The key performance metric of the decentralized finance ecosystem, Total Valued Locked (TVL), suffered a significant dip in 2022. It lost $127.57 billion over the year, falling to $39.21 billion from $166.78 billion at the start of the year.
The 76.49% drop was the sharpest since the industry began.
Total Value Locked (TVL) is the sum of the value of all assets deposited in a DeFi product. However, while the Total DeFi TVL is trending down in 2022, the new floor is well above pre-recent bull market levels.
DeFi yield rates and DeFi TVL are linked. Investors can contribute funds to DeFi protocols and receive a return on their investment. Investors rush to put money into DeFi protocols when yields are high in order to earn lucrative returns. At the same time, investors would also divert their funds to other opportunities where they can earn higher returns with lower returns.
At the start of 2022, the DeFi median yield saw a significant drop, and shortly after, DeFi TVL saw a significant drop. We can therefore conclude that the reason for the crash lies in the decline in DeFi product yield rates.
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DeFi 101: Decentralized finance, or DeFi for short, is the name of a new financial system based on blockchain technology that operates without the support of traditional financial intermediaries such as banks and governments. Decentralized and open-source applications built on top of smart contracts and running on blockchain networks like Ethereum are used in DeFi to conduct financial transactions.
No matter where you live or how much money you have, DeFi aims to make financial services more accessible, transparent, and secure for everyone. DeFi has garnered a lot of interest in recent years due to its potential to disrupt conventional banking and grant financial independence to people who have been excluded from it.
The DeFi industry has seen rapid expansion in recent years. The total value locked in DeFi protocols surpassed $1 billion for the first time in 2020 and has been steadily increasing ever since. The total value locked in DeFi protocols surpassed $60 billion by the end of 2021, demonstrating the rising interest in and adoption of DeFi among both institutional and retail investors.
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DeFi’s growth has been fueled by several factors, including rising demand for decentralized financial services, the rise of yield farming, and the adoption of new protocols and applications offering new financial products and services. Yield farming in particular has been a key growth driver in DeFi as it allows investors to earn high returns on their investments by lending, borrowing and deploying digital assets.
What caused the crash: Several interconnected factors contributed to the ups and downs in DeFi yield that we observed during the 2020-2022 crypto market cycle, along with the subsequent ups and downs in TVL. The rise in US inflation, triggered by the US government’s aggressive monetary expansion strategy, was one of the main drivers of the cycle.
One of the largest groups of cryptocurrency holders in the world are Americans, and they have comparatively high purchasing power. Because of this, Americans have a disproportionate impact on the cryptocurrency markets.
To offset the economic downturn caused by the Covid-19 outbreak in 2020, the US government printed money with stimulus packages. This year, the amount of US dollars increased by 26%. Due to the increased purchasing power of consumers and increased demand, the prices of products and services have increased. As a result, inflation shot up dramatically in 2021.
To avoid rising inflation, savvy investors bought risky assets like growth stocks and cryptocurrencies. The story went like this: “Inflation makes my money less valuable. I need to invest in assets that are increasing in value faster than inflation.“Because of the stimulus, retail investors had more money to spend, prompting them to invest more in riskier assets.
As a result, the demand for cryptocurrency increased significantly. The cost of crypto tokens has skyrocketed. Soaring cryptocurrency asset prices increased the value of the tokens that investors received as returns through DeFi protocols. The harvest was therefore more valuable. Inflation has been fueled by monetary expansion, which has increased the cost and earnings value of crypto tokens. Defi protocols received funds to capitalize on this yield. Because of this process, the bull market took off in full force.
Unfortunately, the good times were not to last as the US Federal Reserve hiked interest rates in 2022 due to excessive inflation. Investors and consumers have then been forced to rein in spending when interest rates are high because it is more expensive to borrow money. Investors move money from other assets into government bonds as high interest rates also translate into higher yields on government bonds. The Fed’s goals of cutting spending and fighting inflation have been met. However, the actions of the Feds lowered the token prices, which reduced DeFi yields and ultimately the TVL of the ecosystem.
Terra Chain crash: The Terra chain gained strong traction from late 2021 to early 2022. Terra’s most popular product was a stablecoin called UST, which was backed by the chain’s native token, LUNA.
The cause of this growth was that Terraform Labs implemented a massive incentive program in the form of the Anchor Protocol. Users can file their VAT in Anchor to receive a fixed savings rate of 20%. The Anchor Reserve Fund heavily subsidized the yield. A small portion of the return came from interest paid by borrowers in the anchor lending market and the rewards from staking loan collateral. This incentive led to Terra seeing a huge influx of users and capital who wanted that incredibly good, fixed savings rate.
Unfortunately, while this seemed like a good idea, backing a stable asset with a volatile endogenous asset (one that comes from the same system) proved unsustainable.
In early May 2022, UST lost its peg and started trading below $1 after a weekend of big UST selling. UST holders could redeem their UST worth less than $1 for LUNA worth $1. As more users redeemed and the supply of LUNA increased, its value decreased. The following week, UST and LUNA holders scramble to exit their positions. As the price of UST fell, more Luna was printed. As Luna’s price fell, confidence in UST was decimated. The resulting death spiral shot the value of both tokens to ~0.
The Terra ecosystem crash wiped $20 billion in TVL from DeFi. At its peak, just before the crash, Terra had a 15% market share. The effects of this collapse echoed throughout the rest of the year. The Terra contagion contributed to the failure of several centralized crypto companies such as Celcius and Voyager, which mismanaged their risk and were unprepared for a downturn.
What you should know: Maker accounted for most of the Collateralized Debt Position (CDP) TVL in 2022. Back in early 2020, back then, getting DAI as a loan against crypto collateral to borrow against cryptocurrencies was the best DeFi option. As of December 2022, Maker held 15% of all TVL in DeFi.
In 2022, the liquid staking category gained significant market share, mainly driven by the success of the Lido protocol. For blockchains that use Proof of Stake (PoS) consensus, validator nodes stake the blockchain’s native token to earn the right to process blocks of transactions and win block rewards. Liquid staking protocols allow users to stake a blockchain’s native assets in exchange for staking rewards and a tradable tokenized representation of the staked position. This caught on and thus led to the rise of the Lido protocol.
The Ethereum blockchain accounted for $23.26 billion of TVL at the end of 2022. This equates to about 60% of total TVL at the end of 2022. Binance took second place with 10.53%, which equals $4.13 billion.
bottom line: DeFi’s rapid growth and associated hype fueled high levels of speculation and irrational exuberance, creating a bubble that eventually burst. Adding to this was the fact that many DeFi protocols and projects were not fully developed or tested, leading to technical issues and outages that further eroded investor confidence.
The 2022 crash was a wake-up call for the industry, highlighting the importance of regulatory compliance, technical stability and the need for more sustainable growth. The DeFi space has since matured, and many protocols and projects have taken steps to address the issues that led to the crash, which has helped restore investor confidence and pave the way for a more sustainable future for DeFi.
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