Force Insight | The Five Factors that Defined DeFi in 2022
As we near the end of this year, let’s take a look at the wrap-up of DeFi in 2022. Despite the market turmoil, DeFi is a powerful brand that is embraced by both large and small companies. It’s still a catchy rallying cry for a financial system that’s transparent, global, and digitally native.
It’s quite impossible for DeFi to expand while anything crypto is called a fraud. However, this will pass. Meanwhile, much work has to be done to move DeFi ahead, from infrastructure to app layer, all the way to fundamental market structure. Throughout it all, 2022 may be remembered as the year that DeFi regulation discussions grew considerably more serious, notably surrounding stablecoins.
It’s been a straight line down for practically all crypto assets and DeFi metrics in 2022. This was emphasized by two significant implosions: first the collapse of Luna and the Terra stablecoin, and then, just last month, the enormous scam at FTX. Neither of these, however, got to the heart of DeFi. The FTX collapse really presents a better argument for non-custodial exchanges and a transparent loan book. Terra’s failure, meanwhile, concluded that algorithmic perpetual motion machines are a fiction.
The overlooked story is that the market collapse did not lead to a DeFi protocol breakdown. In contrast to March 2020 and Black Thursday, DeFi performed beautifully. Nonetheless, the big drop in ETH and substantial stablecoin outflows significantly impacted DeFi TVL and fee-generating capacity. This has hampered investment in the area, making any product introduction difficult. This, however, may be a beneficial trend, by promoting longer times of creating rather than attempting to hurry forth products and ideas before the music ends.
It’s ironic that Elizabeth Warren unveiled a bombshell piece of legislation just this week, in the midst of a busy year of regulatory scrutiny. This proposed rule is a full-fledged assault — KYCing all wallets and going after node operators — with very little chance of passing. And it appears that this is the common thread of all proposed regulatory changes: they go nowhere. We acknowledge to being foolish in expecting that crypto’s bipartisan appeal would translate into law. What is true this year is that regulators have become more knowledgeable about DeFi and the crypto ecosystem.
Nowhere is this more true than with stablecoins. The biggest centralized ones (Tether, USDC, and BUSD) are now regarded as shadow banking arm, with possibly concealed systemic danger to the global financial system. Meanwhile, the blowup of stablecoin Terra makes us question if authorities will give closer scrutiny to anything claiming to be $1.00. For the industry, this means slower growth (see chart below, supply is falling even before the market crash) and a trend away from Tether and toward “safer” centralized stablecoins like USDC and BUSD. Still, the long-term tailwinds on stablecoins are substantial.
With the present market upheaval and regulatory disarray, it’s difficult to believe that nothing will be done, but we’re bracing ourselves for another year of regulatory standstill. While it may seem evident that a transition is needed, regulatory clarification regarding DeFi and stablecoins will likely proceed at a glacial rate.
Cosmos, Appchains, and Modular Blockchains Enter the DeFi Arena
dYdX, one of the earliest DeFi projects, bolted for Cosmos this year and created its own chain. It now offers free transactions for unexecuted orders, and improved its validator set to store the orderbook. dYdX was likely the first successful appchain, a competing vision to the composability-centric EVM architecture. Many people believe that all major DeFi protocols, such as Uniswap, will eventually launch their own appchains.
The emergence of modular blockchain design, has aided this idea. This vision did not come true, but it gained a lot of attention in 2022. Celestia and Polygon Avail are two new blockchains that leverage modular blockchain design to address the issue of data availability. These networks, unlike conventional blockchains, do not validate transactions, instead focusing on ensuring that fresh blocks are added to the network by consensus and are accessible to all nodes. Celestia’s initial partners illustrate possible use cases: dYmension (which enables rollups to issue tokens and select a data availability layer), AltLayer (high-throughput ‘disposable’ rollups in which NFTs are minted and subsequently bridged to an L1), and Eclipse (rollups using the Solana VM and the IBC Protocol).
The Entrenchment of MEV
MEV professionalized in 2022. Yes, there are still anonymous developers roaming the dark forest, but it is today regarded as the playground of the world’s most skilled traders. Flashbots, the leading character in the MEV tale, become even more successful in 2022 with the change to PoS (nearly 90 percent of Ethereum validators are running MEV-boost). Yet with this success also came a recognition of the centralization and censorship concerns from this market design.
The current state of affairs, with Flashbots acting as a trusted middleman, cannot be sustained. What is apparent, as we discovered in our deep dive last week, is that the MEV arena will migrate away from Ethereum and onto a separate network capable of balancing the benefits of MEV profit extraction with the need to democratize and decentralize that market.
SUAVE, a whole new blockchain enabling block construction on any chain, is Flashbots’ response. It’s ambitious, but not different to rival initiatives to limit MEV extraction from CoW Protocol through batch auctions, or Chainlink’s Fair Sequencing Service. All agree that transaction sequencing is critical to maintaining blockchain credibility and limiting rent extraction.
Where are the cool, new DeFi apps?
It’s quite hard to point to a key DeFi breakthrough in 2021 that can match to the likes of the Uniswap launch (November 2018), Synthetix (January 2019), MakerDAO multi-collateral Dai (November 2019), Curve (January 2020), COMP farming (June 2020), or YFI governance distribution (July 2020). The most important and promising DeFi projects appear to have been initiated more than two years ago.
While not entirely incorrect, this viewpoint is exclusively focused on the app layer, or the end-user experience. It, in our opinion, undervalues DeFi since it considers it like Fin-Tech, which is simply a contemporary application wrapper for the existing banking system. The DeFi layer is larger than the app layer. It also contains an infrastructure layer and a market structure layer. And in those areas, there’s been an awful lot of improvement. In 2018, the present slot of DeFi applications was established on crypto infrastructure and market structure. While the industry spent 2022 studying and developing the next generation of DeFi infrastructure and market structure, more development is required before innovation can return to the app layer.
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