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Although Ethereum may still be the focus, it is undeniable that the crypto economy will not reside in a single chain, but will be active in numerous public chains and scaling solutions.
Original title: “The Way of DeFi丨Total Lock-in Value (TVL) Viewing the DeFi Ecosystem “Big Smash” of Ethereum, BSC, Polygon, etc.
Written by: Roberto Talamas, Wilson Withiam
The first quarter of 2021 marks the beginning of the long-awaited ecosystem war. As the crypto market continues to attract mainstream attention, newly discovered retail entrants have pushed Ethereum’s fees to record highs. The surge in demand is a net good news for the industry, but it has prevented most retail investors from using Ethereum, prompting them to start looking for alternative options since the beginning of this year. Combined with the deployment of scaling solutions and the growth of the application ecosystem on other Layer 1 (such as Binance Smart Chain (BSC)), this outflow has become an important factor affecting Ethereum’s dominance in this field.
The second quarter of 2021 continued the momentum of the first quarter. The TVL traffic in the past three months proves that the Ethereum party is still the main battlefield, but it may not be the only party worth attending.
Total locked value (TVL) to fly to the moon
In a relatively short period of time, the total value lock (TVL) in the smart contract has grown parabolic. Since October 2020, that is, only seven months ago, in multiple scaling solutions and Layer-1, the assets flowing to different smart contract platforms have increased from US$10 billion (almost all locked in Ethereum at the time) to more than 100 billion U.S. dollars. This growth is simply extraordinary.
Although the dramatic growth of TVL shows that users’ confidence and activities in the DeFi agreement continue to increase, it still needs to be treated with caution. This indicator is calculated based on the value of the tokens locked in the smart contract in USD, so in many cases, an increase in TVL does not necessarily mean more tokens are deposited. The appreciation of the token price is also a determining factor. Despite this shortcoming, TVL can still be a useful statistic for comparing the growth and adoption of different smart contract platforms because it provides simple comparisons one by one.
Dawn of the “Ethereum Killer”
Although the growth of Layer 1 and Layer 2 may ultimately benefit Ethereum, its dominance in this field is beginning to shrink. Ethereum controls approximately 77% of the $110 billion in TVL’s disruptive period, a decline of more than 20% from its dominance five months ago.
Despite the recent decline, Ethereum is still home to the most dynamic DeFi and NFT ecosystem. Since October last year, as the boom in revenue farming (or liquid mining) has infected the cryptocurrency market, TVL has soared from US$11 billion to US$85 billion (an increase of 631%). As crypto users use more and more assets for various DeFi applications, this movement catalyzed by Compound has become a driving force in this field.
Therefore, Ethereum’s DeFi has always been the main destination of user funds. As of July 5, approximately 47% of TVL belonged to the six major DeFi protocols: Curve, Aave, MarkerDAO, Compound, Year, Uniswap, and SushiSwap. The remaining 53% is distributed among the remaining 169 applications.
As early as October 2020, TVL was mainly concentrated on Uniswap and MakerDAO, which accounted for about 43% of the locked value of Ethereum. However, as investors move assets to find the next hot mining opportunity, the explosive growth of new financial primitives that began during the DeFi summer of 2020 has weakened their dominance. This trend continues in 2021, and long-tail applications now account for almost half of all TVLs.
Binance Smart Chain (BSC) staged a roller coaster development
In the end, the success of Ethereum has become its own burden.
The impact of rising Ethereum transaction fees will begin to manifest in the first few months of 2021. As developers and users began to look for cheaper alternatives to the most popular blockchains, Ethereum’s dominance began to decline. The first Ethereum challenger to Ethereum’s dominance was Binance Smart Chain (BSC).
With the support of a $100 million support fund and the world’s largest exchange, BSC began to rapidly expand its DeFi ecosystem, which features direct copies of successful Ethereum-based applications. BSC is close to Ethereum in terms of build tools, allowing developers to iterate and deploy applications easily and quickly. On the user side, the compatibility of BSC and MetaMask has lowered the entry barrier for many local users of Ethereum, thus achieving a seamless transition between the two chains. The combination of these two catalysts with extremely high token incentives has led to an influx of new users seeking cheap yield agriculture.
By the beginning of May 2021, BSC had successfully obtained total assets of US$15 billion, accounting for approximately 13% of Ethereum’s TVL. PancakeSwap (DEX) and Venus (lending platform) are currently the two most successful applications on BSC, and they are also the applications that received the most asset inflows in early 2021.
BSC’s TVL is like a roller coaster in the second quarter of 2021. Soon after breaking through the 15 billion U.S. dollar mark, the TVL of BNB and its derivatives (such as CAKE and XVS) rose sharply, and its TVL more than doubled to 35 billion U.S. dollars in ten days. However, as a series of negative catalysts hit the market in mid-May, including the US$200 million loss of Venus liquidation and the US$45 million PancakeBunny lightning loan attack, the euphoria that created a record high quickly disappeared. The increase in exploits has exhausted users’ confidence and caused the price of tokens and TVL to plummet.
Although the TVL on all smart contract platforms has shrunk, the loss of BSC is particularly large because most of the value locked in its application is hired capital and consists of assets that are almost useless except for motivating users. Unlike Ethereum’s TVL, which is mixed with a large number of stable coins, the composition of BSC’s TVL is heavily biased towards the high end of the risk range, making it extremely sensitive to market fluctuations.
As mentioned above, in the early days of Binance Smart Chain, TVL focused on the two most successful applications: PancakeSwap and Venus. In October 2020, PancakeSwap is the leading application, accounting for 60-70% of all funds on the platform. When Venus entered the market in December 2020, things changed quickly. The lending platform quickly occupied a large part of TVL and consolidated its position as the second largest DeFi agreement in the BSC ecosystem.
From December 2020 to April 2021, these two agreements control approximately 90% of the assets in the platform. In mid-April, with the introduction of the new agreement, TVL began to expand to other agreements such as MDEX, Ellipsis Finance and Wault. However, as of July 5, PancakeSwap and Venus have regained their dominance in the BSC ecosystem, controlling more than 65% of the funds locked in smart contracts.
Polygon’s journey to fame
The second platform that began to weaken Ethereum TVL in April 2021 is the Layer-2 solution Polygon. Like BSC, Polygon uses Ethereum’s high-fee environment to guide its application ecosystem by providing lower fees and faster transaction times. Polygon’s biggest advantage so far is its compatibility with Ethereum, which reduces the learning curve for users and developers. As far as TVL is concerned, it is currently the third largest chain, processing 5% of all assets locked on all platforms.
Polygon’s TVL increased from less than US$50 million to more than US$5 billion in the second quarter. This explosive growth is the result of two different factors. The first is the deployment of DeFi header protocols Aave, SushiSwap and Curve on Polygon. These agreements began to explore Polygon’s scalability capabilities at the beginning of the second quarter of 2021 in an attempt to solve the congestion problem of Ethereum. Given their popularity and strong communities, it is not surprising that migration has led to an increase in user acquisition.
The second reason for the almost exponential growth is the launch of Polygon’s DeFiforAll fund. The team promised to support the growth of its DeFi ecosystem in the form of liquid mining rewards for different applications as high as 2% of the total supply of MATIC in the next two to three years. Unsurprisingly, the largest share of rewards currently flows to users of the top DeFi apps in the ecosystem, including Aave, Curve, and SushiSwap.
As a result, these three agreements account for nearly 65% of all value locked in Polygon. In particular, due to its liquid mining plan, Aave’s market share in TVL has exploded, rising from less than 10% to 70% almost immediately.
User growth inspired by tokens has become one of the most popular strategies used by the protocol to guide the community. Although this strategy is effective in the short term, it can sometimes prove to be harmful if it is not well managed. In many cases, a higher rate of return will eventually attract the hired capital of users who want to make money quickly but have no vested interest in the long-term success of the project. In this case, the agreement can earn millions of dollars, but when the token incentives cease, these funds will leave.
Although it is too early to draw conclusions, this kind of user behavior is manifesting in Polygon’s largest application. The three DeFi giants with more than $3 billion in TVL are beginning to see capital flow back to Ethereum. In the case of Aave, which is the protocol that provides the highest liquidity mining reward, it reached a point where the TVL between Ethereum and Polygon was divided by 70% and 30%, respectively. However, in the past two weeks, approximately 10% of Aave’s total TVL has returned to Ethereum.
SushiSwap follows a similar pattern. The TVL in Polygon began to grow rapidly in May, when token incentives were announced. Therefore, SushiSwap’s TVL split between Ethereum and Polygon immediately increased from 95% and 5% to 75% and 25%. Similar to Aave, as Ethereum’s share of TVL began to climb, the narrative in the past two weeks has changed.
Finally, among these three agreements, Curve is the one with the least amount of funds flowing into the Polygon branch. Within six weeks after the announcement of liquidity mining rewards, approximately 15% of Curve Ethereum TVL migrated to Polygon. As with the previous two times, Ethereum’s TVL began to increase in June as users flooded from the sidechain. After the recent migration, Polygon’s share of Curve’s total TVL has shrunk from 15% to 7% within a month.
There are few potential reasons for this behavior. As mentioned earlier, the first one may be the result of users locking up funds in a short period of time to take advantage of the excessive returns provided by the entire ecosystem. One piece of evidence supporting this is the relationship between the size of the incentive and the number of TVL captured by Polygon.
For example, Aave’s liquidity mining plan is divided into the first phase and the second phase. In the first phase, 1% of the total supply of MATIC (approximately $40 million at the time of writing) was allocated to Aave’s liquid mining plan. About 2 months later, the second phase was launched, extending the incentive plan to January 17, 2022 and increasing the reward from 40 million US dollars to 85 million US dollars (assuming the MATIC price is 1.7 US dollars). As a result, as expected, Aave experienced the largest inflow of assets among the three DeFi protocols. In contrast, Curve’s liquidity mining plan is only a small part of Aave. The program was launched on April 22 and only $6 million was allocated to match CRV rewards within a 16-week window. Therefore, in the case of Curve, the amount of value transferred from Ethereum to Polygon is relatively small.
Another reason for the withdrawal of funds may be due to the asset composition of the two chains. Similar to BSC, if assets locked in Polygon applications are more risky than assets locked in Ethereum, then during a market downturn, the value of dollars locked in Polygon will shrink relative to Ethereum. Although this may be a possibility, it is worth emphasizing that most of the value of escaping to Ethereum via Polygon’s bridge is in USDC.
However, the root cause of USDC’s decline may not be entirely driven by the escape of mercenary capital. The decline in the supply of USDC locked on the Polygon Bridge peaked on May 18, which was the same day as the Iron Finance/Titan collapse. The bank run triggered by investors dumping their TITAN tokens may be the culprit for the massive migration of USDC back to Ethereum.
Finally, the third potential reason for Polygon’s short TVL peak may be due to the continuous improvement of Ethereum’s fee environment. The average gas fee per transaction has dropped from a level of as high as $30 per transaction in mid-May to the level in December 2020. Part of the decline was due to increased activity on other smart contract platforms such as Polygon and BSC.
Although this may be one of the driving factors behind the withdrawal, it is hard to believe that users will simply return to Ethereum because of the lower fees. Currently, Polygon’s liquidity mining plan is still active, which means that users can enjoy low-fee transactions while receiving a large number of rewards. From the perspective of maximum utility, unless the market’s overall view of Polygon deteriorates in recent weeks, Ethereum’s low fees should not be enough motivation to leave the “free money” given by Polygon.
In this new multi-chain world, BSC and Polygon are not alone. So far, they have attracted most of the attention outside of Ethereum by imitating the development environment and end-user tools of Ethereum. However, although designs such as Solana and Cosmos are completely different, they still receive attention.
Solana has been optimized for speed for Ethereum compatibility. It uses different virtual machines and several new methods to manage transactions and state changes to achieve first-class transaction processing time. Solana’s speed enables it to support a new class of encryption use cases, such as the on-chain matching engine supported by Serum. But it turns out that imposing Ethereum compatibility into Solana’s new environment is tricky and can hurt performance. In response, the project abandoned the EVM route and relied on funds such as hackathons and Alameda to incentivize developers to build on Solana in its current state.
These efforts have brought some early signs of success. Solana’s DeFi division now has less than $1 billion in TVL, which has grown approximately 4 times since the beginning of the second quarter. Since Solana’s current DeFi ecosystem is relatively small (DeFi Llama tracks eight projects), this total is only a small part of the assets locked in Ethereum, BSC, or Polygon. But the network has a large number of new financial products that will be launched or migrated to it in the next few months.
If Solana can continue to expand its developer base and application pipeline, its uniqueness may become an advantage. The project will not be able to easily migrate its contracts and liquidity to the secondary network. With a booming economy, inherent developer lock-in, and sufficient idle funds, Solana may become a popular platform for DeFi users to deposit assets in the near future.
Cosmos’ multi-chain DeFi ecosystem is gradually becoming active. By the end of the second quarter, Terra users had locked up assets worth more than $2.2 billion in its two applications, Mirror Protocol and Anchor Protocol. Although THORChain was launched under protection, its liquidity reached nearly USD 140 million in the first three months. Kava also quietly accumulated $250 million in TVL (flat growth in the second quarter) in its borrowing protocol called the HARD protocol and its built-in crypto-collateralized stablecoin system. Even the upstart AMM platform Osmosis attracted nearly $80 million in TVL within a few weeks of its mainnet launch.
With the exception of Osmosis, these chains operate independently of each other. Some bridges or entrances to external networks have been established (Shuttle Bridge between Terra and Ethereum, and Bifrost gateways between THORChain and several Layer-1), but none of them implement IBC. IBC is defined by the Cosmos ecosystem Interoperability features allow these other sovereign chains to communicate. Terra, Kava and THORChain may change their IBC status before the end of 2021. But the question remains whether the Cosmos Hub can capture any of their asset flows by facilitating cross-chain transactions.
The only real case study of IBC transaction flow is Osmosis. It uses various IBC connections (and incentives) to quickly guide liquidity and transactions. Although its launch caused an immediate surge in IBC activity across the Cosmos ecosystem, the ultimate beneficiary was Osmosis, not Hub. If the prolific regions of Cosmos are connected to each other rather than routed through the Hub, the Cosmos Hub may miss the opportunity to consolidate itself as a core component of its eponymous ecosystem.
Attracting capital flows is exactly why the recently released Gravity DEX is crucial to the long-term strategy of the Cosmos Hub. The exchange provides users with a reason to deploy funds to the Hub or use it as an entry point before moving to the next area. It can also link the value of the Hub to the growth of the ecosystem. If Gravity becomes the main trading venue with the deepest liquidity pool in Cosmos, it can consolidate Hub as the center of the ecosystem economy and earn fee income from every passerby.
Write at the end
A year ago, the concept of a multi-chain world was only an abstract concept. At the time, the available data pointed to a fact: Ethereum is the only destination for DeFi applications. In just six months, this fact has changed dramatically.
We now live in a world where several blockchains outside of Ethereum have significant appeal and a large number of developer activities. Although Ethereum may still be the focus, it is undeniable that the crypto economy will not reside in a single chain, but will be equal to the overall economic activity that occurs in many layer 1 and scaling solutions.
Although attracting funds is a mandatory first step, these newer Tier 1 and scaling solutions must figure out how to retain new users. As demonstrated by the shift of dominance from BSC to Polygon in May, the incentive liquidity pool attracts hired capital, which will quickly withdraw when hot money finds a new home. Retaining capital will require the network to provide differentiated use cases and ancillary services to supplement (rather than cannibalize) existing applications.