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* The article is based on the opinions of Dalvir Mandara and Bilal Hafeez — two financial analysts who advise venture capital funds at research firm Macro Hive.
After a turbulent 2022, the crypto market has started 2023 with optimistic signals. However, the community still rages on important debates, such as whether centralization or decentralization will drive crypto adoption in the future.
DeFi is at the forefront of this debate, and its supporters argue that without DeFi, the crypto dream would be over. So what is the current state of DeFi? What indicators should we monitor to determine its health? Here are three key trends taking place in DeFi.
DEX vs CEX
The collapse of centralized exchange FTX is an important test for DeFi. Will investors move to decentralized exchanges (DEXs) or give up crypto altogether? The answer is obvious — DEX trading volumes surged when the FTX crash occurred in November 2022. Daily trading volume peaked at $12.5 billion on November 10, and total trading volume in November was about $114 billion compared with October’s $66 billion.
For example, Uniswap entered the list of top DEXs, reaching a trading volume of $2.85 billion from November 13-16. Meanwhile, over the same time period, the second largest CEX Coinbase is on a downward trajectory, sitting at $1.9 billion. Given the large disparity between the number of staff serving the two platforms, (less than 100 on Uniswap versus over 5,000 on Coinbase), this is quite remarkable.
Due to this spike in DeFi, the DEX token is also in an uptrend. According to Delphi Digital, as of 11/11, the basket of DEX tokens is up 24% compared to the equivalent basket of CEX.
Much of these outflows can come from investors leaving centralized exchanges. Many CEX exchanges have seen record outflows during the same period – including Binance, the largest cryptocurrency exchange by trading volume. This may have led traders to look for alternative trading platforms that are less prone to centralization errors, such as DEXs.
During Terra’s crash in early 2022, DEX trading volumes also spiked. Finally, traders may have moved trading to a DEX to reduce their exposure to a single centralized exchange.
Read more: What did I do to protect my assets against a flood of bad news from the market?
The development of TVL
The second trend is the growth of total value locked (TVL) in DeFi. TVL is the total amount of assets deposited into the protocols and platforms in the DeFi ecosystem. Assets including cryptocurrencies, stablecoins and other digital assets are used to engage in lending, borrowing and trading activities on these platforms. It serves as a measure of the size and liquidity of the DeFi ecosystem, and a key indicator of its growth and maturity.
In 2021, TVL hits an ATH at $181 billion, according to DeFi Lama data (chart 2). The bull run in crypto – when Bitcoin and Ethereum hit record highs – helped. 2022 saw a big reversal for TVL as the Fed raised interest rates and the Terra (LUNA) and FTX ecosystem collapsed.
But 2023 is off to a relatively optimistic start, with TVL up 20% to $46 billion. Most of the major DeFi protocols saw double-digit gains in collateral in mid-January. Since the lowest cycle on January 1, about $8.4 billion has returned to the DeFi ecosystem.
However, much of this can be attributed to the returns of the underlying crypto assets as the market recovers. It should also be noted that DeFi TVL is still down 75% from its December 2021 peak, but it is showing signs of stabilizing.
The blockchain that attracts the most TVLs is still Ethereum. It is the second largest project by market capitalization, with a TVL of around $28 billion and more than 640 DeFi protocols built on top of it, according to data from DeFi Llama (Table 1). However, the number of protocols is not always associated with TVL. DeFi Llama data shows that Tron has only 15 protocols and TVL around $5 billion, while BNB Chain has 530 protocols and owns the same TVL.
We can also determine the valuation of the chains by calculating the market cap on TVL (market cap divided by TVL, Mcap/TVL; Table 1). This is akin to the price (P/B) multiplier for stocks. Note that Arbitrum does not have a native token yet, so this metric does not apply to it. The latest Mcap/TVL values show that all chains in the top 5 by TVL are overvalued except for Tron, which has Mcap/TVL around 1.
How will interest rates affect DeFi?
The third and most prominent trend to watch is how interest rates will affect DeFi. After all, DEX volume plummeted in 2022 as soon as the Fed started raising rates (Chart 3). There are a number of reasons why the high interest environment poses challenges for the DeFi ecosystem.
first. Declining demand for DeFi loans and loans. Higher TradeFi interest rates make DeFi lending and borrowing protocols less attractive to investors, because they can secure higher yields through less risky investment vehicles ( e.g. government bonds).
2. Liquidity starts to decrease. As investors withdraw from the DEX to take advantage of the higher returns in TradFi, the liquidity of the DEX decreases. This has a knock-on effect on trading volume. Since the beginning of 2022, the 30-day moving average of daily DEX trading volume is now down 73%.
3. Volatility increases. Rising interest rates increase uncertainty in the market as investors speculate on the path of future rate hikes and their impact on the economy and financial markets. More uncertainty leads to more cautious moves and this can reduce DEX trading volume.
Which trend is the most important?
Two of these three trends positively impact DeFi: the uncertainty surrounding CEX and TVL in DeFi protocols.
Uncertainty around CEX will lead to more inflows into the DEX. Meanwhile, TVL in DeFi protocols appears to be stabilizing, although valuations on some protocols appear to be higher than they really are. But the trend that may be most important – the Fed raising rates higher – remains a risk.
For now, markets expect the Fed to end its rate hike cycle soon, then start cutting rates. If this happens, DeFi will be supported. If the Fed fails to tame inflation and force further rate hikes, DeFi could once again face a challenge.
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