When it comes to the free and open future of crypto’s financial backbone, the majority of people in the blockchain space didn’t comprehend how close disaster loomed over the field in the just-concluded year. Even though the DeFi world survived, there are still significant and ongoing challenges for DeFi. There is currently no greater political competition than that between DeFi constructors, stalled lawmakers, and overzealous regulators.
If crypto is to advance, legislators and developers must quickly find common ground and keep the bureaucrats in line when it comes to DeFi supervision. Where should investors put their money in 2023 to grow the cryptocurrency financial services industry is addressed in this post.
Revenge of the dApps
In the year 2022, Ethereum transaction fees have significantly decreased, and dApp competition dynamics have changed. This decrease was made possible through EIP-1559. The Ethereum Improvement Proposal (EIP) 1559 upgrade aims to modify how Ethereum determines and handles network transaction fees (called “gas fees”). Instead of bidding on gas prices to more fairly incentivise miners in times of high or low network congestion, the upgrade made Ethereum transactions more efficient by employing a system of block-based base fees and sender-specified maximum costs.
The three biggest Ethereum-based applications, Uniswap, Lido, and OpenSea, now generate more monthly fees than the entire Ethereum L1 on a combined basis. More volume is moving from Ethereum to its scaling solutions (Polygon and Optimistic Rollups, in particular) or to new tailored app chains (dYdX on Cosmos), where the dApps have more control over their value capture techniques and consensus rules.
Last year, Aave and Uniswap introduced their protocols on several new networks, quickly taking control of their respective markets in terms of volumes and TVL. This shows that most users’ Schelling points aren’t the native, chain-specific implementations of loan and decentralized exchange but rather the most popular user applications. Aave will likely rule in whichever digital country (L1) it enters, just as Binance will probably thrash the leading local “Thai-first” exchange in Thailand once it enters the market.
After the United States imposed sanctions on Tornado Cash and detained one of its key developers, usage of Tornado Cash fell dramatically. Shortly after, Aave decided to geo-fence its front end from Americans, essentially eradicating one of its major user bases. Some investors are putting out proposals that call for the regulation of front-end services because concerns about regulating software and front-ends are so pressing.
Uniswap, the Final DeFi Unicorn
According to Messari, Uniswap might be the most reliable AMM protocol. When it comes to the amount of working capital these DEXs need to maintain dependable, low-slippage exchanges, Uniswap V3 has shown to be a genuine 10x improvement. Professional market makers’ “concentrated liquidity” has arguably produced greater liquidity for important asset pairs than even the biggest centralized exchanges. However, Messari agrees that there isn’t “much alpha left in inventing new AMM invariants.”
Offering dynamic fees that change based on volume or volatility or enhancing the accuracy and dependability of their reference price oracles are two possible areas where AMMs may engage in competitive activity. Perhaps successful central limit order book models could still emerge. Even while some doubters wonder whether on-chain order books are dead as a result of the ongoing flux in the NFT and gaming markets, 0x has established itself as the foundation of many new ones.
If this doesn’t happen, most AMMs will struggle to stand out from the crowd, according to Messari. A leading player on the BNB Smart Chain, PancakeSwap settles transactions using a mostly centralized infrastructure and is heavily dependent on Binance. Other AMM DEXs are dealing with a variety of particular difficulties. Balancer has been engaged in hostage negotiations with an activist token holder while Curve has been taken over by mercenary “board members”. The leadership reorganization for Sushi has been a nightmare, the Terra collapse in Q2 severely affected Osmosis, and Serum was actually killed by FTX.
Additionally, Messari believes that other DEXs will not overthrow Uniswap through tokenomic maneuvers or slight price increases.
Competition cannot be based on fees but rather on values, and Uniswap has demonstrated that it is Uniswap’s main rival in terms of generating more value for its users. The community will develop and implement the protocol’s fee switch, in which UNI token holders will vote to (finally) allocate a portion of protocol trading fees to the treasury. That is the only issue Messari claims to have for 2023.
Real-World Collateralized DeFi
It’s amazing how the blockchain space quickly went from saying that most customers don’t care about decentralization to saying that DeFi lenders were the only ones who weren’t rekt this year.
The irony is that the biggest DeFi lenders seem to have had much cleaner loan books than the centralized lenders, who blew up on risky bets and toxic token collateral.
Using Maker DAO as an example, MakerDAO started experimenting with real-world assets (real estate, bills, trade receivables, and commercial loans) in 2021, and at this time completely reserved dollar stablecoins make up the majority of the collateral supporting the Dai stablecoin. They increased their exposure to U.S. Treasuries by $500 million when risk-free returns increased and DeFi yields declined.
Since real-world yield is becoming more accessible while crypto risk premia are rising, one may assume that these processes are reversed. Instead, the opposite has occurred.
Aave decided to join the overcollateralized stablecoin game as rates have escalated. Its GHO stablecoin, which is native to the Aave protocol, enables users to borrow GHO while earning yield on deposited collateral and enables protocol “facilitators” to issue a finite amount of GHO in a trustless way. The success of GHO would be advantageous for the project because the Aave protocol will keep 100% of the interest revenue from it, as opposed to 10% on its other assets. Soon is the anticipated formal deployment date for GHO and Aave V3 on Ethereum.
Undercollateralized DeFi Lending
The demand for leverage from margin traders and market makers is where overcollateralized DeFi lenders get the majority of their return. Due to last year’s decline in risk appetite and margin trading opportunities, those yields have dried up. Conversely, undercollateralized lenders like Goldfinch and Maple Finance offer yield on undercollateralized positions and have been successful in producing double-digit yields from this riskier type of lending.
The Terra fallout was successfully avoided by lending to delta-neutral crypto market makers. Even though there was a decline, it’s possible that Maple’s delegates were more cautious when dealing with counterparties. But risk comes from cryptocurrency in unforeseen ways. Maple’s active loans were down to just $41 million as a result of the FTX contagion, which caused Maple to liquidate $37 million worth of loans. Currently, $10 million of that is in difficulty.
As a result of solely lending to non-crypto borrowers (reduced reflexivity), Goldfinch still maintains a spotless track record. A stronger exposure to developing economies and the fintech industry are just a couple of the protocol’s special hazards.
Genesis Capital, BlockFi, and Maple Finance all had a distinguished track record. However, this industry has completely dried up due to a lackluster on-chain identity, reputation, and creditor infrastructure. Since its public debut at the beginning of the year, Goldfinch has decreased by more than 90%. Since its April high, maple has fallen more than 90%.
Superfluid Collateral & Synthetic Stakes
Thousands of Ethereum investors were able to stake ETH more easily thanks to liquid staking protocols, boosting the security of Ethereum’s post-Merge Proof-of-Stake blockchain.
Thanks to protocols like Lido and Rocket Pool, a game for whales (a 32 ETH minimum is needed to stake), with significant duration and technical risk, and high opportunity cost (people can’t use their ETH in the NFT or DeFi markets), was made accessible to everyone.
The development of new synthetic assets, staking ETH (Lido’s stETH and Rocket Pool’s rETH) that accrued Ethereum’s staking rewards (for a 10% fee) atomically, and staked ETH that were liquid and tradable as soon as they were minted allowed these staking protocols to catalyze thousands of incremental ETH stakers.
Messari claims that institutional ETH holders, exchanges, and DAOs should all stake heavily after EIP-4895.
In the crypto world, automatic annuity streams are few. Messari believes the next significant long-term blue chip DeFi assets will be Lido and Rocket Pool. In 2023, Messari predicts that Lido will be the top fee-generating dApp overall. And this year, Rocket Pool’s market share may increase by 5 to 10 times.
Messari warns that there will always be a technical and temporal risk to these products up until ETH holders may withdraw money from the staking contracts. The paper mentioned 3AC, which was destroyed by forced stETH sales after its peg to ETH ruptured amid market turmoil in May.
Messari goes on to say that it views those dangers as being significantly reduced going ahead, but that it’s expected that some issues may arise in the market for synthetic staked tokens as more novel structures are put up to rival Lido.
The Perp Walk: dYdX as an Appchain
Despite a disastrous launch for its decentralization and token value accrual method, dYdX has a great product-market fit. For the fourth consecutive quarter, dYdX’s token awards were given out at a higher rate than the money they brought in, this time by $22.6 million.
Messari believes that things will soon start to improve. A fantastic opportunity to decentralize the protocol and improve the tokenomics of the top on-chain derivative protocol will arise with the release of dYdX V4, a dedicated appchain on Cosmos. Instead of using the centralized dYdX, validators in V4 will run the dYdX order book.
Trading entity realigning protocol revenue and token holders. The neighborhood is also mindful of the incoming tailwinds. Governance decided to discontinue two different token incentive programs in Q3 and cut trading incentives to combat token inflation.
Other communities will be paying close attention to the sheer volume of innovations dYdX is trying to insource and customize as a vertically integrated appchain (base L1, custom modules, off-chain order book network, Oracle network, Alchemy-like indexer, mobile applications, and a bespoke wallet).
The impending migration will be hazardous, but it may also result in the best perpetual product ever produced by centralized alternatives on the market successfully competing with them. Given that one of the biggest markets for cryptocurrency futures has vanished, that is pertinent information.
On-Chain Asset Managers
There aren’t many value-adds to yield optimization services given the declining DeFi returns and investors’ attention on capital preservation and reducing counterparty risk. Messari claims that the blockchain community is back to where it was in early 2020 and early 2019 when using this type of DeFi application seemed risky and like picking up coins in front of a Zamboni (smart contract, governance, and counterparty).
The focus now seems to be on investing DAOs yet Messari finds it puzzling that protocols like Enzyme and Index Coop have had such a difficult time “developing bespoke indexes for cryptocurrency.”
In this cycle, as fundamentals take hold and memes lose their luster, good active managers could prosper, according to Messari. Code-based rules-based asset managers are now much simpler to develop, and 2023 should see a greater performance for protocols that enable the proliferation of on-chain funds and indexes, provided they are developed abroad. The SEC won’t appreciate these, without a doubt.
New Novel Markets: Two Truths & A Lie
- Messari recommends investors fund a demonstrably sustainable, environmentally friendly, and socially responsible organization. Additionally, it expressed happiness that more individuals are beginning to concur with their reports, even if it is only voluntarily.
Messari’s enthusiasm for crypto protocols like Nori, Flowcarbon, KlimaDAO, and Toucan—which are reviving the defunct carbon trading markets and setting the framework for businesses and individuals to minimize their carbon footprints—was once more on display. These protocols have the potential to bring transparency, liquidity, and aggregation to the global green markets by tokenizing carbon offsets and establishing trustworthy on-chain carbon marketplaces.
To cap it all, it unveiled their bullishness on “regenerative finance.”
- One of the major markets in the world is real estate finance. As a result, it is reasonable to assume that there will be a tremendous opportunity for cryptographic protocols to develop in this field. Propy (tokenized real estate), Milo Credit (collateralized mortgage lending), and Vesta Equity (fractionalized ownership) are just a few examples of physical real estate bets that leverage cryptocurrency that haven’t yet gained traction. Messari is also unconvinced that there is a short-term route to meaningful cryptocurrency participation in such a highly regulated and tangible asset class.
- Messari stated that it believes in the prediction market.
Prediction markets seem to be a use case for cryptocurrency that will never come to pass. Surprisingly, in this year’s high-stakes election, they produced virtually nothing of value. Today’s wagers on Polymarket concerning the Republican presidential candidacy in the US in 2024 have a meager $2 million on the line. Without the additional hazards of cryptocurrency, legal sports betting is expanding, and no one wants to play on tokens at this time.
Remember Messari said two truths and a lie. Which is the truth and which is the lie?
DeFi Censorship
The blockchain community, according to Messari, should not minimize the possibility that DeFi won’t make it through the year’s global regulatory test. Members of Congress view DeFi as the crypto industry with the biggest level of danger, thus it will be difficult to convince them otherwise. Simply adding DAOs makes the value of cryptocurrency, taken in its entirety, an even more complex story to communicate for those who are not immersed in its specifics.
Some teams have begun to make plans for a scenario where DeFi protocols are governed at the interface and “Labs” levels. It’s a tough compromise that may have to be temporarily accepted in some jurisdictions (to shield the underlying protocols from enforcement action), then fiercely contested in court.
Implementing specific controls and limitations on their websites is nothing new for the front ends of important protocols managed by centralized teams. Most browser wallets and front end perform some level of IP tracking for AML compliance, Uniswap Labs delisted tokens, and Aave geofenced U.S. users lately, and since certain teams have established precedent, it may be expected that all communities can abide by the laws that are thought to apply to DeFi, and should do so without difficulty or incident.
Using Tornado Cash as a case study, other non-KYC’d transactions will always be executed even if the majority of DeFi users and volume are KYC’d within the next several years. Despite the uproar about network-level censorship in the wake of the OFAC penalties, 30–40% of Ethereum blocks are still processing transactions to and from addresses on the U.S. blacklist.
There is no reason to think that this 70/30 split will change anywhere in DeFi. While we work out how to eliminate the blacklist and safeguard the gray region, the whitelist users will continue to drive the majority of volume, just like the general economy.
Bullish Unlocks → Down Bad
After a year in which the industry saw on-chain attacks totaling $3 billion, Messari suggested that it is time to take security and sustainable token design more seriously. There were other nine-digit hacks in addition to Mango, Poly Network, Nomad, Wormhole, Badger, and Harmony Horizon.
Messari anticipates that in 2023, there will still be a sizable market for network monitors like OpenZeppelin and Blocknative as well as economic security professionals like Gauntlet and Chaos Labs. He also predicts that there would be increased attempts made to create international security standards. Additionally, he urged developers to take action in 2023, saying that the market cannot sustain further high costs.
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