DeFi Proves Resilient in the Bear Market

We saw a significant shakeout in crypto markets in the second quarter of this year. Unless you never check the charts (and admit it, you check the charts) then I’m not breaking any news. On May 1st, ETH was trading above $2700 and the DeFi Pulse Index (DPI), a structured DeFi strategy token from Scalara and Index Coop, was around $150. In the weeks since we’ve seen ETH touch below $900 and DPI drop to a low of ~$55. So what happened?

For one thing, macro markets in risk assets across the board related to inflation and the reversal of central bank policy in the United States. But, we also observed extra downward pressure on crypto. The collapse of the Terra ecosystem and UST, shook investor confidence. Additionally,  widely reported problems with hedge fund Three Arrows Capital and crypto lending company Celsius sparked a liquidity crisis that pushed prices to recent lows over the weekend of June 18th. Never mind the public's confusion on whether or not crypto platforms like Celsius are part of DeFi  – they aren't, but have certainly marketed themselves this way. Still, the resulting pressure on crypto markets may have missed the bigger picture: real DeFi has prevailed.

DeFi and the Downturn

It’d be fair to say a few things broke around DeFi. Centralized institutions providing yield swaps and using customer funds to generate yield in DeFi broke. Centralized institutions using customer funds to juice returns in liquid staking derivatives without proper term-related risk management broke. Loans to crypto hedge funds that “couldn’t miss” in the bull market broke. But DeFi – real DeFi – did not break. The above examples are centralized institutions who used DeFi as a tool. But all evidence indicates that DeFi itself operated as intended despite the extreme volatility and downward price pressure in June. In fact, DeFi lending protocols have transparently viewable loan portfolios. Anyone can observe the health of those loans on the blockchain publicly. If the parties above were operating solely on-chain, we wouldn’t be discovering the risks they were taking after a blow-up.

Core DeFi protocols didn’t break because they were patiently built in the depths of the previous bear market with the possibilities that bear markets bring in mind and they didn’t sacrifice those principles during the excesses of the bull market. The largest protocols are actually earning the “blue chip” name now because they’re surviving stress tests and maintaining users as prices pull back.

The three major DeFi use cases that have proven themselves in this cycle are:

• Decentralized ( non-algorithmic) stablecoins

• Overcollateralized lending protocols; and

• Decentralized exchanges

There are others right on the cusp such as synthetic assets or liquid staking, but those three are the ones that have been tested and proven and that I would back with the most certainty to emerge stronger on the other side of a bear market. And clear market leaders have risen to the top for each. Maker for stablecoins, Aave for lending protocols, and Uniswap for decentralized exchanges.

Resilience and sustainability in our DeFi Index

At Scalara, we’ve watched this play out from our seat of maintaining a DeFi tracking index: the DeFi Pulse Index, perhaps best known for its token implementation by the Index Coop, DPI. Over its two-year history – mature in the world of DeFi – the Index has tracked the performance of DeFi governance tokens through a euphoric rise and then a fall back down to more sober levels. And it is largely composed of those protocols built during the previous bear market: currently, Uniswap, Maker, and Aave account for more than 50% of DPI.

Scalara aims to echo the same patience and long-term vision of blue-chip DeFi protocols. This hasn’t always been easy, especially during the heights of the bull market in 2021. Two examples come to mind:

• The rise of DeFi 2.0
• Last year, Olympus DAO prompted the rise of DeFi 2.0 with the breakthrough concept of protocol owned liquidity and their (3,3) meme. A series of OHM forks and other projects proclaimed a new era in DeFi. At the same time, the Terra ecosystem was gaining traction along with its algorithmic stablecoin, UST. This produced a lot of pressure for new additions to the DeFi Pulse Index and prompted some challenging questions for us. Were we “falling behind” as a tracking mechanism for the sector? Should we re-evaluate some of our objective criteria around protocol age and token supply mechanics? Our answers were “no” and “no.” That criteria remained crucial predictors of good mechanism design for passive holders who wanted exposure to DeFi. Despite temporarily being behind the 2.0 narrative, we managed to maintain a durable representation of DeFi through a hype cycle and bear.

• The interesting case of Curve
• Curve’s locking mechanism makes it difficult to hold Curve in a passive index. We’ve been criticized for excluding it from the DeFi Pulse index. But that exclusion is not a qualitative judgment on the project. Far from it. We’re fans of what Curve has accomplished and their relative TVL share speaks for itself. But the token itself has characteristics and uses that aren’t conducive to passive holding and for that reason, it isn’t a fit for an index designed for on-chain token-based implementations.

The challenge for Scalara during the bull market was to remain true to our principled methodology for the DeFi Pulse Index. This wasn’t always easy when reflexive price action for untested new mechanisms in DeFi took over the industry narrative. At Scalara, we’re determined to maintain an index that can be used to create investable products with on-chain implementations like DPI.

Challenges on the horizon for tracking DeFi

Representing DeFi in an Index is critical, but Scalara also aims to ensure the investability of token implementations. On that front, there are challenges with investing in DeFi. My degree of confidence in the success of Uniswap, Maker, and Aave as innovations remains high. But whether someone can take their innovation and capture market share remains to be seen. This is why an index approach is ideal. For a time during 2020 and 2021, it appeared Sushiswap was going to outpace Uniswap on innovation, execution, and accrual of value for token holders. That appears increasingly unlikely as time goes on, but it doesn’t stop another entrant from doing so for any of these protocols.

A bet on DeFi as a sector is a strong one due to the survival of that technology through this recent crypto downturn. In my view, the greater risk comes not from “Will DeFi be around after this bear market?” but rather: “Will currently investable options capture the value of DeFi going forward?” There are two distinct challenges to that latter question.

• Value Accrual for Governance Tokens: We’ve all heard the “valueless governance token” meme. At the risk of oversimplifying, this can boil down to “will Uniswap flip the fee switch?” I’m not here to litigate this issue but do want to point out that there’s some uncertainty, both regulatory and functional, regarding the mechanics of value capture for governance tokens.

• On-chain Governance Remains Imperfect: Governance token issuance and payment to lead the direction of a protocol and related businesses is a fairly new concept. There have been hiccups with Uniswap grants and there are currently concerns around the direction of Maker governance. Neither of these reflects concern about the function of the underlying DeFi protocols. But they do introduce some uncertainty about the structures around them and the future of those tokens.

Despite these challenges, governance tokens for blue-chip protocols remain the best option for tracking performance in the sector. DeFi presents the opportunity for a more transparent and accessible financial system regardless of token prices. The liquidity problems we’ve observed in the last few months are a bad look for the industry but have little to do with DeFi. True DeFi remains focused on delivering on the promise of a financial system that works better for all of us.

About Scalara

Scalara, a DeFi Pulse brand, creates and maintains indices for a decentralized world. Scalara is the first crypto-native index publisher and designs indices that benefit specifically from the interoperability and composability of crypto and DeFi.

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