DeFi protocols have begun to shift in their business life cycle, with some dApps even showing periods of profitability
Regulatory Actions
In August, the US Treasury sanctioned the cryptocurrency mixer, Tornado Cash. This is seemingly the first time the Treasury sanctioned a piece of code (as opposed to an individual or entity) but likely not the last. The CFTC has also been active, issuing a settlement order finding that Ooki DAO and its founders violated the Commodity Exchange Act and applying a $250k fine. The Commission defines the Ooki DAO unincorporated association as those holders of Ooki tokens that have voted on governance proposals with respect to running the business. This implies that, if the DAO is discovered to have broken any laws or regulations, token holders who participated in governance may face legal action and fines from authorities. Another first for crypto regulations, the CFTC served these potential defendants using a chatbot on the online forum for Ooki DAO. The implications of this within DeFi could be severe but there is still a long road ahead before these matters are settled in or out of the courts.
Sector Revenues
During Q3 2022 Total Crypto dApps generated around $200 million in revenue across all sectors (NFT, DeFi, Gaming, and Other). Of these sectors, DeFi, which comprises DEXs, Lending, Asset Management, Derivatives, and Insurance, was the highest grossing for the quarter. DeFi revenues specifically amounted to $93 million, down 46% QoQ. Meanwhile, NFT revenues recorded $75 million for Q3, a 70% reduction compared to the previous quarter. Gaming revenues, while not material, had an abysmal quarter decreasing 98% since Q2. lastly, the "Other' segment which comprises Infrastructure, Bridges, and Liquid Staking, managed $20 million in revenues, down 34% QoQ. Overall, total sector revenues have seen a 64% decline in QoQ while the market cap for all cryptos (excluding stablecoins) recorded a modest 6% gain, implying some cautious optimism for the near future.
DeFi Sector Revenue
The DeFi industry is primarily dominated by DEXs and Derivatives Exchanges, with both industries accounting for ~75% of all DeFi related revenues. However, over the last quarter (Q3), there has been a shift in user preferences between the two. Q2 saw DEXs command a 45% share of all DeFi revenues with Derivatives a distant second at 29%. During the third quarter, these ratios have flipped, with DEXs at 28% while Derivatives now boast over haft of revenue share at 52%. Below it shows the evolution of DeFi revenue share by sector over the last two quarters.
While DEXs revenues did fall 63% QoQ to $26m, Derivatives exchanges saw revenues remain flat, only decreasing by 2% to $48m. In fact, Derivatives was the only DeFi sector that saw revenues hold even QoQ, with all other sectors seeing double-digit declines. Lending revenues fell 53% to $11m, Asset Management revenues fell 59% to $7m and Insurance revenues decreased by 67% to $0.6m.
Total Value Locked (TVL)
As of Q3 2022, TVL has remained mostly flat, only growing 3% in the last quarter to $63 billion. With just under $25 billion locked in non-Ethereum chains, the market share of these chains stood at 40%. This is an improvement from last quarter where non-Ethereum held 36% of the total TVL. The sharp rise in Ethereum's market share was due to the sudden collapse of the Terra ecosystem. Below it shows the evolution of TVL for the last quarter.
Over the last quarter, the top six blockchains by TVL have remained the same. Layer 2 chains are ranked 7th and 8th in terms of TVL and it will not be surprising to see them enter the top 6 next quarter. DEXs and Lending protocols continue to host the largest TVL within crypto, followed by Bridge protocols a distant third. The below chart highlights the six largest DeFi sectors by TVL for Q3 2022.
DEXs
Looking more closely at the DEX sector revenues, it is important to note that Uniswap is not included because all fees are distributed to liquidity providers (as opposed to token holders or the treasury). A Uniswap governance proposal recently agreed to enable fees in some trading pools, so we may see revenues in the future. However, for Q2 and Q3 we see that revenues were dominated by Pancakeswap with 76% of total DEX revenues. Pancakeswap operates solely on BSC and averages $2m in weekly revenues and its token, CAKE, was up 56% for the quarter. Second on the leaderboard is 1inch, a DEX aggregator that locates the best DEX for a user to implement a trade in return for a finder's fee. Below it shows the leading DEX protocols by revenue over the last two quarters.
When looking at trading volumes, however, Uniswap is still the market leader with a 51% market share. Pancakeswap and Curve, the two highest-grossing DEXs, facilitate 13% and 7% of volumes respectively.
As a whole, September's $55 billion in trading volume marked the third consecutive month of decline, down from $86 billion in July. DEXs also lost further ground to their centralized exchange (CEX) counterparts with volumes decreasing to ~11% of CEX volumes.
Derivatives Sector
Derivatives are now the leading DeFi sector by revenue and continue to gain in popularity. Over the last two quarters, nearly $250 billion of volume has been traded on decentralized derivatives exchanges. High trading volumes, scalability of Layer 2s, and a large suite of financial products (options, perpetual futures, structured products, etc.) have led to the sector's success. Below it shows the revenues among the leading derivatives protocols for the last two quarters.
While dYdX continues to be the market leader in this space, GMX has started to become a serious contender. The rise of GMX is especially notable as over the last quarter, GMX spent $23m in token incentives, 36% less than dYdX's $36m and far below Synthetix's $72m. Below it shows the token incentives for the three largest derivatives protocols by revenue.
Lending Sector
Lending is the lifeblood of any thriving economic system and DeFi is no different. Q3 saw Lending protocols generate $11m in revenue (-53% QoQ) based on $26 billion in TVL. Lending leaders Maker DAO and Aave ended the quarter with 37% and 35% revenue share respectively, while third place Compound, managed 5%. Both Aave and Compound operate solely on Ethereum while Maker DAO has offerings across the majority of EVM-compatible blockchains.
Lending rates have come down since the start of the year but have been on an upward trend since June's low of 1.5%, ending the quarter at 2.7%. When withdrawals are enabled for staking on Ethereum, it may set a floor for lending rates among DeFi protocols. Lenders will be less incentivized to lend too far below the staking rate as lending can be a riskier endeavor. Similarly, if lending rates are lower, borrowers can take ETH loans and stake those funds, thereby capturing the difference. Currently, ETH staking yields are around 6%. Below the chart shows the evolution of lending rates.
Examining the health factor of the lending sector we see below that the most leveraged positions, USDC and stETH, are pegged/linked assets. USDC is a regulated reserve-backed stablecoin and has a low chance of de-pegging from $1.00 and Lido stETH has decoupled in the past but never near 20%. Lido stETH likely has a low relative collateralization ratio due to a popular trade of
- depositing stETH to borrow ETH
- using ETH to buy stETH
- repeat both steps until the desired risk level
An advantage of DeFi lending vs TradFi lending is that the transparent nature of the blockchain allows for more accurate estimates of rehypothecation among projects. During the latest quarter, rehypothecation levels averaged around 25%. These levels remained mostly flat throughout the period but were higher than in Q2 likely due to the growing popularity of liquid staking derivatives.
Treasury
At the end of Q3 2022, the crypto treasury market stood around $10.1 billion, up 31% from $7.7 billion recorded at the end of Q2 2022. The largest treasury belonged to Uniswap which had $1.7 billion on its balance sheet. The top 8 protocols corresponded to 70% of the total treasury market. Active treasury management has started to become more commonplace as protocols swap a portion of their native tokens for stablecoins and other assets to diversify their holdings. Below it shows the protocols with the largest treasuries for Q3 2022.
Price Action
DeFi token prices have recovered slightly since Q2, with the average DeFi token up 11% since the end of June but down 29% since mid-August. The top performers among this set include CAP (+386%), Lyra (+220%), GNS (+141%), and GMX (+100%). The similarity between these dApps is that they're all derivatives exchanges built on top of Ethereum Layer 2 protocols. As discussed earlier, the Derivatives sector saw steady revenues QoQ so it appears that the market is reacting to this development. Furthermore, the fact that they're built on Layer 2s is not surprising as we're outlined in our previous reports since Q1 why derivatives products would excel on Layer 2s. The laggards of the group were BENQI (-50%), dYdX (-31%), and SpookySwap. BENQI is a lending protocol on the Avalanche blockchain and saw users, revenues, and TVL meaningfully decline due to a fall in AVAX price. SpookySwap, the leading DEX on the Fantom blockchain, suffered a similar fate for the same reasons. While dYdX, a perpetual exchange, still has notable trading volume, the controversy and difficulties over the team switching from an Ethereum Layer 2 to a Cosmos chain may be weighing on the price. Below the chart shows an equally weighted index for the leading DeFi tokens over the latest quarter.
Number of DeFi Users
Athough one user can have multiple addresses, the number of unique addresses can still serve as a proxy for unique users. Below it shows the average number of daily unique addresses declining in each of the major blockchains except Polygon which saw users rise by an average of 17% during Q3 2022
Simultaneously, user activity on Ethereum Layer 2s, Arbitrum and Optimism continues to grow with average daily addresses of 25k and 17.5k respectively.
Stablecoins Supply
The value of all stablecoins in DeFi remained unchanged for the quarter with fully backed, centralized stablecoins continuing their dominance. The vast majority of stablecoins are issued by Circle, Tether, and Pax/Binance. These coins are mostly backed by US cash & cash equivalents, other short-term deposits, and commercial paper held in bank accounts to help maintain trust in the peg. Below it shows stablecoins holding their market cap/supply around the $150 billion mark for Q3.
As further evidence of the importance of stablecoins within the DeFi ecosystem, we see below that the growth of stablecoins and DeFi TVL remain highly correlated with a correlation coefficient of 0.79.
DeFi Risk
No financial sector is without risks and within DeFi there are many that one should be aware of including but not limited to i) volatility risks, ii) smart contract risks, iii) value accrual risks, iv) liquidity risks, v) stablecoin risks, vi) governance risks and vii) regulatory risks. In terms of attacks, Q3 2022 was close to being a record low for DeFi-related hacks but during the penultimate week of September, Wintermute, one of the largest market makers in crypto, saw their wallet drained for over $160m. Below it shows the largest DeFi exploits for Q3.
Conclusion
All in all, Q3 2022 has been another negative period for revenues (-64%) but slightly positive overall for DeFi token prices (+11%). The Derivatives sector is in fashion and shows little sign of slowing as DEXs cede control of trading volumes to them. The power-law distributions in terms of TVL and usage have waned as competition remains fierce. Lending rates are on the rise (+80% since June lows), implying some revival of borrowing interest within the space. DeFi users are down slightly but growing on Ethereum layer 2s like Arbitrum and Optimism (as well as Polygon). DeFi continues to mature as ponzinomic tokens are being rejected in favor of revenue-generating protocols and scaling technologies are now beginning to hit their stride. However, regulation by enforcement may slow the pace a bit while hacks continue to plague even the most sophisticated actors. While DeFi protocols have matured, there is still a very large room for improvement.
Source: CoinShares
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