ORIGINAL REPORT

Measuring Ethereum Defi GrowthWith interest in decentralized finance (DeFi) surging, candidly assessing

the actual growth, adoption, and traction of the various projects inhabiting

this broadly defined space takes on greater importance. This article

examines the metrics used to track DeFi’s growth across major sectors,

offering commentary on particular issues major projects face.

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• The Ethereum DeFi ecosystem has demonstrated strong growth, though highly concentrated in the lending and crypto-collateralized stablecoin sectors.

• While many cite Total Value Locked as evidence that all of DeFi is growing, a closer observation reveals that this metric is skewed by the importance of collateral and staking by design in the most popular protocols including MakerDAO, Uniswap, and Compound.

• Considering alternative growth measures such as trading volume, DEXs and prediction markets have struggled to gain adoption. Measured by the value of loans originated, Compound is rapidly growing.

KEY TAKEAWAYS

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IntroductionOne of the major industry developments in the past year is the emergence of

‘Decentralized Finance’, or DeFi, applications that seek to offer alternatives to

various traditional financial and banking services, such as lending, through a

disintermediated, open protocol. The vast majority of DeFi projects are built on

Ethereum smart contracts and use ETH, primarily as collateral, though the sector

could easily be imagined to expand to other blockchains. Despite the sector

being frequently represented in industry discussion as an uncomplicated story

of growth, closer examination reveals significant divergence in traction across

classes of application. This article highlights metrics to track DeFi’s growth across

major projects and sectors, and offers brief commentary on particular issues facing

projects.

WHAT IS 'DEFI'?

Semantically, ‘DeFi’ is a rather nebulous concept, alternatively called ‘Open Finance’

in some contexts. Most uses of blockchain technology are ‘DeFi’ in some way, as

they generally involve some sort of financial activity arbitrated by a decentralized

database. One could argue for an expansive definition that includes all

cryptocurrencies, which function as general purpose monetary systems and operate

in a decentralized fashion. Another edge case is fiat-collateralized stablecoins, such

as USDT and USDC; while these projects utilize smart contracts to some degree,

their reliance on the central issuing party for collateralization limits their functional

degree of decentralization or censorship resistance. As such, industry discussions

of DeFi typically use the term more narrowly, referring to smart contract platform'

applications that offer direct alternatives to services provided by traditional financial

firms. This category primarily comprises of finance-focused Ethereum dApps with

significant on-chain logic. This discussion follows this convention.

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Measuring the Growth of DeFiAcross a range of metrics, the DeFi space has seen considerable growth over the

past two years. The most commonly cited metric for tracking this growth is Total

Value Locked (TVL), which is the equivalent ETH value for all tokens staked, most

commonly as collateral, in various smart contracts related to DeFi applications. One

argument for TVL as a valid growth metric is that since locking assets in a DeFi

protocol necessarily has some opportunity cost and/or risk, it is less able to be

cheaply manipulated than a metric such as Daily Active Users (DAUs) or transaction

counts, which has occurred on no-fee smart contract platforms such as EOS. The

majority of this amount is staked through ETH itself, but also includes the ETH-

equivalent value of DAI or USDC loans, for example.

The vast majority of TVL is through MakerDAO’s Collateralized Debt Position (CDP)

system, which currently requires ETH as collateral for the DAI stablecoin. Additionally,

Compound has gained significant traction with ETH and other Ethereum-based

assets ‘locked’ in loans. Presently, over 2% of the outstanding ETH supply is locked

in DeFi.

However, TVL is just one metric to measure the ecosystem, and the measure has

its shortcomings. TVL overweights applications where ETH is used specifically as

Figure 1

Total Value Locked (TVL) in Ethereum DeFi Protocols

Source: DeFi Pulse

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collateral, which, given the broad design space for DeFi — roughly, financial services

that can be specified as autonomous, secure code — may not accurately measure

all facets of its growth. To some extent, the focus on and growth in this metric is a

product of the very designs of these projects, particularly MakerDAO, which function

as a direct result of high collateralization requirements.

While growth in Total Value Locked is commonly cited as evidence of the broad growth of the entire DeFi sector, a closer examination of metrics within individual sectors of DeFi reveals a more nuanced evolution of the space.

STABLECOINS

A rapidly growing category with DeFi is crypto-collateralized stablecoins, led

by MakerDAO. MakerDAO is a platform for crypto-collateralized loans and

stablecoins, in which users create Collateralized Debt Positions (CDPs) by staking

ETH and receive the USD-pegged DAI stablecoin. This system can be used as

a decentralized margin trading platform, for example offering users a method

to leverage a short or long trade on ETH. All CDPs are required to maintain a

collateralization ratio of at least 150% issued DAI value staked in ETH, and CDP

holders pay a ‘stability fee’—effectively an interest rate—for each loan, payable in

MKR.

The DAI stablecoin has maintained a relatively stable value of within 5% of the $1

peg. While this degree of volatility certainly is not ideal or even lowest within the

stablecoin space, with Tether staying within 2% of the peg over the past year, it

Figure 2

DAI Price

Source: Nomics

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arguably does represent a general state of success for DAI in being a ‘stablecoin’.

This relative stability has occurred in conjunction with a volatile and generally

declining ETH price, requiring CDP holders to continually fund their contracts

with ETH to maintain a collateralization ratio of at least 150%. A notable upcoming

change is the release of Multi-Collateral DAI, allowing a broader range of assets

beyond just ETH, including those pegged to physical assets, to backstop the price.

This feature is intended to lend more stability to the system, as collateral price

fluctuations may be distributed across many assets, thus reducing ETH’s importance

and potentially reducing the high collateral ratios necessary in the present single-

collateral system.

The total supply of DAI has risen steadily to roughly 80 million, though growth

has leveled off over the past few months. The stability fee, a network parameter

effectively representing an annual interest rate that CDP holders must pay,

increased to a peak of nearly 20% in mid-2019. Determined by an MKR holder vote,

this stability fee increase is a response to the increased demand for new CDPs, and

represents a key mechanism through which the system maintains a DAI price peg.

LENDING

Smart contract-based lending protocols, such as Compound and dYdX, exemplify

another application category that has grown significantly. To some extent,

MakerDAO also falls in this category. These lending protocols use a variety of

market designs to match borrowers and lenders. One useful metric to track growth

Figure 3

MakerDAO Metrics

Source: MakerDAO

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is the nominal value of loans originated. The category has seen strong growth,

driven primarily by Compound, with nearly all loans in DAI, ETH, or USDC.

Currently, the largest such project, Compound, offers pooled lending services

through money market funds with algorithmically determined interest rates.

Users can borrow and lend various Ethereum-based assets, presently DAI, ETH,

USDC, REP, ZRX, WBTC, and BAT, through Compound’s non-custodial protocol.

Compound’s approach contrasts with other peer-to-peer lending protocols that

function primarily as matching engines between individual borrowers and lenders.

Rather than matching, collateral is pooled for each asset’s money market and

interest rates fluctuate for all users with an outstanding loan. All Compound loans

accrue interest dynamically based on the current rate and do not have a fixed

length. Compound’s strategy of providing pooled liquidity through money market

funds and algorithmic variable interest markets is duplicated by other projects, such

as dYdX, an alternative lending platform that also offers margin trading using the 0x

protocol.

In contrast to Compound and dYdX, the original version of Dharma facilitated

lending by matching individual borrowers P2P with fixed term loans. After significant

early growth, Dharma pivoted to become an interface for stablecoin savings

accounts, actually using Compound’s pooled lending liquidity as a backend

protocol through which savings accounts are routed. While the sector is still early

in development and alternative designs may emerge, this variation in adoption

suggests that P2P loan matching faces significant challenges moving forward.

Despite the growth in the above metrics, one could argue that DeFi lending

approaches are rather capital inefficient. In a traditional lending system, loan

Figure 4

Loans Originated

Source: Loanscan

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originators use some form of credit scoring to assess an individual or organization’s

credit worthiness, examining their financial history and record of repayment.

Blockchain-based applications presently lack a robust identity system to track this

history; a user could default on a loan linked to one pseudonymous address, which

may not be linked to alternative addresses and loans. Lacking a credit scoring

system, the prevailing alternative is to require users to overcollateralize all loans

and crypto-backed stablecoins. This is shown in Figure 5, Average Collateralization.

This overcollateralization requirement represents a significant hurdle for mainstream

adoption of such lending protocols, since the resulting interest rates are generally

higher than consumer loan alternatives from the traditional financial system. While

this prevalence of overcollateralization is perhaps unsurprising given the lack of

alternative methods, it does represent a key area in which future DeFi projects may

innovate and attract new users. Assuming stablecoin stability and loan default rates

stay the same, users would prefer to use systems with a lower cost of capital and

subsequent lower interest rates.

DECENTRALIZED EXCHANGES

In contrast, other sectors of DeFi do not have the same growth, particularly when

tracked by metrics other than TVL. For example, DEX traction may be tracked by

following changes in traded volume, shown in the following figures. DEXs as an

alternative to centralized exchanges are expected to offer greater audibility and

decreased custody risk. Despite these potential benefits, adoption to date is limited,

with average monthly volume across all DEXs under $500 million over the past

two years. By comparison, the leading centralized exchange, Binance, regularly

Figure 5

Average Collateralization* Compound v1 had a collateralization ratio of over 6000% in late 2018, declining to 450% before v2 was released; this outlier is excluded in the interest of chart scale.

Source: Loanscan

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processes over $1 billion in daily trading volume. For further discussion of prospects

and challenges facing DEXs, see Smith + Crown’s 0x Deep Dive Report.

However, DEX traction is not uniform across projects. One DEX design that has

attracted considerable attention is Uniswap, which uses an automated market

maker (AMM) design similar to Bancor to pool liquidity for token pairs within a smart

contract.

In contrast to 0x and most other DEXs, Uniswap does not maintain an orderbook, and instead users effectively trade against a smart contract that holds a balance of both tokens. By supplying tokens to individual liquidity pools, users can earn trading fees. The result of such a design is that liquidity is always available at some price against the smart contract counterparty, though large trades may incur significant slippage.

Uniswap’s growth may be explained by a variety of compelling characteristics.

Since all liquidity for a trading pair is pooled, there are no large bid/ask spreads

across individual order books, thus offering a reduction in slippage for small traders.

Relative to other AMM designs such as Bancor, Uniswap’s lack of a native token or

listing approval process allows developers and traders to trade on a permissionless

protocol using existing and more liquid assets, bypassing the friction of a native

token.

Figure 6

Decentralized Exchange (DEX) Volume, Monthly

Source: Bloxy

Figure 7

Uniswap Total Value Locked

Source: DeFi Pulse

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Figure 7 shows growth in tokens staked in Uniswap liquidity pools in the first half of 2019.

The case of Uniswap highlights how the uncontextualized use of TVL as metric

can mislead observers as to actual sector or project growth. While DEXs, including

Uniswap, have seen relatively low trading volumes, Uniswap’s growth in TVL is

presented elsewhere as evidence that the entire sector is rapidly growing. Much like

overcollateralization is a direct product of MakerDAO’s design, locking tokens is a

result of Uniswap’s pooled liquidity design, such that significant growth in Uniswap’s

TVL is observed even when its trading volume is still quite minimal.

By examining a variety of metrics in context, it becomes apparent that DEXs as a sector remain struggling for adoption amidst a variety of challenges, though Uniswap’s particular design emerges as a relative bright spot with some demonstrable traction.

The case thus illustrates why TVL as a metric should be contextualized to the DeFi

sector and particular applications.

PREDICTION MARKETS

Finally, prediction markets, an early and much-heralded application of blockchain

technology, have thus far struggled to obtain significant volume. Most prominently,

Augur is a decentralized oracle and prediction market platform that acts as a

framework for the creation, trading, reporting, and settlement of individual, user-

generated prediction markets. Augur launched in mid-2018 after multiple years of

development. Despite prominence within the industry and a complex oracle design

that has thus far correctly arbitrated all of over 2000 finalized markets, Augur’s

trading volume has averaged less than 1000 ETH per day with open interest for all

markets averaging under $1 million. Further, interfaces built on Augur such as Veil

have quickly shut down after struggling to gain initial user traction.

Another member of the prediction market space, Gnosis has also struggled to gain

widespread adoption, following a mid-2017 token sale that valued the network token

supply at $300 million Though a codebase for the Gnosis protocol has been open

sourced and is operational, various related prediction markets have seen minimal

volume. A new platform, Sight, is currently under development.

There are a number of potential explanations for this lack of growth within

Figure 8

Augur Open Interest, All Markets (USD)

Source: Crystal Ball Be

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prediction markets, including fragmented market liquidity, a difficult user onboarding

experience, and regulatory uncertainty. The issue of fragmented liquidity may be of

particular importance; while there are a large number of open markets on a wide

range of topics, platforms such as Augur lack a strong incentive for market creators

to seed the initial market order book. This prevents potential users from taking large

positions without significant slippage.

A second open issue for prediction market sector is the inherent possibility of illegal

and/or dangerous markets, such as assasination markets. Since there is by design

no administrator that curates the sort of questions possible, such unsavory markets

can occur. While this has not been a particularly topical problem to date, it is an

inherent problem to the sector that may deter widespread adoption from concerned

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ConclusionWhen examining summary metrics such as TVL, the DeFi space appears to be an

uncomplicated story of growth over the past few quarters. However, this growth

has been very narrowly concentrated, with certain applications such as lending

and collateralized stablecoins representing the vast majority of this growth, in

contrast with areas such as prediction markets and DEXs. Though the space is

still in its relative infancy and many unsolved problems remain, the Ethereum DeFi

ecosystem stands out as a promising development that has captured the mindshare

of much of the developer community: at the recent ETHBerlin hackathon, over

25% of submitted projects were related to DeFi. Thus, despite the variability of

demonstrable traction across the DeFi space when examining a more nuanced set

of metrics than TVL, there is reason to believe that this emerging set of composable

financial primitives presents new possibilities for the sector to expand further with

new combinations of functionality, and application-specific growth metrics will be an

important method to examine this industry development moving forward.

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