Crypto winter may be just what DeFi needs to grow and thrive
In the military, a baptism of fire is the first time a soldier experiences battle. Ideas and innovations find fertile ground in a bull market where there is an abundance of capital and an appetite for risk. However, facing and surviving a “winter” is the real baptism of fire for any crypto project.
At its peak in December 2021, the total value locked (TVL) in decentralized finance protocols reached more than 250 billion US dollarsand at that time it accounted for 8.2% of the total crypto market capitalization, which peaked at around 3 trillion US dollars in November 2021. Since the start of the crypto winter, DeFi has lost around 75% of its total TVL, which currently stands at US$66.6 billion. This decline is in line with the decrease in the total crypto market capitalization. However, the relevance of DeFi within crypto has remained stable, signaling that it is not part of a temporary trend but rather one of the key pillars of the entire industry.
Considering that DeFi is only a fraction of the overall crypto market today, DeFi has plenty of room to grow in the future, both on a relative and absolute basis. However, this is only true for DeFi projects that survive this baptism of fire. While it’s too early to identify who will be the winners and losers in the DeFi space, there are two characteristics that will help projects thrive in the next bull market cycle.
- Integration with approved custodians
Investors will still have control of their funds if they are held by an approved custodian, and the recent difficulties faced by several large centralized financial platforms underline the importance of asset segregation. In general, there are many types of assets tied to the operation of a given DeFi protocol. Some of them are held on-chain by the protocol itself while others are distributed to investors in the form of tokens.
A DeFi protocol holding its assets and carrying out transactions through an integrated custody solution is able to operate with a higher degree of security (e.g. increased protection against hacking), and more flexibility in terms of adapting to changes regulations. In a highly regulated environment where asset security and compliance are of the utmost importance, there is no doubt that DeFi will benefit from extending this approach to its infrastructure.
Since DeFi protocols provide investors with tokens of economic value, it is also important that these digital assets are stored securely. In practice, this has proven difficult for some projects. The DeFi space is growing at an incredible speed, which means custodians must constantly upgrade their platforms in response to emerging trends and technologies. Custody solutions that allow investors to seamlessly participate in the decentralized economy and easily deploy strategies through decentralized applications contribute to economic value and security in the DeFi space.
- Limits for whales
Whales are big, beautiful and fascinating, but they can also be dangerous. We can borrow the analogy of whales swimming in an aquarium to analyze the activity of whales in the crypto industry. In such a finite space, the movements of a large whale will likely damage the aquarium. The first minor cracks that appear slowly on the glass quickly spread in flashes on the walls of the tank. Soon the structural integrity of the aquarium is no longer strong enough to hold the water, which will cause the tank to collapse under its own weight.
DeFi protocols are in fact nothing more than a more or less complex structure, like pools of liquidity governed by a set of rules. Liquid pools, similar to water tanks in an aquarium, are finite in size, so the whales are forced to “swim” in a limited space. Translating the image of the cracked aquarium to DeFi, we can easily see how dangerous a crypto whale that is too big for the pool it is in can be.
For example, if a crypto whale providing $1,000,000 to a decentralized trading pair liquidity pool of $1,500,000 decides to exit, it can cause significant damage to other investors. They will experience a sudden collapse in liquidity and face a potential temporary loss. The more imbalanced the pool, the greater the potential temporary loss.
DeFi protocols that wish to protect their ecosystem by developing a stable and diverse investor base will benefit from setting limits on whale participation and/or volume per transaction. This may slow protocol growth at first, but sustained TVL growth will be associated with a higher degree of resilience and economic strength. In contrast, a protocol with a large TVL consisting of a few whales may seem like a successful protocol at first, until suddenly the first cracks appear when a large whale makes a move and tries to get out of the pool.
Stress tests reveal the best
This crypto winter has already shed light on the risks that DeFi faces. Concepts are under significant stress testing and there will likely be a lot of consolidation in the industry. Currently there are more than 1,750 DeFi projects, and TVL is the only way to measure who is leading and who is struggling.
MakerDAO, Lido, AAVE, Uniswap and Curve are the current the first five protocols with a total of US$34 billion in TVL which accounts for nearly 40% of the entire DeFi market. They are leading the pack at the moment, but it would be premature to say that they will still be the leaders after this crypto winter.
Projects such as Arrakis Finance (based on Ethereum, Optimism and Polygon) are gaining market share and climb the ranks, while other projects that looked promising but had underlying issues have already burned down, along with the blockchain they were built on. Regardless of which protocols come out on top when the crypto market regains momentum, it is clear that the DeFi sector is already proving itself during this baptism of fire.
Not only has the institutional appetite to participate in the decentralized economy remained at a stable level, but the sector is also seeing growing interest from traditional finance players who view the shift to blockchain-based solutions as a trend. that can generate significant alpha in the future. The regulatory blessing will be the real turning point for mass adoption, and places like Dubai that are embracing the change are already seeing a significant influx of talent, capital and resources with a boost to their local economies and market relevance. global financials.
DeFi will likely emerge as one of the winners of this crypto winter, as all the lessons learned so far only make the sector stronger and a potential candidate to lead the next bull run.