“The Ground Shook, And the Foundation Held”

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Decen­tral­ized finance (DeFi) is still a new­er entrant to the school­yard of finance, but if it’s any­thing, it’s the up-and-com­ing scrap­py fight­er that learns from its knock­downs, goes home, and instead of sulk­ing it does the work to improve, com­ing back smarter, stronger, more resilient, and more robust than ever. That’s accord­ing to Bit­wise, which took a look into the very over­looked resilien­cy that the DeFi mar­ket has dis­played recent­ly, even through the Ter­ra UST/Luna crash.

The DeFi cred­it mar­kets are one of the largest sec­tors in cryp­to today, at a com­bined mar­ket cap of $8.5 bil­lion and greater than $50 bil­lion in total deposits, but it has tak­en work and hard lessons learned to get to the point it is now.

DeFi allows investors to cre­ate yield from their cryp­to assets, whether cryp­tocur­ren­cies or oth­er­wise,  by earn­ing inter­est on cryp­to assets deposit­ed with a pro­to­col like Com­pound. With­in the DeFi cred­it mar­ket, investors will deposit their cryp­tocur­ren­cies into a “lend­ing pool,” and those pools are used to col­lat­er­al­ize bor­row­ing stablecoins.

The onset of the pan­dem­ic in 2020 that saw all asset class­es plum­met had a heavy impact on cryp­to in par­tic­u­lar since it is con­sid­ered by some to be one of the riski­est of the risk assets. Prices of all of the biggest cryp­to assets dropped dras­ti­cal­ly, and vol­ume spiked on the decen­tral­ized pro­to­cols, caus­ing liq­ui­da­tions to the tune of mil­lions of dol­lars as the lend­ing pro­to­cols failed.

It’s some­thing that the biggest DeFi play­ers set about address­ing and pre­vent­ing from ever hap­pen­ing again.

“The lead­ing play­ers per­se­vered and imple­ment­ed lessons learned, becom­ing more sophis­ti­cat­ed than ever in man­ag­ing risk and opti­miz­ing for growth and resilience. As a result, a cat­e­gor­i­cal trans­for­ma­tion is under­way in a sys­tem that is focused on fine-tun­ing sta­bil­i­ty and scal­a­bil­i­ty,” the authors of the Bit­wise paper wrote.

Image source: Bit­wise

The two lend­ing pro­to­cols, Aave and Com­pound, have been put through their paces since then; in May 2021, ETH dropped 41% in a sin­gle day, and both pro­to­cols processed $330 mil­lion in liq­ui­da­tions in a day, with more than 100x the assets that prompt­ed the crash in March of 2020 with no mean­ing­ful insolvencies.

DeFi Performance During the UST Crash

I was inter­est­ed in find­ing out how Com­pound and Aave had per­formed in the rash of sell-offs that occurred around the time of UST’s col­lapse, so I asked Bit­wise for some follow-up.

“We had a $60b blowup, and the sys­tem cleared. There was no bailout, no cas­cade of failed liq­ui­da­tions. The ground shook, and the foun­da­tion held. That’s worth not­ing,” Ryan Ras­mussen, DeFi research ana­lyst at Bit­wise, said in a com­mu­ni­ca­tion to VettaFi.

It turns out that DeFi remained resilient and robust even amid the mar­ket pan­ic. Since its crash in 2020, a whole host of para­me­ters and tools have been imple­ment­ed, includ­ing col­lat­er­al fac­tors, inter­est rate mod­els for each lend­ing pool, reserve fac­tors, and more.

“Gauntlet’s analy­sis of on-chain activ­i­ty between May 9th and May 12th found that Aave and Com­pound oper­at­ed smooth­ly dur­ing the recent mar­ket sell-off and demise of UST/LUNA. Both pro­to­cols expe­ri­enced no mate­r­i­al insol­ven­cies (the ones that did occur were across dust accounts, mean­ing the cost of liq­ui­dat­ing was more than the prof­it for liq­uida­tors because the amount was so small),” Ras­mussen explained.

So what of sta­ble­coins? What got cryp­to into this whole mess in the first place, or at least this most recent mess? Well, it’s not sta­ble­coins that are the issue per se, but instead that sub­set of sta­ble­coins that are based on algo­rithms with­out any real-world col­lat­er­al to back them, and that’s exact­ly what was seen in the mar­ket. There was pan­ic sur­round­ing UST los­ing its peg to the dol­lar and the sub­se­quent implo­sion of UST and its sis­ter token Luna, and that fear passed tem­porar­i­ly into oth­er sta­ble­coins like Teth­er, which briefly dipped below its $1 peg before recovering.

“Under­col­lat­er­al­ized (or algo­rith­mic) sta­ble­coins have yet to prove their stay­ing pow­er. But oth­er sta­ble­coins that are over-col­lat­er­al­ized (e.g., DAI) or fiat-backed (e.g., USDC) have been around for years,” Ras­mussen said. “They are promis­ing — and thus far resilient — appli­ca­tions of the inno­va­tions of cryp­to and blockchain technology.”

Bit­wise offers the Bit­wise Cryp­to Indus­try Inno­va­tors ETF (BITQ), the Bit­wise 10 Cryp­to Index Fund (BITW), and a host of oth­er cryp­to funds focus­ing on var­i­ous aspects of the cryp­to economy.

For more news, infor­ma­tion, and strat­e­gy, vis­it the Cryp­to Channel.

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