Decentralized Finance (DeFi) has experienced exponential growth since its inception, expanding over 1,200% in 2021 in terms of total locked value (TVL) and surpassing $240 billion in invested assets. While DeFi has since fallen to about $60 billion from TVL as a result of broader macroeconomic trends, such as rising inflation, the seeds are ready for DeFi to reconfigure the foundations of our financial infrastructure when the next market cycle comes.
Historically, the return to the bull market has evolved over a period of four years. This time around, a rebound is possible in 2024 due to recent monetary policy maturation and easing economic headwinds, which could allow for lower interest rates and refinancing into space. Let’s take a look at the determinants and early signs we should watch out for in the coming months.
This bull market is likely driven by four factors: taming global inflation, renewed confidence in the sustainability of DeFi business models, and the migration of at least 50 million crypto holders from the world of centralized exchanges to the world of decentralized applications (today there are more than 300 million cryptocurrency holders). Cryptocurrency holders around the world, mostly via exchanges), and perhaps the next change in the difficulty of Bitcoin (BTC) mining.
Source: DeFi Llama
Everyone is wondering where users and developers should go next for opportunities. Will the next cycle repeat ‘Summer DeFi 2020’, only bigger and with more users?
Shift to economic sustainability
Startup founders can no longer count on the “magic internet money”. What this means is that the market is unlikely to return to the levels of trust that allowed DeFi founders to reward early users with large amounts of tokens generated by the protocol, thus supporting annual returns of over 100% or even 1,000% on invested capital. .
While DeFi tokens will continue to play a role, the minting of these tokens will come under greater scrutiny. Market participants will question whether the protocol is able to generate enough fees to fund its treasury and ultimately hold (or invest) more value than it distributes to end users via inflation or rewards.
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Of course, this does not mean that DeFi protocols are expected to be profitable from day one. Web3 founders will need to consider the concept of unit economics, which is borrowed from Web2 and Silicon Valley. This will allow a technology-backed business model to generate free cash flow in excess of operating costs and user acquisition once massive early-stage investments are no longer required.
In the world of DeFi, the concept of unit economics translates into a necessity for capital efficiency of liquidity providers and market makers. Simply put, this means that the DeFi protocol should eventually be able to generate enough transaction fees to reward liquidity providers once it can no longer rely on arbitrary protocol token inflation anymore.
What does this mean for decentralized exchanges
Decentralized exchanges (DEXs), also called automated market makers, have always been at the forefront of DeFi. For example, SushiSwap pioneered the concept of early protocol-sponsored bonuses and “vampire attacks” to incentivize liquidity providers to move away from Uniswap.
Historically, DEXs were not very capital efficient, requiring large amounts of liquidity from liquidity providers in order to operate every dollar of daily trading volume in a decentralized manner. Since the liquidity pools generate low fees per dollar of locked-in liquidity, they have relied on tokens generated by the protocol to generate sufficient rewards for the liquidity providers.
We are now seeing more capital-efficient DEXs emerge in a direction that every other DeFi column is likely to follow.
For example, Uniswap v3 allows liquidity providers to focus their capital to enable trading between specific price ranges only. This allows one dollar of liquidity to enable more dollars of daily trading volume, as long as prices stay within that range, thus getting more transaction fees for each dollar invested in liquidity without relying on token inflation generated by the protocol.
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Another example is dYdX, a decentralized derivatives platform. Because dYdX uses an order book to match buy and sell orders, it does not require regular users to commit liquidity in liquidity pools and instead relies on the most efficient professional market makers to act as counterparties to end users.
Capital efficiency is the name of the game
The next wave of DeFi innovation will come from founders who are able to design decentralized business models that generate sustainable unit economies for liquidity providers and market makers.
The startups that will create these business models may not exist today. as a decision