Two years ago, on June 15, 2020, Compound launched yield farming, sparking the DeFi Summer and subsequent year-and-a-half bull run in the crypto market. As before, this bull market ended with a sharp decline. By June 15, 2022, the total value of the entire crypto digital asset market had fallen 67.5% from its peak.
DeFi’s Unusual Plunge and Market Failure
DeFi has fared particularly badly in this market crash. By June 15, 2022, while the total value of DeFi lock-ins had fallen 69%, essentially in line with the broader market, the market value of DeFi projects had collapsed in extreme terms. Uniswap lost 88.5% of its market value, Compound lost 94.2% of its market value. A large number of prestigious DeFi projects were closed and their prospects were bleak. Even the DeFi blue chip projects, once hailed as the future of finance mostly fell by more than 95%.
We think it’s unusual for the DeFi market to have such a crash. DeFi is the first pure on-chain application category with a clear monetization model, which is more open, transparent and secure than CeFi in the traditional financial and crypto markets. So there was a time when people not only took the explosion of DeFi for granted but also believed that its success could be sustained, that DeFi could lead bull markets and withstand bear markets.
If so, why has DeFi been particularly bad in the crash?
One factor that cannot be ignored is a market failure caused by pseudo-innovation. This means that many DeFi projects deliberately create complex financial assets, business logic and incentives for distorted purposes to send a large number of false price signals to the market, resulting in a massive misallocation of funds.
Market failure is a phenomenon used by economics to describe the failure of the market mechanisms in allocating resources. In most cases, market mechanisms can guide participants to adjust and optimize resource allocation spontaneously through price signals. However, in some cases, the market mechanism fails and resources cannot be effectively allocated, resulting in serious resource waste and low efficiency.
All economics textbooks tell us that there are three main causes of market failure. The first is product externalities, the second is poor market structure, and the third is information asymmetry. The main cause of this DeFi market failure is information asymmetry.
Information asymmetry can lead to market failure. George Arkloff reveals this truth in The Market for Lemons: Quality Uncertainty and the Market Mechanisms. In the second-hand car market, because of the inevitable information asymmetry between buyers and sellers on the actual condition of a vehicle, buyers are either deceived and paid high prices or out of the mentality of fraud prevention, they will only pay the lowest price. This leads to the loss of price signalling and the failure of the market mechanisms.
The key role of blockchain and DeFi is to reduce information asymmetries. Two of the biggest features of DeFi are its license-free and complete openness and transparency. Business logic and transaction records are completely transparent and can be queried and audited by anyone.
If so, why is the DeFi market failure? Why is the extraordinary collapse of DeFi considered to be related to market failure?
The leading projects developed in the early days of DeFi, such as MakerDAO, Uniswap, Compound, Aave, etc., are indeed open, transparent, and eliminate information asymmetry as their value proposition. They are relatively simple, clear, well-documented, and have been running for a long time to fully understand their business logic.
However, in the past two years, some of the so-called innovations in the DeFi industry, have not only given full play to technical advantages and reduced information asymmetry but to find ways to improperly construct new information asymmetry. These pseudo-innovations not only failed to solve the real problem but also obscured the flash point of the core of DeFi, resulting in a serious failure of the capital market under the deliberately created information asymmetry. In other words, investors, traders and DeFi users are allocating large amounts of money to the wrong places during DeFi’s investment, financing and asset transactions. As a result, when the market correction was corrected, these misallocated funds incurred sharper losses than expected, adding to the turmoil in the market and causing the market value of the DeFi project to collapse.
Therefore, we think it would make sense to look at DeFi’s collapse from the perspective of market failure.
Four Signs of DeFi Market Failure
The failure of the DeFi market is due to new, deliberately created information asymmetries, which at first sounds counterintuitive, given that DeFi is known for being transparent and trustworthy. DeFi fans often proudly claim that everything from transaction records to financial logic to implementation code is transparent in DeFi, and if you are willing to research, you can have the same information and knowledge as the project side.
Theoretically, yes. DeFi does achieve mandatory transparency in its technology infrastructure. But many DeFi projects recreate information asymmetries for a variety of reasons, intentionally or unintentionally misleading the market. Specifically, there are several situations.
The first is to engage in all sorts of whimsical financial pseudo-innovations and hide their fatal flaws through complex logic, code and incentives such as liquidity mining”.
There have been many fantastic ideas in the centuries of financial practice, most of which have been eliminated by history due to serious flaws. After the outbreak of the DeFi summer in 2020, many innovators with little knowledge of financial history launched various DeFi projects based on their enthusiasm for gold rush. Many of these projects are not rigorously theorized. Some even violate basic financial principles and have serious loopholes. Their good performance depends entirely on rising currency prices or overall markets. If they go beyond what is expected, they will be flawed and disproved in tragic ways.
However, these pseudo-innovations are often very good at stacking complexity to create opacity and hide their flaws. They often construct complex mathematical formulas, claim to work wonders, and then copy code from mainstream protocols. In the face of such complexity, the market is unable to identify and evaluate it, resulting in a large number of venture capital investments being misallocated to pseudo-innovation projects. Many of these projects received financing and, at one time, gained high market values. After a period of testing, most of them have been falsified by the market, resulting in near-zero loss of funds allocated to them.
The second scenario is to treat the governance token as a stock and treat the total value of the governance token as the market value of the project. This misleads many funds into the wrong allocation.
To avoid being identified as security tokens, most DeFi projects’ governance tokens are described as having only political rights such as voting rights, governance rights, etc., but these governance tokens are rarely used for voting and are mostly used for trading. But how do you value the votes? As a result, the actual value of these governance tokens has become very difficult to judge and highly volatile.
We do not criticize this situation per se, as it is a corollary of an uncertain regulatory environment. The problem is that there is a widespread misleading narrative in the DeFi market that treats ‘governance tokens’ as equity in a project to calculate its market value. In fact, this has led to an asymmetry between the rights and responsibilities of the project side: in a bull market can enjoy the benefits of a market value bubble, but when the market falls, there is no obligation to support the price of the governance token with real business income.
For example, at its lowest point on June 15, Compound’s TVL was still well above $4 billion and still had a good spread income. But the total market value of $COMP is only $212 million. If the Compound project was valued, many people would probably give it a higher value. However, as a governance token, the relationship between $COMP and the value of the Compound project is unclear, and Compound’s operating income cannot support the price of $COMP.
Misleading narratives like this have led a large number of investors to think they are investing in the DeFi projects themselves, when in fact they are only investing in a voting right with an ambiguous value. The healthy profitability of these projects themselves cannot be passed on to governance tokens or support the market when the market is tumbling.
The third scenario is the formation of nominally safe but in fact high-risk assets through a series of nested complex structures that send the wrong interest rate signal to the market.
Many post-2021 DeFi projects aren’t really solving financial problems, but instead, focus on building assets with a false risk-return structure. In contrast to the first scenario, these innovations do not exploit code complexity to create information asymmetries, but take advantage of DeFi’s open infrastructure to create very long chains of financial structures, often involving several third-party protocols and dozens of assets, nested and complexly combined to construct even more opaque assets. Of course, no matter how packaged, these assets are inherently leveraged on highly volatile assets and necessarily high-risk assets.
We’ve all seen what happens to these assets. When the market is in a systemic correction, these supposedly risk-free assets collapse quickly and unexpectedly. Many investors who thought they could be lying on their safety mats and collecting high-interest rates suddenly find that not only are interest rates falling flat, but they’re losing money.
The fourth scenario is under competitive pressure to force spurious demand through liquidity mining and high yields, leading to a false boom that sends the wrong signal to the market.
Since Compound’s successful launch of liquidity mining, almost all DeFi projects have introduced their own liquidity mining incentives. It should be said that this mechanism can help the project rapidly expand the scale of users, forming a network effect. However, the use of liquidity mining incentives should be limited to real business objectives and serve to promote real business growth. Once away from this goal, spurring pseudo-demand with high yield will accumulate huge risks and lead to a vicious game structure.
A typical example is that many DeFi protocols split about 4% APY above Aave into priority and inferior, and then give 10–20% more APY through governance token incentives in order to create the illusion of high trading volume. But such a game structure is clearly not sustainable. These agreements are ruthlessly smashed after giving large incentives to govern money. They simply cannot build a loyal user base with large incentives up front, nor can they build the funds needed to survive. The project dies immediately when earnings fail.
Lessons learned from the crisis
Our proposal: return to simple, clear and principle-based innovation.
DeFi is destined to be a great innovation movement that will transform human finance and the economy. The movement entered a new cycle in the midst of a brutal decline in 2022. In the last cycle of many famous tricks and fashionable concepts, in the unexpected market winter has shown its original shape. Yet, in the metaverse of financial markets that magnify human flaws infinitely, they are doomed not to die, but to hibernate. In the next warm spring of the crypto market, they will definitely make a new face and revive.
The DeFi industry should learn from the crisis and avoid repeating it. Here are our recommendations:
- Promote a new concept of DeFi innovation, that is clear, simple, adheres to the principles, straight to the core.
- Explain the significance of DeFi innovation in terms of economic principles. As the latest technological tool of the free market system, all blockchain and DeFi innovations should conform to basic principles of economics, solve real problems, create real value, and improve real efficiency, not just a gimmick to slice the pie.
- Oppose pseudo-innovations that do not create real value such as serial arbitrage, circular pledge, and leveraged bribery.
- Create more transparent assets with clear valuation logic, such as debt assets, correct the false narrative of governance tokens as stocks, and reduce the active and deliberate overlay of leverage on opaque assets such as governance tokens.
- Establish an industry-level stress testing mechanism, such as the establishment of a simulated market on the test network, advocating or even requiring DeFi projects to conduct stress tests in it to test their performance in extreme market conditions.
We know that the Crypto and DeFi markets will never be free from human greed and fear-driven folly, but we also believe that DeFi will not stand still. As the evolution of this crypto industry over the past 13 years has proven, as long as we are honest about our problems and learn from our lessons, we can make real progress and do better next time.
About Prestare Finance
Prestare Finance (Prestare) is a lending protocol that offers a lower collateral ratio and can even support under-collateralized loans without using off-chain information. Under-collateralized borrowing is achieved by allowing the borrower to use a portion of the previously accumulated interests as collateral to borrow more funds next time. SoulBound Token containing credit score for all users need to be minted if users want to borrow on Prestare. Users with higher credit scores can have a loan with a lower collateral ratio.