start using DeFi.
Leverage and finance have been relentlessly linked for hundreds of years. Since DeFi is built on top of the crypto infrastructure, it makes sense to understand that early users have a long bias and tend to receive credit in addition to these assets. Ultimately, this is strongly reflected in the yield of stablecoin, the primary means used to access this leverage.
