Top 5 DeFi protocols to illustrate the space… and some tips to spot its future leaders

Top 5 DeFi protocols to illustrate the space… and some tips to spot its future leaders

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Happy New Year, dear readers! 🎉

We’re back on track and this year’s first Newsletter is dedicated to DeFi: demystifying, guiding through, and maybe even tipping off a bit 😉

DeFi, or Decentralized Finance, is one of the crypto economy’s pillars with currently almost $40 billion of total value locked (TVL) across its protocols. Sure, this has been a long fall from an all-time high of $180 billion in November 2021, but still a substantial amount, showing the young industry’s resilience… and a growing demand for non-custodial and independent financial services.

DeFi has come a long way since the first decentralized exchange (DEX) appeared in 2016. The bear markets of 2018 and 2022, countless scams and exploits, as well as some spectacular crashes (Terra was a DeFi protocol 😅).

However, the industry is still immature. Even if its four main sectors – DEXesdecentralized stablecoinsstaking, and lending-borrowing apps – have each evolved significantly, they are still a niche waiting for a breakthrough to become popular.

Also, DeFi protocols are still a major temptation for hackers, and since human-written code is unlikely to reach perfection, an effective insurance system that would protect users from its flaws is a must.

This Newsletter is a review of DeFi’s four main sectors, their evolution and perspectives, illustrated by the top 5 protocols: Lido, MakerDAO, Aave, Curve and Uniswap. We believe that DeFi insurance can one day become a full-pledged sector too, and include its leading protocol Nexus in the list ⬇️

Lido, leader in liquid staking

This week a liquid staking protocol Lido flipped the oldest DeFi protocol MakerDAO and became the leading DeFi service, with $6.5 billion of TVL (source: DeFiLlama). Its governance token $LDO has gained 100% in a week. Why?

Staking cryptoassets on Proof-of-Stake blockchains gives users the possibility to participate in their activity (validating transactions and creating blocks) and to earn reward. The main evolution in this sector was the creation of liquid staking protocols, which took away the trouble of running a blockchain node and complying with any additional requirements, and allowed users to easily stake their crypto and earn a passive revenue. What’s more, such protocols issue and give users a sort of IOU token (in case of Lido – an stETH for every staked ETH), which can also be used in the DeFi ecosystem.

Liquid staking got big after Ethereum launched its PoS chain in the end of 2020 and grew rapidly after the blockchain fully transitioned to the PoS consensus last autumn. The biggest CeFi players like Binance or Kraken jumped on the opportunity instantly, but the fears of Ethereum centralization (and the rising mistrust in centralized exchanges) kept them from defying a decentralized Lido, which can now be expected to thrive as long as Ethereum thrives.

MakerDAO, a decentralized stablecoin

Since the end of 2017, MakerDAO has been issuing a decentralized stablecoin DAI, which maintains its value of approximately $1 by over-collateralization: users are required to spend more than $1 worth of ETH to be able to mint 1 DAI. Together with the diversification of the underlying asset portfolio, this allows to maintain the DAI stable.

MakerDAO now registers a TVL of $6.4 billion, and DAI’s market cap is over $5 billion.

Over-collateralization is not an ideal scheme from the business point of view, and the next stage for decentralized stablecoins is expected to be an algorithmic stablecoin. However, its most prominent example – TerraUSD – has failed spectacularly 🌠, and the market is still waiting for a decentralized algorithmic stablecoin that will work.

Aave, the lending-borrowing specialist

Launched in 2020, Aave is now the third biggest DeFi protocol, with $4 billion of TVL.

How does a DeFi lending protocol work? A user can deposit their crypto into the protocol’s liquidity pool and borrow another crypto (often a stablecoin) that other users have loaned. The former pay interest, the latter – earn interest, and the volatility issue is tackled by overcollateralizing the loan.

This sector has evolved significantly since the first days of DeFi, notably by introducing the pooling mechanism (pool-to-peer instead of peer-to-peer) and improving user experience. 

Curve and Uniswap, the biggest decentralized exchanges

Just like centralized exchanges, the first DEXes were using an orderbook to match buyers and sellers. However, this method proved inadequate due to the risk of frontrunning (block validators passing their orders before the clients’) and insufficient liquidity. Replacing orderbooks with AMMs, or automatic market makers, has allowed the DEXes to flourish, and as of today, Curve ($3.8 billion TVL) and Uniswap ($3.4 billion TVL) are the two biggest ones.

An AMM relies on a math formula to price an asset according to the available liquidity pools, where professionals and individuals deposit crypto to earn reward in form of LP tokens. It has its downsides too: the problem of impermanent loss (when the price ratio of deposited tokens changes abruptly) and the impossibility of placing limit orders (setting a price at which a user would like to buy/sell).

These two issues remain unsolved (although Balancer has claimed to tackle the impermanent loss 🤔), and a future DEX leader may be the one that solves them.

Nexus, a DeFi insurer

DeFi insurance is by all accounts an underdeveloped sector: its biggest service Nexus Mutual is currently occupying only 38th place in the DeFi ranking, with a TVL of only $180 million.

At the same time, Chainalysis reported over $3 billion of crypto hacks as of mid-October 2022, the quasi majority of them concerning DeFi.

Nexus offers its members a smart contract cover, protecting their crypto from bugs in the contract and the resulting exploits for a small fee of 2.6% annually for most protocols (which can however rise to over 50% for protocols considered as dangerous). The $3 billion of crypto lost to hackers could have been insured… but it mostly wasn’t.

Nexus is developing steadily (recently adding a “custody cover” for funds locked in CeFi), but in our opinion the market’s demand for crypto insurance is much greater.

💁‍♀️ Our tips for spotting a new DeFi champion

  • Look out for user-friendly protocols (yield optimisation services like Yearn, DEX aggregators like 1inch, wallet integrations like MetaMask swaps… or a drastic improvement in some DEX’s user experience);
  • A DEX that will solve an impermanent loss problem?;
  • Don’t forget about a largely untapped DeFi insurance market;
  • Terra’s crash doesn’t mean the algorithmic stablecoins’ potential is lost (you would like to insure it though😉)

Don’t miss out on the next opportunity !