DeFi has more than just yield farming to thank for the recent surge

DeFi ecosystem has come a long way over the past few months. From a Total Value Locked (TVL) figure of $539.8 million right after the market crash in March, it has recovered extraordinarily well. At the time of writing, the same figures had risen to as high as $4.58 billion.

Leaving ETH behind

Interestingly, while the DeFi sector surged over the last few months, Ether’s valuation didn’t (until quite recently). This may have stumped many in the community, but it wasn’t unexpected; while Ethereum remains the base layer for DeFi, Ether’s primary functionality right now is to act just as a medium to pay gas prices.

In fact, even as a form of collateral on DeFi, ETH is being slowly squeezed out by the emergence of native DeFi tokens (Synthetix’s SNX) and stablecoins (USDC, DAI).

Yield Farming and some useful context

Anyways, how then can one explain DeFi doing so well? Well, the short answer is demand, with the recent surge in the same precipitated by the popularity of yield farming following the launch of Compound and yEarn Finance’s own Governance tokens.

However, characterizing the sector’s growth as a product of Compound and YFI’s performance may be an understatement because it implies that if and when these go bust, so will the sector, and DeFi will once again significantly dependent on Ether’s valuation. Such characterization is evident when researchers compare the sector’s market cap to some of the market’s top crypto-assets and publicly traded layer 1s outside of Bitcoin and Ethereum.

Now, I must clarify that there is nothing inaccurate about these observations. However, they are presented without context and fail to look into what’s driving the growth of a sector that has seen its TVL YTD grow by a staggering 600%.

There are a few key structural factors at play here, and some of these were recently highlighted by Arca’s VP of Portfolio Management, Hassan Bassiri. According to Bassiri, two factors can be credited for DeFi’s performance – a) Real (non-inflationary) yield in the form of exogenous cash flows and, b) Community Involvement/Governance.

Compound v. Aave – Why token accretion models matter

On the first point, Bassiri argued that recent DeFi protocols have struck upon a monetary model that creates actual value and real yield for token holders via these exogenous cash flows. Here, it is important to highlight the examples he used – Compound and Aave.

Under Aave’s model, participants can reinvest or stake the returns they get from selling USDC/ETH/BAL “to effectively own a bigger part of the network (thereby entitling them to more future flows).” That is all well and good, but most importantly, this model, by doing so, fuels buying pressure on the token as more and more tokens are staked, a development that pushes the Total Value Locked figures on the network even higher.

On the contrary, that is not the case with the Compound model, with Arca’s VP arguing that liquidity miners instead recycle assets to mine COMP and then immediately sell them to offset their interest expense. Simply put, since yield can be generated on Compound by selling COMP, selling pressure is inevitable.

According to Bassiri, the exogenous cash flows seen in models such as Aave are crucial to long-term token accretion in the DeFi ecosystem, not only because they allay selling pressure concerns, but also because they bootstrap “positive, reflexive behavior.”

In fact, token accretion models with such exogenous cash flows can also be compared to centralized exchanges and their own native tokens. Whether it is BNB or FTT, there is no real value accretion when exchanges like Binance and FTT offer buybacks and make burn announcements, with Arca’s VP going on to say that such gestures are merely “symbolic” since “no actual cash is received.”

Community is everything

The second point is equally, if not more, important than the first one in determining the recent success of the DeFi sector. Part of the reason why Community and Governance are so important is that they reinforce decentralization, one of the sacred tenets of the space. For those who were worried about the cryptocurrency industry getting too centralized, the emergence of DeFi has been heaven-sent.

Look no further than how Synethtix is decommissioning its Foundation to give up control to three DAOs –  protocolDAO, grantsDAO, and synthetixDAO. In fact, a statement from Synthetix had read,

“….while we have been governed through rough consensus for some time now, this shift puts significantly more power directly into the hands of token holders.”

More power directly into the hands of token holders. Here, the decisions taken by token holders and the community are tied to the future of the protocol. Not only is this perfect for decentralization, but it also ensures active engagement among community members. Governance, it turns out, does matter.

To conclude, it’s hard to really say how far the DeFi sector will go. On the face of it, despite it being dwarfed by the larger cryptocurrency market, the sector does retain strong fundamentals. In fact, some have argued that the DeFi market may just be stuck in a positive feedback loop. That may be the case, but since this is the cryptocurrency space we are talking about, one never knows.