DeFi Weekly #54

dYdX AUM Drop 50%, Non-Ethereum DeFi & 2020 Musings

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Welcome everyone! I've taken a nice break from crypto-related stuff for the past month or so but I'm back now with DeFi Weekly. Plenty to cover so let's jump right into it!

  • During the drop to $120/ETH dYdX saw their total assets locked up drop from $30m all the way down to $15m! Why? Basically the volume of people trying to liquidate was so high that dYdX's front-end servers collapsed under the pressure. As a result many traders got liquidated and lost a lot of confidence in the platform. They're slowly making their way back up but it really shows how an incident like this can cause irreparable harm to a product/protocol's reputation when it comes to reliability. When we think about making software, reliability isn't a big as a focus compared to more traditional industries like medicine/automobiles etc due to the ease of making changes. However, I think the mindset of ensuring reliability in all cases is hard to enforce in the land of money enabled software as it takes a different mindset when designing your architecture (not just for smart contracts but the entire stack). The team's more than capable of fixing this but it should serve as a good reminder to any DeFi team that the reliability of your front-end is just as important as the reliability of your contracts, especially if the number of 3rd party interfaces for your protocol is limited. Furthermore, if liquidity is a moat to defend, a large loss of it can really impact both sides of the money market's equation. Stepping back though, one thing which does concern me is that when many liquidations take place on-chain liquidators are scrambling to liquidate eligible positions to claim a reward. Competitive bidding spikes gas prices up really high and anyone that doesn't keep up doesn't end up being able to liquidate a position. CDPSaver encountered this briefly during the last massive drop, but as the size of DeFi grows I'd anticipate this becomes a bigger problem. Protocols can mitigate this temporarily by increasing collateral requirements although there's going to have to be a point where we have to start moving DeFi to layer 2 and using the main chain as a settlement layer. I think there's a real opportunity for someone to build a layer 2 system that makes it attractive for many DeFi protocols to build on although the incentive for each team to come to a common layer 2 solution isn't particularly high. Furthermore, if there is some sort of layer 2 system, there's probably a great opportunity to introduce a token as well to capture part of that value. If there's one thing I've been hearing through various conversations, it's that the only real monetisation strategy in crypto is tokens. A layer 2 consensus token is almost as good as a base layer token - something that sells very well to VCs and other large investors.

  • I think everyone's in on the fact that DeFi is a great use-case for blockchain technology - only question is can competing chains get a piece of that action? As wrong as I could be, I'm willing to bet pretty strongly that no - they can't. Rule #1 in the DeFi game is that liquidity is king. Now when I say liquidity it has two aspects to it. First is the base layer coin must be liquid, valuable and have a large group of actors with accrued wealth from that coin. Second, the base layer chain must have a stable coin with a significant liquid pairing to the base layer coin (ETH/DAI, ETH/USDT etc). Third of all, you need developers to build out all the infrastructure to make money market protocols, synthetics etc. Many VCs are willing to bet that point 3 can be solved through better, faster technology + a strong developer community. However I think point 1 and 2 are commonly forgotten. Let's run through this:

    • Team: Hello, we're XYZ, an Ethereum "killer" that can do 10,000 TPS and solves the scalability trilemma

    • VC: Great, we'd like to get floor prices so by the time this goes to the public we can return a minimum 10x to our LPs or 1000x if you truly live up to your Ethereum killer promise

    • Team: Cool, we'll take your money and leave out retail because regulatory reasons but also we can use this as leverage for the next round of institutional money

    • VC #2: VC #1 came in? Great. We'll come in at a higher price as long as we know there's another round or retail comes next.

    • Team: Sure. rinse repeat until the token's been marked up 10x.

    Now the token itself launches, but what happens? Well, it basically dumps or only drops 50% (best case scenario). However there's also been a few key properties that are worth taking note of:

    1. Early VCs hold a large stake while making a killing from selling a small portion

    2. No retail people are interested because they weren't included in

    3. Developers aren't convinced about the viability of the platform as the only party that's shown confidence/trust is VCs whose agenda was purely monetary

    This poses a problem for being a competing "DeFi" chain since there may be a protocol to build a competing MakerDAO/Compound/Synthetix although who's actually going to lock up their money? Sure every VC talks about "generalised mining" and being "value add" but you've got to look at it from their point of view. Why would they lock up $10m worth of their tokens and then pay say 5% interest to borrow a stable coin unless they really think it's going to go up? But even then, I really don't think they're going to get mandate from their LPs to go long, risk the capital and pay for it as well. This also makes a big assumption that the base layer token has good on-chain liquidity via DEXs (because contracts gotta liquidate somewhere). Money locked in DeFi is from early ETH holders and ICO whales - something no other chain has. To conclude, money locked in DeFi doesn't represent capital but trust at it's core. Trust that the value of this ecosystem will go up and not liquidating at a low price is the smart thing to do. Conversely, I'd also argue that ETH locked in DeFi is capped out because the amount of people with capital who trust the price will go up is approaching a local maxima. The increases we're seeing are mainly because ETH locked in DeFi includes SNX tokens (which are on a good speculative run), people adding more ETH to prevent being liquidated and price increases. Don’t believe the Twitter hype of DeFi sky rocketing.

  • Finally - what I'm excited for in 2020! Well, I think for starters I'm excited to see all the ETH killers that finally launch this year. Not because I can't wait to see them fail, but because I actually think it represents a real buying opportunity. One of these chains that launches isn't going to be useful because it ends up "killing" Ethereum, but actually manages to find a niche that no one has really thought of yet. A key component of this being true is that I think the creation of new chains will ultimately dwindle to a near low as the years progress on. Raising money for a new chain isn't going to really be that viable as investors are tired of the new chain narrative but also regulatory issues are going to sprout up as crypto competes against the existing financial system. As the next wave of money being thrown is probably going to be at the application layer, the only base layer protocols available are going to be those that are live. I'm also pretty certain that any chain that was meant to launch this year but doesn't is going to die into obscurity as the amount of catchup will be astronomically high. Similarly, we're going to see at least one, potentially more equity companies transitioning into open source protocols with a token. DeFi tokens may turn out to be extremely lucrative plays provided the value capture mechanism is good and profits earned create price action. Kyber and 0x's recent tokenomic changes have left the market underwhelmed since drive in usage doesn't have a strong correlation to the price of the token. These tokens may be initially overvalued but will represent a good buying opportunity when things cool down once again. All of this experimentation and shipping is ultimately going to set the stage for the next bull market which will fuel the next generation of speculators allowing the industry to grow and contract in another large macro cycle.

  • I hope you all enjoyed this week’s edition, also feel free to reply directly to this email to let me know your thoughts on the above!