DeFi Playbook Part 1: Blockchains and Protocols
Decentralized finance has become one of the hottest themes of venture capital investments in 2022. With the expectation of revolutionizing financial rails, VC funds are doubling down on DeFi startups. The driving force behind this expectation is speculation — on the potential of DeFi and the dreams of operational efficiency, transparency, and price reduction that DeFi promises. There are over 600 DeFi focused blockchains and over 2000 different protocols. Amidst the chaos of so many different market participants, it’s important to understand the evolution of different blockchains and protocols, the dynamics between different competitor personas, and the way forward.
As the first part of a series on a complete playbook for decentralized finance, this article is aimed at explaining the current DeFi landscape from a blockchain and protocol standpoint. In the course of this text, we’ll first learn about how different blockchains are positioned for DeFi adoption. After that, we’ll discuss the different kinds of DeFi protocols and lastly, we’ll cover the different approaches to building DeFi protocols adopted by different blockchains.
DeFi focused blockchains
The total value locked (TVL) for any decentralized protocol is the value amount of cryptocurrencies deposited in a DeFi protocol. The current overall global TVL is USD 230B (in April 2022), peaking at USD 255B+ in December 2021. Of this, 90%+ of the locked value is concentrated within 10 blockchains of which 50%+, amounting to approximately USD 125B is concentrated with Ethereum itself.
Ethereum’s market dominance is seconded but not challenged, by Terra, with a distant TVL of approximately ~USD 30B. With such market dominance, it may seem that there’s no place for other chains to exist and sustain popularity among mainstream DeFi investors. To determine the value of projects and predict future trends of adoption, it is important to observe the ratio of a token’s market cap and TVL, which indicates whether a DeFi focused token is undervalued or overvalued.
The industry average for Market-Cap/TVL is approximately 9x, approximately 3 times that of Ethereum, which dominates the DeFi market. This high value is due to 2 reasons:
- More than 40% of crypto’s market cap is dominated by Bitcoin, which is not a DeFi focused blockchain
- A long tail of DeFi focused cryptocurrencies are overvalued, with quick early adoption driven by speculations around a currently underdeveloped DeFi ecosystem
If Ethereum’s market capitalization is considered a reasonable standard at its current DeFi TVL, all of the top 10 DeFi focused blockchains by TVL are within steady limits, with their M.Cap/TVL beneath that of Ethereum.
Fantom, the 6th largest DeFi blockchain by TVL, is significantly undervalued, with its M.Cap/TVL beneath 1. Terra, the second-largest DeFi blockchain, with M.Cap/TVL slightly above 1 has a very healthy valuation. The likes of Polygon and Cronos are at the edge with a ratio close to that of Ethereum.
On the contrary, popular blockchains like Solana and Binance Smart Chain have significantly high ratios and are prone to correction. Near protocol and Polkadot have extremely high valuations concerning their TVL, with their M.Cap/TVL ratios greater than the industry standards.
The ratio is a great way to understand the health of any DeFi blockchain as well as protocol and assess whether the early adoption of DeFi protocols by mainstream users is sustainable or not. Along with sustainability, it’s important to assess the ecosystem of DeFi protocols that a blockchain has to offer and also how adoption has been across the protocols in the ecosystems. The correct metrics include the number of DeFi protocols in a blockchain and the TVL per protocol in a blockchain.
As per the 3 parameters, blockchains can be classified into 4 categories.
These include blockchains that have a wide range of offerings and have garnered significant popularity among DeFi investors. Ethereum has 500+ DeFi protocols with each protocol having a TVL per-protocol of more than USD 200M, indicating strong adoption among investors. Solana follows a similar path, with a slightly less number of protocols, yet widespread popularity among investors. Terra, on the contrary, has just over 25 protocols, but the protocols have garnered a very strong adoption with TVL per-protocol of over USD 1B. The entire Terra ecosystem has a complete set of necessary DeFi offerings required for mass adoption.
These are blockchains that have developed a complete set of DeFi offerings but have yet to achieve substantial popularity and adoption among DeFi investors as compared to Ethereum, Solana, and Terra. Examples include Fantom, Binance Smart Chain, Polygon, and Avalanche, which have the greatest potential for adoption among investors. Their current focus is to increase adoption.
Preliminary DeFi Chains
These are blockchains that have several DeFi protocols, although they don’t have a complete set of DeFi offerings necessary for mass adoption. Their current aim is to build a substantial set of offerings and drive initial adoption. Examples include Near protocol, EOS, Gnosis, Heco, etc.
These are single or few DeFi protocols built on top of a standalone blockchain and have garnered some popularity. Examples include Elrond, Kava, ThorChain, OkExChain, etc.
Now that we know how different blockchains are positioned in the DeFi market, it’s time to take a closer look at the protocol level.
Types of DeFi protocols
To understand DeFi, it’s important to understand all of the current DeFi offerings. There are 13 types of DeFi protocols:
A) Decentralized Exchanges (DEX)
A decentralized exchange is a protocol that allows users to swap fiat currencies with cryptocurrencies and vice versa without any permission via direct peer-to-peer transactions. For any exchange to be a true DEX, a protocol should have the following characteristics:
- DEXes are permissionless — users must be able to operate them without any 3rd party involvement
- DEXes democratize market-making — allowing anyone to provide the liquidity required for the functioning of the protocol
DEXes are the most popular DeFi protocol archetypes. Examples: Sushiswap & Curve is a multichain DEXes; Uniswap is an Ethereum based DEX; TerraSwap is Terra’s inbuilt DEX. DEXes are capable of building an independent business with their offering.
B) Lending Protocols
Lending protocols are decentralized P2P lending platforms allowing users to deposit collateral assets and borrow assets within the collateral rate without the need of matching a lender and a borrower. Lending forms the 2nd largest DeFi protocol archetype after DEXes. Similar to DEXes, lending protocols are capable of building an independent business with their offering. Examples of lending protocols include Maker, Aave, Compound on Ethereum, and Anchor on Terra.
C) Liquidity Providers (LP)
Liquidity providers are protocols existing as a complementary offering, providing DeFi users the opportunity to deposit their cryptocurrencies in liquidity pools required for the functioning of DEXes, lending protocols, and other exchanges. For depositing cryptocurrencies in these pools, users are awarded yields and token rewards. These deposits power other protocols which require liquidity of cryptocurrencies to function. Examples of LP protocols include Convex Finance, Quarry, Spectrum, etc.
These are protocols that help transfer any digital asset from one blockchain to another. This is one of the most standard offerings provided by the blockchain itself, to ensure interoperability. Examples include Polygon bridge, which enables transferring of assets from Ethereum to Polygon; Wormhole protocol, which helps transfer assets from Solana to other chains and TerraBridge, which helps transfer assets from Terra. Bridges are also typically an extension feature for non-custodial wallets. Hence, there is limited play for a standalone bridge.
E) Collateralized Debt Positions (CDP)
Collateralized debt positions are protocols that generate stablecoins when an amount of cryptocurrencies is locked in the protocol. As an example, Maker allows users to generate and borrow DAI, a stablecoin pegged to USD, when a cryptocurrency like Ethereum, equivalent to 150% of the value of DAI generated, is locked into the protocol. If the position becomes uncollateralized, the locked cryptocurrencies are sold to obtain the DAI and the liquidation fees. It essentially serves. as a mechanism for generating stablecoins. Examples include Maker which uses cryptocurrencies to make DAIs which are stablecoins pegged to USD.
F) Staking Protocols
These are protocols where users can lock their cryptocurrencies to ensure a higher probability of selection for verifying transactions on a blockchain. Mathematically, the probability of getting selected to verify a transaction on a blockchain is directly proportional to the number of cryptocurrencies you stake in a Proof of Stake protocol. There are 2 types of staking protocols:
- Direct staking: These are blockchain-built staking protocols where users can directly stake their cryptocurrencies and increase their chances of selection. Example: Terra Station manufactured by Terra
- Indirect staking: These are standalone protocols that pool cryptocurrencies on behalf of investors and stake them to increase the probability of selection. The probability is increased multifold due to the pooling together of cryptocurrencies. Example: Lido
On every verified transaction, the verifier is given a reward in the form of fees, allowing users to generate yield by staking.
G) Yield Aggregator
These are protocols that remove the hassle for users to find and decide which lending, liquidity mining, or staking protocols they should use to maximize their returns. Yield aggregators have smart contracts that follow a specific strategy for investment in multiple yield-generating protocols. They have the following characteristics:
- Maximize yields: They shift funds between various DeFi protocols to maximize the yields.
- Minimize gas fee: They also aim to minimize the gas fee associated with transacting on the Ethereum blockchain
- Improve user experience: Mainstream users can get the same result by utilizing one yield aggregator protocol as they would by investing in multiple yield-generating protocols.
Examples include Convex Finance, Yearn, dHEDGE, etc. This is a completely independent play with significantly high demand.
H) Algo Stables
Algorithmic stablecoins are protocols used to empower stablecoins by stabilizing their prices via issuing more coins to bring down prices of stablecoins when demand and prices are higher and buying them off the market to bring up prices when demand and prices are lower. They are one of the 3 ways stablecoins maintain their prices pegged to an asset. The other 2 ways are fiat-collateralized stablecoins which are backed by cash (e.g. USDC, USDT), and crypto-collateralized stablecoins which are backed by cryptocurrencies (e.g. DAI backed by the CDP in Maker). Examples of algorithmic stablecoins include the functioning mechanism of Terra, which has a host of stablecoins, and ESD & AMPL. They usually are associated with the blockchain itself or have an independent play run by DAOs.
Like traditional derivatives, crypto derivatives are contracts whose value is determined by an underlying asset. In traditional finance, the underlying asset can be stocks, bonds, commodities, or any other product. In crypto derivatives, the underlying asset is a cryptocurrency or an NFT. The contract entails parties that agree to buy and sell the contracts at a particular price and time. A party can enter the contract by buying it or exit it by selling it. There are 3 kinds of crypto derivatives:
- Crypto futures: Contracts where traders decide to sell a cryptocurrency in the future at a specific date and price. At the time of realization, the delta between the live price of the crypto and the decided price of the futures contract determines the profit or loss of the investor.
- Crypto options: Similar to futures, a crypto option allows traders to sell or buy a cryptocurrency in the future at a specific date and price. In this case, the trader has an option to not bear a loss by not executing the contract. However, (s)he would still have to bear a trading fee.
- Perpetual swaps: These are very similar to futures or options except that they don’t have an expiry date and can be kept for as long as the trader wants to. To keep the contract, the holder has to pay a holding fee called the funding rate. In the case when the price of perpetual futures rises, traders who have bought the contract, or have gone long, have to pay the funding rate to those who have sold the contract or gone short. In the case when prices fall, sellers have to pay the funding rate to the buyers.
Derivative marketplaces can exist individually and independently from a blockchain.
Payment protocols allow users to transfer cryptocurrencies from one wallet to another by converting them into stablecoins and batching transactions together to reduce transfer fees. There is significant scope for a standalone offering in this domain. Examples of payment protocols include CHAI on terra and lightning network on Bitcoin.
Crypto synthetics are tokenized investment products mimicking the behavior and trend of other traditional finance products like prices of stocks, shares, foreign currencies, oil, energy, etc. They aim to create a synthetic version of any off-chain offering. Examples include Mirror protocol on Terra and Synthetix on Ethereum. Synthetics are usually offered with Derivatives or CDPs. There can be standalone plays as well, but derivatives are better suited to offer the product.
Insurance protocols offer insurance to avoid any loss that can potentially occur in case of incorrect smart contract execution. This is a highly untapped domain at the moment, with a large scope for individual play. Current examples include Nexus Mutual, Guardtime, and Etherisc.
These are tertiary offerings provided by DeFi protocols. Example use cases include DAO tooling protocols like Syndicate and Superdao; and prediction markets like Polymarket. There is a scope for standalone solutions with both types of products.
DeFi protocols within blockchains
The approaches followed by mature DeFi ecosystems like Ethereum, Solana, and Terra are very different.
Ethereum, having the most evolved ecosystem, has taken a platform-led approach on which developers can build independent applications on top, across all 13 categories. Being first to market and having trust among mainstream users makes independent plays possible on top of Ethereum across all categories.
Solana has tried to take a similar approach which helped it gain widespread popularity. Solana’s approach has been to provide multiple DApps in top-performing categories. Hence, it has a satisfactory set of offerings with good adoption but does not have any DApps across a few categories. The inability to provide additional complementary offerings across different categories has hindered its adoption.
Terra on the contrary played a product-first game where it offered a very finite set of offerings, all across different categories and different models. It allows developers to build applications on top. If any of the offerings are lacking, Terra aims to provide that offering itself. With a finite yet complete set of offerings, Terra has grown substantially to become the second-largest DeFi ecosystem globally.
With this, we have learned about how different blockchains are positioned to serve DeFi requirements, the different kinds of DeFi protocols that exist; and the protocol ecosystem among mature DeFi blockchains. In upcoming articles, we will discuss in-depth the business playbook around each type of protocol.