By Bittracy@gaoy98093289 ,Investment Manager of AC Capital
The crypto market was caught in the liquidity crisis that gave rise to severe impacts on the DeFi ecosystem in May. The slump of token prices was followed by the liquidation of on-chain positions. According to the data provided by DeFi LIama, total valuation locked（TVL）fell sharply with a drawdown of over 70% from the peak. Within them, lots of well-known DeFi protocols had to deal with a series of issues, including payment difficulties, disorganized management and credit imperfection. The article intends to retrospect this round of liquidity crisis to explore the root cause of the crisis and bear market’s influences on the development of the DeFi ecosystem.
Above all, let’s replay the whole story of the liquidity crisis. Terra ecosystem was attacked by short sellers in May, 2022. LUNA, which used to be worth dozens of billion in market value, nearly lost all its value and returned to zero when LFG failed at its bailout plan. Jump Capital, Three Arrows Capital (3AC), Celsius incurred enormous paper losses due to significant positions in LUNA. As the critical moment that marked the transition to bear market, “Finance Contagion” quickly happened among crypto institutions on account of the stack of DeFi ecosystem. In the following month, the price of Bitcoin slipped below $20,000, which is a drawdown of 50% from the peak in May. 3AC’s huge loss of liquidity in LUNA brought considerable pressure on capital. Furthermore, holding large amounts of GBTC, ETH, under the circumstance of a low-performance market, made 3AC’s situation worse so that 3AC dumped most of the tokens it invested. Meanwhile, the incident that lending platform Celsius concealed its loss was exposed. Celsius started to undersell its digital assets in the market in return for liquidity in order to respond to customers’ requirements, leading to the unanchored stETH.
Drastic fluctuation of digital assets resulted in the liquidlity crisis of DeFi：Lending protocol enforced liquidation on positions that were under margin. Tremendous selling pressure initiated the downward spiral. In the meantime, spreads of stablecoins in swap pools were widening. Unsecured loan protocols began to raise bad debt risk. The DeFi ecosystem, which used to be widely trusted by investors, appeared to be overwhelmed by the liquidity crisis. As of the publish of this article, the price of Bitcoin had gone up to above $20,000. Impacts on DeFi brought by the liquidity crisis deserve introspection.
From the entire process, Terra seemed to be a point of departure of the market crash. Will the bull market lasts forever if Terra never exists？In fact, the market size of US dollar stablecoin had stopped growing in April. Risk management problems of Celsius and Babel have always existed. What is the root cause of the liquidity crisis? The article will analyze the fundamental reason in the method of “Up to Bottom”.
1）Macro factors：Tight monetary policy lowered the valuation of digital currency. Tighter liquidity boosted pressure on the market.
After the outbreak of coronavirus in 2020, All central banks from around the world initiated monetary expansion to stabilize the economy. Growth rate of the monetary base in the United States exceeded 300% year on year. The spillover of liquidity promptly pushed up prices of financial assets. The size of the Federal Reserve’s balance sheet increased to more than double, from $4.16 trillion to $8.92 trillion. The global economy gradually staged a recovery in 2021. However, the inflation rate was driven up substantially by monetary expansion. The United States’ CPI rose to the record high for 40 years. Jerome Powell decided to tighten the scale of bond purchases from November in 2021 and shrink the balance sheet from June in 2022. According to the roadmap of balance sheet reduction released by the Federal Reserve on May 4th (reduce $95 billion each month), it is estimated that the size of the Federal Reserve’s balance sheet will fall below $6 trillion in Q3 of 2025. Tightening of liquidity margin brought apparent pressure on highly valued assets.
U.S. Treasury yields have always been the anchor of pricing so that the rise in the benchmark interest rate reevaluated major asset classes. In 2021, the overall market capitalization of digital assets exceeded trillions of dollars for the first time while Bitcoin had already been considered as one of major asset classes in its true sense with respect to minority group’s value consensus. Within the macro vision of tighter liquidity, crypto, which is extremely sensitive to liquidity, became the first to be affected.
2）Change in crypto market cycle: The bull market driven by halved Bitcoin had been near to completion. Innovations of Dapp dried up. The number of newly increased addresses declined.
From the perspective of the crypto world, we will analyze the market changes in Q2.
Take the history as reference, the bull market driven by halved Bitcoin had been near to completion. Due to the important implication of Bitcoin in the crypto world (with a proportion of approximately 70% of the whole market cap), reviewing the historical performance for the last three time when Bitcoin halved, we discover that Bitcoin reward halving is the unique cycle of the crypto market which can raise the cost of Bitcoin mining and push forward the market quotation. On the basis of Bitcoin’s performance after Bitcoin halved in the past three times, each round of bull markets lasted for around 22 months. On May 12th, 2020, Bitcoin started its third time halving, which marked the beginning of the bull market. By the end of May in 2022, the length of the bull market had continued for more than 2 years.
In terms of technological progress, developers’ innovation shows signs of fatigue. Thanks to the innovative development of smart contracts by technicians in 2020， the decentralized world is getting rich and colorful(“DeFi Summer”in Q2 of 2020; the wave of GameFi in 2021; Layer 1 sprung up). As time went by, in Q2 of 2022, more emerging Dapps aimed at the replication and optimization of existing modes. Innovations that can make an impression are now becoming increasingly scarce. As an investor, it’s hard to pick an investment target. Under the circumstance that prices go down and innovation stagnates, the market has been switched to NFT driven by narrative. Market liquidity is consumed by degrees. The number of newly increased addresses has been declining since May 2022 on account of sluggish endogenous growth. Attraction of the crypto world for external users was falling.
3）DeFi mechanism：The liquidity shrinks and the risk increases during the downside fluctuations.
Impermanent loss happens no matter whether the price of crypto rises or falls. When the price falls, the loss of liquidity providers will even be worse owing to the asymmetry of impermanent loss. Regarding impermanent loss’s performance in the face of the fluctuant market, Pintail interprets elaborately in his article, “If long term price movements are large, they could result in losses much greater than the return from fees.”
Pintail. (2019, January 11). Uniswap: A Good Deal for Liquidity Providers? Medium. https://pintail.medium.com/uniswap-a-good-deal-for-liquidity-providers-104c0b6816f2
Therefore, liquidity providers choose to withdraw their investments as signs of crisis arise, which leads to the negative cycle of DeFi’s tighter liquidity and the sharp contraction of TVL in a short space of time.
The AMM mechanism is the core foundation of DeFi, but it cannot avoid the price impact brought by block trades. When the market goes down, users tend to have the timely demand for redemption. The staking funds in Swap is difficult to meet users’ transaction requirements if transactions occur on a large scale within a short time. First of all, in the DeFi ecosystem, the scale of staking funds in Swap Protocols is roughly equal to that in Lending Protocols. Swap Protocol is unable to provide sufficient depth for liquidation at the time of the large-scale liquidation. More importantly, with large transactions, the market price will notably deviate from the original price under the AMM trading mechanism (single large-scale liquidation will greatly affect the location where the transaction occurs at the constant product curve). Igor Mikhalev and Zoia Mandrusova indicated their research findings in the paper Agent-Based Modeling of Blockchain Decentralized Financial Protocols that trade size is positively correlated with impermanent loss. Single large transaction will disrupt the transaction value. Take the unanchored UST in Curve protocol as an example. On May 7th, a transaction which required USDC in exchange for 85 million dollars’ worth of UST in STw-3CRV Curve pool immediately resulted in the liquidity shortage of UST. DeFi, built on AMM, appears to be inadequate while being confronted with the market crisis.
Conclusion：Under the pressure of the macroenvironment, poor performance of the digital asset market not only affects DeFi and CeFi, but also endangers traditional financial institutions. Shrinkage of the Federal Reserve’s balance sheet and collection of the excessive liquidity will tighten financial conditions and increase the risk-free rate. Weighing on the global financial market to varying degrees, the surplus of the Federal Reserve’s policies will increase the average of the global interest rate. Risky assets with high valuations will be impacted the most in particular. Moreover, innovation of blockchain is at a standstill. Attraction of the crypto world for external users is getting less because of the sluggish endogenous growth of the industry. More critically, due to the operational characteristics of DeFi transaction mechanism, the situation of the on-chain financial system will be more dangerous in response to market modification.
1）DeFi has entered into the stock market. The market is getting more concentrated upon the head.
In the first place, decline in the market lowers the on-chain trading volume as well as the desire to borrow. Consequently, the competitive context in DeFi intensifies. Since trading fee and interest spread are DeFi’s main sources of return, market space will shrink during the bear market as trading volume and TVL drop markedly. For a long time to come, what developers of DeFi face is a stock market, even a market with reduced volume. Increased competition makes the plight worse for those DeFi Dapps that just started.
Compared with the bull market, it will be tougher for new protocols to acquire liquidity in the bear market so that market shares of leading DeFi protocols will conspicuously increase. Investors are losing their interests in participating in new mines because of lower risk appetite. In the specific case of market maker mechanism, DeFi protocols obtain their income by selling tokens when they launch. Development teams use tokens to motivate market makers and users. They take arbitrage costs(impermanent loss) and tokens as the function of trading fees. In addition, they determine the amount of reward for liquidity providers. Nevertheless, the likelihood that users FOMO recklessly decreases under the depressed market with low liquidity. New protocols can hardly guarantee the profit of market makers(maintain token prices).
It’s worth noting that leading protocols were encroaching on the vivosphere of other protocols. Curve announced the upcoming pushout of its over-collateralized stablecoin in July. simultaneously, lending protocol AAVE planned to issue its own stablecoin GHO and provide corresponding Swap service. Leading DeFi protocols were converting to other racetracks and utilizing their own advantages to expand their growth space in the context of weak on-chain transactions.
2）DeFi protocols need to optimize the structure of governance and promote the efficiency of governance
The problem of DeFi protocols’ oligarchic governance hasn’t been solved so far. Frankly speaking, project teams and investors have strong control power over protocols, hence creating moral hazard. In the presence of the stress test, users’ interests cannot be assured for the reason that those institutions which declare decentralized governance(Celsius, Terra) sacrificed the interest of customers and did violations for self-insurance. As a matter of fact, there have always been problems in DeFi’s governance structure. Users turned a blind eye to them in the bull market. But it’s too late to take action after the occurrence of the crisis.
Investors start to focus more on how to optimize DeFi governance. The topic of how to ensure the interest of all parties by the stress of the market was discussed frequently in recent roadshows of DeFi protocols. In order to avoid recommitting the same error, communities should establish effective mechanisms to prevent project teams from being immoral although a project requires centralized governance to guarantee efficiency in the primary stage of development.
I wrote an article related to governance at the beginning of this year. DAO governance is inapplicable to every scenario. We can assure the effective operation of protocols if we apply centralized governance properly. DeFi protocols ought to select the appropriate governance mechanism based on the nature of their business so as to facilitate protocols to be built to last.
Orientation of innovation：The security of assets receive attention: growth opportunities in insurance and privacy
In 2020, DeFi constructed a financial system for the decentralized world as the foundation of a prosperous industry. In the wake of a stronger market, DeFi was moving towards a direction which has higher efficiency and profits. We’ve observed a lot of experiments, including semi-collateralized/unsecured algorithmic stablecoin protocol(UST); unsecured lending protocols（TrueFi 、Maple Finance）；staking protocols with higher profits(Alpaca Finance、Lido). Innovations on liquidity improve capital efficiency and generate higher returns. Some protocols gain high profits at the expense of liquidity, while others adopt higher leverage to get FarmingYield. However, due to the composability of DeFi，the financial system with a highly stack frame will easily get into trouble as soon as liquidity shrinks. It helps explain why we saw LUNA returning to zero, sETH delinking from ETH, large-scale liquidations happening and Dapps acting with confusion when the market shows a fluctuating downward trend.
Take a long-term perspective, practitioners should take risk management more seriously. Establishing an effective risk management system is supposed to be the emphasis of developers’ work in the DeFi ecosystem. After the DeFi liquidity innovation blossoms, I personally look forward to the emergence of a variety of “safety tools” in the DeFi world. Taking Gauntlet as an example, as a decentralized risk management platform, its role is to help DeFi protocols control risks and improve capital efficiency. The protocol provides guidance for the capital utilization efficiency of DeFi protocols through sensitivity analysis in different scenarios, in order to provide more direct incentives for market makers and users. Currently, Gauntlet has partnered with AAVE, Compound, MakerDAO, Sushiswap, and Balancer. Meanwhile, Gauntlet has partnered with DeFi Pulse to assess “economic security levels” for different funding platforms. For example, users mortgage funds to Anchor to get a 19.5% interest rate return, and senior players do not know what the level of risk they faced. Gauntlet can be used as a rating tool on the member side to help users quantify risks. From the high level perspective of Decentralized Finance, we must admit that risk management is the shortcoming of the current DeFi ecosystem. Because of this, insurance and safety tracks may usher in a good development period.
DeFi is an important foundation for the development of the decentralized world. In the bull market, its benefits come from the excess inflation of governance tokens and the leverage ratio. Obviously, when the market falls, these are no longer reliable. In a bear market, the protocol needs to earn its own living space through trading fees and interest rate differentials. The development of DeFi will be closer to the essence of finance, and the development team will also provide the market with reliable business models and solidity products; more balanced governance models, more solid revenue methods, and safer risk management. But the logic of future DeFi development is fundamental.
2、《Uniswap: A Good Deal for Liquidity Providers?》
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