An analysis of Ethereum’s decentralized finance ecosystem in Q1 2021.
DeFi applications are deployed as smart contracts, and the rules/logic of the application are written as code rather than enforced by companies and legal documents.
They are global and permissionless — with an internet connection, anyone can interact with them, whether in Almaty or Anchorage.
DeFi applications are composable. One DeFi smart contract or application can be used by other smart contracts and more complex applications, and nearly all DeFi smart contracts are public open-source code, which means that the entire financial system is being built in the open.
It may seem like money is already digital. You can take out your phone and use Venmo to send money to a friend. Decentralized finance takes this further — even the money itself is digital, programmable, and verifiable on Ethereum’s blockchain. One side effect of the Game Stop saga was that even casual observers were introduced to the centralized financial rails by which stocks settle, namly the DTCC causing brokerages like Robinhood to halt trading, drawing the outrage of retail investors left holding the bags.
One of the primary benefits of DeFi on Ethereum is that financial activity is transparent and settles in real time. Wallets like MetaMask allow for anyone in the globe to trade assets on decentralized exchanges like Uniswap. If someone else controls the financial rails, do you really own the assets you trade?
There were approximately 130 million unique Ethereum addresses on January 1st, 2021. As of April 1, 2021, there are now 146 million unique Ethereum addresses, a 12% increase from the beginning of the year. MetaMask, the gateway to Ethereum and the leading wallet in all of crypto, surpassed more than 5 million monthly active users.
How many of those addresses are using DeFi protocols? It turns out, still not very many. By the end of Q1, 1.75 million unique addresses used at least one DeFi protocol, despite DeFi users growing by 50% this quarter, and a 10x increase from the end of Q1 2020. Still, DeFi users only represent about 1% of the total Ethereum addresses.
While all of this growth has been incredibly beneficial for the entire crypto ecosystem, increased demand does present some challenges to the network. The median gas price has increased from roughly 100 Gwei at the beginning of the year to around 150 Gwei at March 31st, a 50% increase in ETH. This increase came during a time where the price of ETH also increased from $732 to almost $2,000 in the same time period, compounding the dollar value users are required to pay for gas. The increase in gas price and ETH price led to average transaction fees increasing from $5.4 at the beginning of the year to $22.9 at the end of Q1, a rise of approximately 4.2x.
The pie chart on the left shows that in Q1 2021, Ethereum’s total fees were double that of the Bitcoin blockchain. The leading AMM, Uniswap took nearly half the fees of Bitcoin, which accrue to the liquidity providers of various tokens. On other DEXs, like Curve, a portion of these fees actually accrue to the treasury fund itself. In the future, users might be distributed these fees based on the amount of tokens they hold, or their treasuries could be utilized to buyback tokens on the open market. They can also accrue to the value of the DeFi asset itself.
The continued growth of DeFi in Q1 was paired with a corresponding increase in supply of stablecoins on Ethereum. This correlation makes sense considering how stablecoins are the main medium of exchange and can be used in DeFi applications to earn yield through lending, a return on investment as a liquidity provider (LP), or as collateral for synthetic products. Stablecoins total supply on Ethereum increased from $19.5 billion on January 1st to $37.4 billion on March 31st, an increase of close to 2x. This trend is even more dramatic when examining the data year over year, as stablecoin supply increased from $5.5 billion at the end of Q1 2020 to $37.4 billion by the end of Q1 2021, an increase of almost 7x.
Ethereum is emerging to not only be the settlement layer for nearly all of the leading dapps, but also for almost the entire ecosystem of digitized dollars. Total stablecoin supply on March 31st was approximately $42 billion, more than a 4x increase than the total supply at the end of Q4. Even traditional financial service companies such as Visa will allow for transaction settlement to occur with USDC on Ethereum, displaying how stablecoins are now moving well beyond traditional crypto use cases.
Additionally, the demand for algorithmic stablecoins with novel pegging structures has continued to rise. Most recently, Fei protocol raised 639,000 ETH, which is roughly $1.27 billion at current prices. Fei uses a new stability mechanism called direct incentives, which uses dynamic mint rewards and burn penalties on DEX trade volume in order to maintain the stablecoins peg. Their mechanism removes the need for an overcollateralized debt system to achieve stability, which makes it different from MakerDAO’s DAI. They utilize a bonding curve in order to try and maintain a peg. Yet these novel algorithmic stablecoins pose significant challenges. Because of how the protocol was designed, the FEI token became impossible to sell as its liquidity pool priced the token at a negative value because the purchasing rebate mechanism was disabled because of a vulnerability in the system.
Other algorithmic stablecoins utilize elastic supplies in an attempt to maintain their peg. The leader of the elastic supply algorithmic stablecoins is Ampleforth. When price is above the peg, the total amount of Ampleforth increases. Therefore if I had AMPL in my wallet, my AMPL balance would actually increase because of the new AMPL distribution that is meant to lower the price. When price is low, Ampleforth actually reduces supply, which leads to a wallet decrease in supply. There is far more price volatility in algorithmic stablecoins based on elastic supply compared to dollar backed stablecoins, as AMPL has dropped to a low 32 cents and has risen to a high of $4.
Each sector within DeFi benefited from Q1 2021’s 50% increase in users. DEX volume increased from approximately $25 billion in monthly volume for the month of December to $63 billion in March, an increase of 2.5x. Weekly transaction volume increased on Uniswap from approximately $5 billion for the first week of January to around $7.8 billion for the last week in March, an increase of almost 1.6x. Interestingly, Sushiswap saw a decrease in weekly DEX volume, as their weekly volumes decreased from around $2.6 billion in the first week of January to approximately $1.9 billion in the last week of March, a decrease of about 27%.
From January 1st to March 31st 2021, outstanding loans in DeFi increased from around $3.6 billion to $10.8 billion, an increase of 3x. In Q1, approximately $3.3 billion worth of assets in USD were borrowed, a 2.75x increase from the protocol's Q4 net borrowing of around $2.75 billion. Aave has also experienced similar growth. From January 1st to March 31st, total outstanding loans on Aave increased from $670 million to approximately $1.6 billion, an increase of almost 2.4x.
With the fundamentals of DeFi projects exponentially increasing, from users to total value locked (TVL), one should not be surprised that the market recognized these improvements within the ecosystem. DPI, a decentralized finance market cap weighted index token that tracks the leading DeFi related digital assets (AAVE, Synthetix, Uniswap, Yearn Finance, Compound, Maker, REN, Loopring, Kyber Network and Balancer), rose from approximately $117 on January 1st to $410 March 31st, a 3.5x increase. BTC increased only 2x in the same time period, indicating that the growth in value of DeFi assets is likely tied to the increasingly strong fundamentals and not just driven by the rising sentiment for digital assets overall.
Yet high fees are a persistent issue for users of DeFi. Consequently, DeFi developers are looking to move their applications and users on to layer 2 in order to take advantage of lower gas fees. TVL on layer 2 increased from $38.4 million on January 1st to $273.4 million by March 31st, a 7.1x increase. Leading DeFi applications such as Synthetix and dYdX, have announced they have been ardently working on integrating with Layer 2 solutions. Synthetix has been working with Optimsm for months now, while dYdX recently announced that their new cross-margined perpetuals are live on Starkware’s STARK based roll-up solution. We expect this trend to accentuate for the rest of the year.
The Google search volume for the term “NFT” reached an all time high in early March. Search volumes are relative between 0 to 100, with 100 being the maximum value from a defined time period. NFT’s Google search volume hit 100 on March 12. NFTs are essentially data minted as liquid intellectual property on the blockchain. This data could be art, virtual goods for games, reputation scores, access to private networks, etc.
The meteoric rise of NFTs can be attributed to various factors: due to the coronavirus pandemic, many revenue generating activities for artists disappeared, and a record amount of time is being spent on the internet. The global pandemic changed the way we use the internet. NFTs change the default ownership of a digital IP from the platform to the creator, in a climate where 62% of artists are currently unemployed. Before the pandemic, visual artists had very few, heavily intermediated ways of generating revenue from their art; creating commissioned art, bringing illustrations to a corporate environment, side jobs, and/or wealthy parents. The pandemic created a fertile environment for obsessively online and out-of-work artists to monetize their work, NFT platforms arising and including the technical requirements to support developing NFT standards.
By the end of 2020, the total market value for NFT crypto art was $52,293,650 (42,720 ETH) with 53,663 unique works of art sold on the five largest platforms. Currently, the total market value for crypto art is $490,242,627.92 (244,953.521 ETH) with 151,977 total artworks sold within the last 30 days.
In contrast, the global traditional art market’s volume of transactions has steadily decreased through the pandemic. In 2018, the global art market was valued at over 67 billion U.S. dollars and is currently valued at 50.06 billion USD. The 2019 Art Basel and UBS Global Art Market Report, states that 92% of millennial collectors reported having bought art online, yet the report failed to include NFT art sales. Millennials now make up nearly half (49%) of all collectors globally and were also the most active consignors, with 71% of millennial collectors saying they’d resold works from their collections, compared to just one-third of boomer collectors. As online art sales skyrocket, along with bonding-curve based NFTs and ERC-1155 based digital art, these new works create an alluring asset class for Millennials looking to speculate and resale art for profit.
Many news outlets are reporting on the decline in search volume for the term “NFT” as well as the decline for average price sale. Yet, art NFTs only represent 11% of the overall NFT market distribution.
Axie Infinity, a wildly popular collectible trading card game, has over 22,846 monthly users, with over 173,813 transactions in the last 30 days. Blockchain-based gaming has yet to fully take off largely because of throughput challenges. As we venture to Eth2, look for games and gaming NFTs to skyrocket.
In the last 30 days, there have been 150,651 crypto-collectible sales amounting to $217,402,636 generated. Cryptopunks, CryptoKitties, & Hashmasks are the most valued collectibles, with a peak of 39,000+ unique buyers within the last month.
At the end of Q1, 2021, a decentralized autonomous organization (DAO) was formed nearly overnight, specifically to bid on an NFT for the popular teaser video for the Uniswap V3 launch by an artist who goes by "@pplpleasr1." The buyer of the was a DAO called "pleasrdao,” originating from a tweet from PoolTogether’s Founder, Leighton Cusack. Leighton really wanted to own the NFT, but realized the only way to win would be get a bunch of friends to pool together capital to outbid. They ended up winning with a 310 ETH bid, and have since gone on to snatch up Edward Snowden’s first NFT for 2,224.00 ETH ($5.5M at current prices).
The proceeds of both NFTs went to charities, but the mechanism of DAOs winning high-profile NFT auctions will be a trend to watch in Q2. FlamingoDAO, formed specifically to purchase worthy NFTs, has a treasury of 6,240 ETH. Gaming NFT focused DAOs like Yield Guild Games (YGG), raised the $1.3M from crypto VCs like Delphi Digital and Scalar Capital. And perhaps the biggest NFT event of the quarter, Beeple’s “The First 5,000 Days” sold to Metakovan, whose fund Metakovan already tokenized Beeple artwork as ERC-20 tokens called B.20. DAOs are quickly becoming a way for distributing ownership of rare art.
Toward the end of Q1 2021, flashbots emerged as a dynamic new locus of activity on the Ethereum network. In March alone, 12 mining pools accounted for over 58% of Ethereum network hashrate — all using flashbots for mining. This created a lot of discussion over whether these flashbots are contributing gas prices, and the extent by which there is a market-driven separation of the “high-speed” and “low-speed” transaction highways. Ethereum researchers Leo Zhang and Georgios Konstantopoulos wrote Ethereum Blockspace: Who Gets What and Why, to analyze the dynamics of bots participating in “priority gas auctions” and bidding exorbitant gas prices to front-run specific types of transactions according to a predetermined algorithm. It is yet to be seen how Ethereum network upgrades that simplify gas fees, like EIP-1559 in Q3 will affect these arbitrage and trading strategies. But expect to see more news from the “dark forest” of predatory arbitrage bots monitoring the activities in the mempool.
Since the publication of our last DeFi Report, a number of significant legal and regulatory news events have occurred. We’ll explore the following four updates:
As many were ordering that last-minute Christmas gift in time for overnight delivery to their annoying Uncle Frank, FinCEN published an NPRM imposing additional recordkeeping and reporting requirements on banks and money services businesses (MSB) with respect to CVCs and digital asset transactions. Specifically, FinCEN would define CVCs and legal tender digital assets (LTDA) as “monetary instruments” under specific rules giving FinCEN statutory power to collect Currency Transaction Reports, and imposing reporting and recordkeeping requirements of such CVCs and LTDA transactions over $10,000 and $3,000, respectively. Notably, FinCEN provided a hasty 15-day comment period for the NPRM. After significant pushback, it reopened the comment period for an additional 15 days for comments on the proposed reporting requirement and an additional 45 days for comments on the proposed recordkeeping requirement.
If finalized, this NPRM would require banks and MSBs to report any CVC or LTDA transactions of more than $10,000 involving self-hosted wallets (i.e., the user maintains their own private key) or “covered wallet” (defined by FinCEN as wallets held by a financial institution in jurisdictions of primary money laundering concern - currently Burma, Iran, and North Korea). Additionally, the current anti-structuring rule would be expanded such that banks and MSBs must monitor and detect those transactions that are just below the thresholds with the intention to evade the reporting requirements. Expanding upon the current Funds Transfer Recordkeeping Rule, banks and MSBs would be required to keep records of the name and address between its customer and a counterparty using a self-hosted wallet for transactions greater than $3,000.
FinCEN’s goal in this NPRM is to combat bad actors who utilize self-hosted wallets and digital assets to send large sums of money to fund illicit activities. FinCEN’s long-held position is that new financial products and services must operate within the existing regulatory framework, and argues its regulations are technology-neutral. Therefore, FinCEN’s approach reflects an expectation that new technologies will be developed and adapted consistent with existing frameworks.
Critics point out that these requirements impose costly compliance programs and do not account for how blockchain technology operates. Additionally, many in the DeFi ecosystem are concerned that these regulations could create a chilling effect on self-hosted wallets which serve the unbanked and underbanked.
As a global intergovernmental organization charged with developing policies to combat money laundering and financial crimes, FATF issued guidance in 2015 and 2019 recommending virtual assets be treated similar to traditional financial products, including KYC/AML requirements typically required by banks and financial institutions. On March 19, 2021, FATF announced an update to Draft Guidance on a Risk-Based Approach to Virtual Assets and Virtual Asset Service Providers. Significantly, FATF’s guidance expands the definition of VASPs to exchanges, platforms, and owners or operators of DApps, and consequently broadens the applicability of FATF recommendations to more industry participants. These FATF recommendations would require exchanges, platforms, and dapp providers to carry out extensive KYC/AML checks for each party of a transaction, including self-hosted wallets.
Additionally, among other due diligence best practices, FATF recommends VASPs be subject to The Travel Rule, a rule applied only to U.S.-based regulated entities. This may pose significant issues and resources for certain providers, particularly non-custodial liquidity providers. Similar to that of the recent FinCEN proposed rule, reaction to the FATF guidance is mixed. DeFi enthusiasts particularly target the gap still unresolved by applying traditional regulatory rules to the decentralized technology operating virtual assets for which these rules are not a natural fit.
FATF is accepting comments to the updated proposed guidance until April 20, 2021.
Introduced in March and passed on April 22, 2021, bipartisan U.S. lawmakers established a digital asset working group between the Securities Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) along with other industry representatives to clarify regulatory oversight of digital assets in bill H.R. 1602 - Eliminate Barriers to Innovation Act of 2021,. The ultimate goal is to determine which regulatory body has jurisdiction over each particular token or cryptocurrency, essentially determining whether each token or cryptocurrency is a security. If a token is deemed a security, the SEC would have jurisdiction, whereas if the token is classified as a commodity, the CFTC would preside over the jurisdiction. The bill still needs to be passed by the Senate before reaching President Biden for signature and becoming law.
The working group will have 90 days from the passing of the bill to establish itself and be charged with filing a report within one year analyzing a wide range of issues, including current regulations and their interaction with digital assets, how that interaction impacts primary and secondary markets and the U.S.’s competitive position, future best practices for fraud prevention, and how custody and private key management are currently treated under law. It will be the first time the SEC, CFTC, and other industry representatives worked together in a formal action with the purpose of working through key issues in the DeFi space. The working group’s possible success could bring unprecedented U.S. regulatory clarity and guidance to the classification of various digital assets and cryptocurrencies, the legal implications of custody and private key management, and a host of other currently unresolved issues.
The OCC set off New Year fireworks when it published Letter 1174 on January 4, 2021, authorizing banks to use INVNs and stablecoins to facilitate payment activities. The primary role of banks is to sustain the operation of commerce and maintain the movement of money, debits, and credits across all parts of the economy. In that role, banks must monitor and adapt their practices by utilizing new technological developments that improve the transaction settlement process. In its letter, the OCC acknowledged the changing financial needs of the economy. They recognize the demand in the market for faster and more efficient payments. In recognition of this demand, they determined that banks may serve as a node on INVNs to validate, store and record payment transactions, including stablecoin transactions. The OCC was also careful to note the expectation of banks to continue to operate these activities consistent with currently applicable law and safeguards, including obtaining the identity of all transacting parties — another reference to identifying parties utilizing self-hosted wallets.
This letter is the latest of a number of supportive letters of decentralized technology published by the OCC, broadening the authority to banks to participate in DeFi, blockchain technology, and cryptocurrencies. In these letters, the OCC recognizes the importance of the U.S. financial system and, by extension, its banks’ competitive position. While OCC letters are not law and can be challenged in court or re-written by Congress, they provide crucial guidance to the industry, and specifically banks, to take advantage of this technology.
As the market matures and mainstream adoption builds, regulators are working to keep pace and provide clarity to users, protocols, and DeFi companies. The industry is seeing a wave of regulatory focus on KYC/AML requirements, particularly related to self-hosted wallets, for banks and financial institutions and possibly virtual asset service providers. The DeFi industry is anticipating more answers regarding which agencies will oversee particular assets, future best practices and requirements for money-laundering prevention, legal treatment of private key management, among a number of other issues. The industry and regulators are still wrestling with how to close the unaddressed gap between traditional regulatory schemes built for banks and financial institutions and whether or how to apply such rules to a novel technological advancement based on decentralized systems.
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