Lending Landscape
After a booming Q1, the lending sector found itself cooling off during Q2. The first half of the quarter, however, was a continuation of the momentum from the previous quarter. From March up until the May crash lending deposits ballooned from $25 billion to a peak of $45 billion (an 81% jump in just six weeks) as investors sought to capture the exorbitant lending yields available across all lending protocols. However, the party came to a sudden halt as the market turned belly up. Motivated by the mounting market turbulence, investors flocked to safer assets triggering a collapse in lending deposits which completely erased the previous week’s growth. In the end, the total amount of assets locked across the major lending platforms increased a mere 15% quarter-over-quarter.
Unsurprisingly, the number of outstanding loans followed a similar pattern. During the first six weeks of Q2, the total amount of outstanding loans increased 62%. However, unlike lending deposits, the decline following the market crash was not as drastic. In total, the collapse amounted only to $4 billion, or 21% from the top, in the following ten days. By the end of the quarter, the aggregate amount of outstanding loans increased approximately 44% over the quarter.
Additionally, supply yields across all lending platforms collapsed as investor’s borrowing demand dwindled. In the span of three months, lending rates for stablecoins, in particular USDC, dropped nearly 85% from an average rate of 9.6% to 1.4%.
Source: LoanScan
Q2 Developments
Aave Joins The Multi-Chain World
Towards the end of the first quarter of 2021, Aave announced the launch of its Polygon branch in an effort to escape Ethereum’s high fee environment. Following the announcement, Polygon and Aave teamed up to offer early users liquidity mining incentives to incentivize usage as part of Polygon’s DeFiForAll campaign. The program turned out to be a resounding success causing Aave’s TVL to double from $6 billion to $12 billion within two weeks of the announcement.
Propelled by the Polygon launch and the heavy token incentives, Aave’s market share of total outstanding loans spiked in April giving Compound a run for its money. By the end of May, Aave dethroned Compound to become the leading lending platform capturing over 37% of DeFi’s aggregate lending market.
Bridging the Gap Between Crypto and Traditional Banking – Compound Treasury
At the end of the quarter, Compound Labs announced the launch of Compound Treasury, a product designed for non-crypto businesses and financial institutions that wish to tap into crypto’s interest rate markets. The company partnered with Fireblocks and Circle to create a product that allows organizations to access the USDC interest rates available on Compound without needing to worry about crypto-related intricacies such as private key management and crypto-to-fiat conversions. The product guarantees a fixed interest rate of 4% per year on deposits – an astronomical amount compared to the average U.S. saving account.
Looking Forward
Laying the Lending Foundation For The Multi-Chain World – Compound Gateway
As a multi-chain future becomes increasingly apparent, incumbent lending protocols have begun to explore solutions to adapt to this new way of operating. Compound’s approach revolves around the release of a stand-alone blockchain called Compound Gateway as a way to embrace this emerging paradigm. Gateway is a Substrate based blockchain intending to serve as the infrastructure for cross-chain interest rate markets. Similar to THORChain’s THORFi lending feature (set to launch later this year), Gateway’s goal is to provide users with the ability to borrow assets native to one chain (i.e Ethereum) with collateral from a different chain (i.e Solana).
In a nutshell, Gateway enables blockchain interoperability by using a type of connector contract called Startport as the core mechanism to connect and transfer value between different chains. Starports exist as contracts on peer ledgers (such as an Ethereum smart contract) and have the ability to lock assets until they are released by a Gateway validator node.
Source: Compound
As of March 1st, Gateway is running as a testnet, connected to Ethereum’s Ropsten testnet.
DeFi’s New Frontier – Fixed Income Markets
While the fixed income space is still a nascent niche in DeFi, it is an enormous market in the traditional world. In this context, a fixed income product refers to any instrument that generates a steady and predictable stream of cash flows such as corporate bonds, treasury bills, and fixed-income mutual funds. The concept of fixed rates is a relatively new and unexplored field in DeFi where variable interest rates offered by protocols like Aave and Compound are the norm.
As of today, the fixed income landscape can be broadly defined in three different categories:
Securitization and Tranching
Fixed-Rate Lending and Borrowing
Interest Rate Swaps
Securitization and Tranching protocols were the first ones to hit the market. At a high level, applications such as Saffron Finance and BarnBridge aggregate variable yields from distinct lending protocols to create separate risk tranches each one with a different risk/return profile allowing users to customize their exposure to yields. Before risk-tranching protocols were around, users faced an all-or-nothing scenario. They either incurred 100% of the risk of lending/providing liquidity or none by staying out of the game. With risk-tranching protocols, DeFi users now have a spectrum of risk options available instead of a simple binary option.
The second wave of fixed income protocols that entered the space were fixed rate lending and borrowing applications. Unlike Aave and Compound, which primarily offer variable interest rates, protocols like Yield and Notional enable users to borrow and lend at fixed rates over a predetermined time horizon. These protocols don’t expose users to interest rate volatility making it easy to plan ahead and properly hedge risk when lending and borrowing.
The third and most recent kind of fixed income applications in DeFi are interest rate swap protocols. At their core, these protocols take interest-bearing tokens (like aTokens and cTokens) and separate them into a principal component and a yield component. Given the variable nature of interest-bearing tokens, the value of the yield component fluctuates over time while the value of the principal component stays the same. The result is the creation of interest rate markets that allow users to speculate on the future state of yields. Protocols such as Pendle, Element, and Swivel are at the forefront of the interest-rate derivatives space.
Asset Management
Q2 Development
Looking Forward
A New Paradigm in Liquidity Provision
As a consequence of Uniswap V3’s concentrated liquidity model, liquidity management is no longer a passive game. The famous “set and forget” strategy that once dominated liquidity provisioning has become antiquated and suboptimal. In this new world, the highest returns will flow to those who research, develop and successfully implement active management strategies by constantly updating liquidity ranges to capture the highest amount of trading fees.
Uniswap’s new functionality has led to the creation of a new breed of market participants called “Liquidity Managers”. In the same way, professional asset managers are paid to effectively navigate the uncertain waters of financial markets, Liquidity Managers seek to fill the same need in the increasingly complicated realm of liquidity management. There are early entrants to the arena such as Visor, Lixir, Charm, Popsicle, and Gelato Network, as well as the elephant in the room Yearn which is also developing Uniswap V3 strategies.
Derivatives
Derivatives Landscape
Decentralized derivative volumes continued their massive growth in the second quarter of 2021. Although still a fraction of decentralized spot trading volumes (see DEX section), perpetual swap trading volumes reached nearly $20 billion in the quarter, more than a 3,000% increase from Q4 2020 and a 155% jump from the previous quarter. Despite the current scaling hurdles (more on this below), decentralized derivative protocols are starting to see strong signs of adoption among DeFi users.
Following the market crash, trading volumes in June unsurprisingly declined as investors’ appetite for risky assets and leverage vanished in the face of increasing market uncertainty. However, when compared to levels at the beginning of 2021, trading volumes remain on a steady upward trend.
Q2 Developments
Dominating the Decentralized Perpetual Swap Market – Perpetual Protocol
The most important development in the second quarter of 2021 was the dominant rise of Perpetual Protocol. Despite its late arrival relative to incumbent players like dYdX, Perpetual Protocols currently offers investors the most trading options available in the perpetual swaps market and controls the vast majority of the decentralized futures trading volume.
In a matter of six months, Perpetual Protocol became the dominant perpetual swaps exchange by a wide margin. At the beginning of 2021, the protocol controlled less than 30% of all the trading volume in decentralized futures markets. After five months, its dominance tripled, now controlling over 90% of the perpetual swap market.
Looking Forward
In Honor of Marie Curie – Perpetual Protocol V2
Perpetual Protocol announced the release of the second version of the protocol called “Curie”, in honor of the famous physicist Marie Curie. The upgrade is set to launch on Arbitrum in order to improve user experience, increasing transaction speeds, and lower trading costs. Additionally, the upgrade will launch with cross-margin collateral management allowing traders to use the same pool of collateral to open multiple positions.
One of the most important features of V2 is the combination of Perpetual Protocol’s vAMM with Uniswap V3 as the protocol’s trading settlement layer. The merger will allow Perpetual Protocol to leverage Uniswap’s concentrated liquidity feature, improving the capital efficiency of the entire protocol. Moving forward, all trades will be executed on Uniswap, using v-tokens, while keeping the trader experience the same as before.
Another interesting aspect of using Uniswap as the trading layer for the system is the emergence of a whole new way of liquidity provisioning. In addition to earning protocol fees, liquidity providers (called makers) will be able to apply leverage when providing liquidity to the protocol. In the same way that traders use the protocol to lever their long/short positions, makers will be able to deposit USDC on Perpetual Protocol and have the option to instruct the clearinghouse – the smart contract in charge of minting v-tokens – to mint vUSDC with up to 10x leverage. The vUSDC can then be deployed in a Uniswap V3 pool essentially creating a leverage liquidity position.
Source: Perpetual Protocol
In addition to the trading mechanism enchantments, Curie will also allow permissionless market creation. The protocol will support Uniswap V3 TWAP and Chainlink oracles to determine the index price of any asset including non-crypto assets like stock and commodities.
Rollups To the Rescue
As mentioned earlier, decentralized derivative protocols currently face a number of hurdles that have hampered the growth of the space. Today, there are three main reasons why the decentralized futures market hasn’t reached widespread adoption. The first relates to token compossibility. At the moment, derivative products can’t be used in activities like liquidity provisioning, yield farming, staking, or governance making them inferior to physical tokens in terms of utility. The second reason is market depth. Due to the nascency of the sector, most exchanges have limited liquidity to trade against and also lack hefty insurance funds to backstop unexpected losses arising from leverage trading.
Lastly, the third reason, and likely the most important one, is Ethereuem’s high fee environment. By nature, derivative products are much more sophisticated financial instruments compared to physical tokens. Therefore, trading derivative instruments in a decentralized manner tends to be more complex than spot trading.
As a consequence, derivatives trading volume, in particular perpetual swaps, is hindered by higher transaction costs which are either incurred by the derivatives exchange or passed on to the trader. However, derivatives applications are on the cusp of reaching a wider market as protocols take advantage of the scaling capabilities offered by Layer-2 solutions like Arbitrum and Optimism.
As the Layer-2 race heats up, derivative protocols are starting to pick their respective horses. For the most part, perpetual swap exchanges like MCDEX, Futureswap, and Perpetual Protocol are choosing Arbitrum as their scaling solution (MCDEX went live on mainnet last month and the remaining two will launch in testnet in the coming months). In late 2020, dYdX announced a partnership with StarkWare, and after eight months of work, the team successfully ported its perpetual trading platform to StarkEx, StarkWare’s Layer-2 scalability engine. Lastly, earlier this year Synthetix staking contract went live on Optimism Ethereum, making the first Ethereum-native DeFi application to cross the chasm to the Layer-2 world.
