The decentralized finance hype is sometimes credited with igniting a broader market rally in July, when new protocols began issuing tokens that immediately posted gains many times their original value. Despite the undeniable price growth, however, it’s not immediately clear whether the sector as a whole has grown, as reliable metrics measuring the fundamental performance of DeFi protocols are incredibly difficult to find.
The projects lend themselves to fairly rigorous analysis methods as they often have well-defined income and expenses. But the rise of liquidity mining, or yield farming, is throwing the metrics off balance in some ways. Protocols reward their users with their own governance tokens, essentially as payment for using the platform. A frantic move to maximize yield from these tokens skewed the dominant DeFi success metric, Total Value Locked, or TVL.
A clear example of this is the Compound protocol, where the value of Dai provided to it exceeds the total amount of tokens by almost three times – $1.1 billion versus $380 million at the time of writing. This is due to Compound users taking leveraged positions on Dai – something that is not typically the case with stablecoins. While this prompted the community to debate the merits of TVL, it also skewed some other similar measurements.
Evaluation of a DeFi lending project
The rating metrics change slightly depending on the project type. For lending protocols such as Compound and Aave, TVL represents the project’s supply-side liquidity, or the total of all deposits currently held by them. It is worth noting that TVL only considers on-chain reserves. According to DeFi Pulse, only around 220 million Dai are locked in Compound, not 1.1 billion.
DAI blocked in the compound. Source: Defipulse.com
However, lenders are generally valued based on book value or the amount borrowed. As this generates revenue, this is seen as a much more direct measurement of the protocol’s financials.
However, due to the distribution of the network’s coin, COMP, according to Compounds Dashboard, all tokens except Tether (USDT) and 0x (ZRX) have a negative effective interest rate on borrowing, meaning users get paid for it. The Compound protocol currently shifts these costs to COMP buyers and holders through dilution.
While it can be difficult to figure out how much liquidity there is to just speculate on COMP returns, it may not be necessary. The purpose of evaluating the earnings of the bank or loan log is to gauge how much of that value can be captured by the stock or token. However, since the token is used to subsidize the cost of borrowing, the value is effectively being deducted from its holders. This can be seen from COMP’s token price. Since its release, the value has continued to fall due to dilution and selling pressure from newly mined tokens.
COMP token price chart. Source: TradingView
Because of this phenomenon, a valuation strategy on Compound could easily ignore or even deduct the portion of book value that deprives token holders of value. Even in the former case, Compound’s book value would only be $25 million out of a claimed $1 billion — the total of USDT and ZRX on loan.
While obviously not all assets are purely for yield, Cointelegraph previously reported that just $30 million worth of Dai was loaned just before it became the currency of choice for liquidity extraction. Andre Cronje, the founder of the yEarn protocol, told Cointelegraph that the market hasn’t taken these nuances into account: “We have this weird TVL equals valuation mentality, which I don’t understand at all when the TVL is $100M, then the market cap – outstanding, not fully diluted – should be $100 million.” Though he finds it “completely insane” to ignore earnings, he continued his thought exercise:
“So if the circulating market cap is TVL, what is the best way to increase it? Increase TVL. How do you increase TVL? Reward with tokens. The token value increases due to TVL speculation and the loop repeats.”
Impact on other protocols
Compound started the yield farming trend, but it wasn’t the only protocol to see a sizeable surge in activity. Decentralized exchanges like Uniswap, Balancer, and Curve have seen a dramatic increase in their trading volume since June. Curve, a DEX focused on exchanging stablecoins with each other, skyrocketed in volume when yield farming began in June.
Monthly volume on decentralized exchanges. Source: DuneAnalytics
Uniswap has a more diverse offering and most of its volume consists of Ether (ETH) to stablecoin pairs, most notably Ampleforth – which has seen a strong boom-and-bust cycle. It has also taken a large chunk of the volume for new tokens like YFI and has often been the first place to list them.
MakerDAO nearly tripled its TVL from $500 million. Most of this is due to the increase in Ether price, although it also increased in ETH and Bitcoin (BTC). As Cointelegraph previously reported, the community has decided to increase the total amount of Dai that can be minted in order to bring the price back down to $1.
While Dai’s growth can be viewed as a success story at first glance, the maker community has decided to zero interest rates on virtually all cash and forego any income from growth. At the same time, Compound has been the main recipient of new Dai, with the locked value increasing from about $140 million to $210 million since the end of July, accounting for over 55% of all Dai.
Is the growth real?
The liquidity mining boom has had an undeniable positive impact on some broad metrics, most notably traffic to DeFi platform websites and the number of users interacting with the protocols. Data from SimilarWeb shows that traffic to Compound has quadrupled since June to about 480,000, while Uniswap has more than doubled to 1.1 million and Balancer has built a strong presence in two months with 270,000 monthly visits.
Additionally, DeFi exchange aggregator 1inch.exchange has nearly tripled its traffic over the past two months. Protocols with a weaker relationship to yield farming also benefited, with MakerDAO and Aave posting more modest but still significant growth.
Related: Compound’s COMP token is taking DeFi by storm, and now it needs to retain the top spot
User activity on Compound. Source: DappRadar
According to a visualization by DuneAnalytics, the total number of DeFi users increased by about 50% from June 1st to August 1st. This is in contrast to the previous two-month period from April 1st to May 31st, which saw a 30% growth.
The majority of new users come from decentralized exchanges, with Uniswap doubling its total user base to 150,000 since June. However, this metric shows all users who have interacted with the logs, not just those who are active at any given time.
Total number of DeFi users. Source: DuneAnalytics
what will remain
To sum up, DeFi growth has been multifaceted over the past two months. While the liquidity mining hype and subsequent price increases likely contributed to additional attention, the fundamental metrics have been severely distorted by the speculation.
Decentralized exchanges seem to have benefited the most from the hype, both in terms of new users and volume, but that appears to be an acceleration of an already positive trend. Whether the growth will continue remains an important question. Kain Warwick, co-founder of Synthetix — a cryptocurrency-backed asset issuer — told Cointelegraph:
“It’s always possible for people to farm the yield and then find a new field, so providing liquidity is no guarantee your protocol will retain users.” […] But providing liquidity with some sort of incentive is a great way to attract new entrants, because if you have something that even remotely matches the product market, there’s likely to be some stickiness.”
Cronje was more negative, using an agricultural analogy to describe what might happen, saying “All the yield hunters just run into the farm to get the yield and then walk away,” which he thinks is the case one negative thing is as they behave like a swarm of locusts. adding, “But after ruining the crop, sometimes a stronger crop can grow and some locusts are left behind, and they end up living symbiotically instead of like the original parasite.”
Cronje believes that the initial impact of yield farming is unsustainable, leading to the misconception among newcomers that 1,000% yields are the norm. As soon as this is no longer the case, users will be left with a bad taste in their mouths, he argues: “Right now it’s overrated; soon it is hated; and what’s left after that I think will be pretty cool.”
Distribute tokens in a new way
Warwick described the purpose of the liquidity reduction as to incentivize early participation with fractional ownership. Cronje was much more skeptical, saying, “All liquidity mining that is currently taking place is paid for backed TVL.” Still, he ran a liquidity mining program himself, but stressed that it was just a distribution opportunity deal in tokens.
“My goal was to create an active and engaged community. And I think yEarn has done that,” Cronje concluded. In contrast, yEarn forks like YFFI and YFII are “pure liquidity mines, and all that happened was people were sold,” he said. The price of YFII has fallen 90% since its peak on July 30th.
Warwick remarked that “there may be a better way to distribute property while stimulating growth,” although he doesn’t know how. He still thinks it’s better than Initial Coin Offerings since users only have to provide their liquidity temporarily: “You obviously take some platform risk, but it’s still better than losing your capital by using it to buy tokens.” While the risks to liquidity miners may be small, the YFII example clearly shows that the impact of dilution and speculative demand can be catastrophic for buyers of these tokens.
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