On-Chain Markets Report by Pedro Negron, IntoTheBlock
The crypto market plunge of 2022 is littered with bankrupt projects. Coupled with challenging macro conditions crypto investors are confronting a tough period. DeFi has been hit equally as bad, although its key protocols performed surprisingly well in contrast with the performance seen in the last market shock when the Covid pandemic struck in March 2020.
There is a third endogenous factor that has made the fall even worse — a massive deleveraging of the system. If this is truly happening, how do we measure it?
The most direct metric to measure the capital allocated in DeFi is usually total value locked (TVL). Both the Ethereum price as well as the in DeFi have decreased in dollar terms by around 75% from their all-time highs. It makes sense considering that if the assets that are locked in DeFi decrease in price, equally the TVL metric decreases:
DeFi decrease in price, equally the TVL metric decreases:
The composability of DeFi allows the capital to be deposited in several protocols, which produces an overcounting of dollars by the TVL metric.
For example, an investor could lend $1M in ETH in Compound, borrow 500K DAI and deploy it as liquidity in a DAI pool in Curve, or even lend back to Compound. The TVL would account for $1.5M, but the investor brought only $1M.
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When the price of ETH decreases the Compound position would start to increase its risk of liquidation and the liquidity could be withdrawn in order to repay the loan, leaving an outflow of capital of $1.5M.
This results in cycles where the liquidity is removed from a series of protocols when the price turns against the positions assembled. This happens mostly when there are large price drops in crypto assets. Why?
DeFi is Inherently a Leverage-long Machine
The main use cases for idle capital in DeFi is to provide liquidity, either to those seeking to trade two assets (by providing liquidity in a DEX), or those seeking to position long/short with leverage (by depositing in a lending protocol). Those that leverage are usually going long. This is inherent to DeFi since those moving capital into protocols are those that hold crypto assets in the first place, and therefore have a positive outlook in the asset that they hold.
The offer of DeFi protocols caters this behavior: the top protocol by TVL is MakerDAO, where besides USDC, ETH is the most prominent asset deposited. Depositing ETH and borrowing DAI is equivalent to taking a long exposure to ETH: one can borrow more if ETH increases in price, while one has to add more collateral or repay the loan if ETH decreases. The same happens with lending protocols such as Compound or Aave.
While they have loaned large amounts of stablecoins, they are mostly idle while these depositors do not borrow ETH or BTC, which would account as a short against these assets.
This imbalance in long/short positioning causes a feedback loop that rapidly deflates TVL in nominal terms when the prices start to fall, and crypto assets need to be sold in order to repay loans.
More leverage is enabled when the prices rise since the borrowing capacities are amplified. The best measurement of this kind of activity can be found in the rates paid in lending protocols such as Compound or Aave.
Lending Protocols as the Main Tool for Leverage
The rates paid when lending stablecoins come from those leveraged long against their crypto assets. For this reason it is especially interesting to check how the stablecoin rates fluctuate over time depending on the price performance of the most loaned asset, ETH. Here you can see the lending rates produced after depositing DAI in Compound protocol:
The inflow of capital to DeFi has been massive through 2020-2021. That alone can explain how the yields have compressed overall during these two years.
As can be seen marked in red, there are certain correlations between bear markets and decreases in yield. Differently, in bull markets yields tend to maintain their levels. The reason for the sharp drop of APY is due to the deleveraging processes that we discussed before.
A similar situation happens with DEXs such as Curve. Here is the historical APY of its most popular pool: 3pool (composed of DAI, USDC and USDT):
As can be seen in green, the yields were sustained around 12% – 6% during the first bull market, and between 2% – 5% during the second bull market. In red can be seen how as soon as the price of ETH decreased, the yields collapsed consequently.
While the capital deployed in Curve is not used to leverage long, it makes sense that they follow the yields from lending markets. This happens because both yields get arbitraged, if a new investor is willing to deploy capital into stablecoins and the Curve’s yield is higher, it would deploy in Curve before Compound, reducing the Curve yield when it is higher.
Same would happen in the inverse case. This is a slightly simplified vision, since the risk of each option is different, and that would balance the risk/reward profile of each protocol.
Many Bulls and Few Bears
In a bull market it is expensive to go long. During the peak of the bull market borrowers were paying over 10% annually to be able to leverage against BTC or ETH in these lending protocols. While now in the current bear market one can borrow stablecoins for less than 2% annually. It became cheap to open a long position.
The opposite happens with shorting. At the top it was relatively cheap to short BTC or ETH, since that would require depositing stablecoins that were being paid between 5-10% annually for being loaned, while the BTC or ETH borrow rates were not as large.
So in the future, a leading indicator of a bull market for DeFi could be an increase in stablecoin lending yields among most lending protocols. Likewise next time that borrowers are paying high rates for stables among most lending protocols one can assume that DeFi is back on track on a highly leveraged cycle. This could help assess when precautionary measures are needed, such as reducing exposure or hedging.
If shorting in DeFi would be more prevalent, the imbalance described would be reduced and liquidation cascades due to overleverage would be reduced considerably. A possible solution would be if traditional finance funds that are not always predominantly long crypto would start to use DeFi.
Leverage and finance have been inexorably linked for hundreds of years. With DeFi being built on top of crypto infrastructure, it is reasonable to understand that its early users have a long bias and are inclined to receive credit on top of these assets. Ultimately, this reflects strongly on stablecoin yields which are the main instrument used to access this leverage.