If you let me choose the best concept of DeFi, I vote for synths. The power of such protocols starts with TVL.
What is TVL? Why measure DeFi with TVL?
If you have been following this year’s DeFi development, you may have noticed that almost every article uses TVL (Total Value Locked) as a measure of scale for a DeFi project. It came from traditional finance but has become a hit in DeFi.
A great portion of traditional finance is built on the credit system, take borrowing and spending for example. The banking system knows who you are and knows that any bad behaviour (like default) affects your credit rating. If something bad happens, your losses in future financial activities outgrow the gains. Therefore, the cost of bad behaviour is relatively high.
In the crypto world that advocates anonymity and where the development of a credit mechanism and digital IDs still lacks a lot, most economic activities are impossible within the margin of the traditional credit system. Here comes collateral and ensures that doing bad costs more than the profit of each user. The value of collateral is the TVL. For instance, I need to borrow 100 USDT. In various protocols, I need to pledge collateral of more than USD 100 in value, like USD 150 in BTC or ETH, to guarantee that if I fail to pay back the loan, this BTC or ETH will cover my debt.
Here is why judging by TVL you can estimate the operating scale of a project to a certain extent. However, can TVL alone reflect the whole DeFi? It seems we are missing out on a bigger thing which is the utilisation rate of the locked assets.
Why is locked asset utilisation rate so important?
Let me tell you a story. A kid asked his father, a financial sector employee: What is finance? The father asked the kid to bring him a piece of meat from the fridge. When the kid brought the meat, the father asked him to put it back and the kid did so. After that, the father asked: Is there less meat? The kid answered negative. The father asked once more: Do you see the grease on your hands? The kid answered positive. The father said: This is what finance is. In this story, the meat is the principal and finance is the profit earned by principal circulation.
Thus, for a financial system to have high profit, its asset circulation has to be frequent. A financial system profits not when you move 100 lbs. meat one time but when you move 1 lbs. meat one hundred times. DeFi’s locking of most assets is contrary to the essence of traditional finance. When we look at DeFi’s development, it is definitely the process of increasing the utilisation of the locked assets.
Synth protocols have extreme utilisation of locked assets
Here I list protocols in the ascending order of locked asset utilisation:
1. PoS and DPoS mechanisms: If token depositing to earn interest is deemed a kind of finance, let us consider PoS staking a kind of finance, too. Take DPoS for example. People lock coins and have a yearly cryptocurrency income within 5%. However, the locked coins just sit there as a proof and do not generate any value. You can only get relatively small rewards with added value. Thus, utilization of such locked assets is low and negligible.
2. MakerDAO: collateralised lending and stablecoin generation platforms like MakerDAO and Wayki-CDP do a great job increasing the asset utilisation. When a user pledges USD 150 of ETH, it can borrow USD 100 of DAI. Though the USD 150 of ETH is locked, the USD 100 of DAI can circulate in the market. Utilisation of the locked assets improved much over PoS because more value can circulate in the market. Still, the USD 150 of ETH pledged in the protocol does not move and there is no way for it to enter circulation.
3. Compound: it is a P2P lending platform where users can over-pledge one token to borrow another one. For instance: I can pledge USD 150 of BTC and borrow USD 100 of ETH. Then there is a trick. Another user can take the pledged USD 150 of BTC if it pledges USD 200 of digital assets (e.g. USDT). P2P lending platforms using this asset pool model achieve a new increase in utilization and hence the profitability of the whole platform. The user who pledges BTC to borrow ETH and the one who pledges USDT to borrow the above user’s BTC pay interest. This is similar to the above meat but for two transfers and two sets of hands getting the grease on them. On such platforms, there is no actual “locking” of the assets.
4. Uniswap: it is a decentralised exchange protocol allowing users to inject liquidity to assets. Other users can trade these assets. When users provide liquidity to Uniswap, the assets are also locked in the protocol but can be utilised. For instance, a user gives ETH and USDT to provide liquidity for Uniswap ETH/USDT trading pair. ETH long traders can buy this ETH. Similarly, USDT long traders can buy this USDT. Long and short traders are one another’s counter-parties, while liquidity providers have trading fee incentives. Here, traders constantly use the collateralised assets and the utilisation is much higher.
5. Uniswap + liquidity mining: On Uniswap, liquidity providers can get LP Token that serves as a voucher for locked assets. Users can pledge this voucher in other activities, for instance to get incentives in other protocols. Funds have two use cases: one is liquidity and the other is proof of liquidity for collateral in other mining activities, thus, utilization is higher.
6. Synth protocols: like Synthetix or Wayki-X. Synthetic assets (synths) are a kind of digital asset collateral. With oracle price feeding, any valuable real-life asset target and even a non-asset target can be minted. See this example. A user pledges USD 800 of cryptocurrency to mint USD 100 worth of a synth stablecoin. Then the synth stablecoin can be exchanged to any other synth (e.g. Alibaba stock or crude oil futures) via a smart contract. The pledger with USD 800 of cryptocurrency is the counter-party of a synth trader in the order book. The pledger earns the money lost by the trader and vice versa.
On Uniswap, an ETH pledger can only be the counter-party of an ETH long trader, whereas in synth protocols, pledged digital assets like SNX or ROG can serve as the order book for global transaction counter-parties. The pledged assets are the order book for traders who long or short BTC and traders who long or short crude oil etc. This brings huge utilization.
Besides, the locked funds themselves bring a tremendous leverage effect. See this example. In a synth protocol, a user who longs BTC has an equivalent of USD 10,000 and a user who shorts BTC has an equivalent of USD 9,000. The funds introduced in synth collateral only bear the long risk of USD 1,000. It means that USD 1,000 collateral can theoretically back a transaction volume of USD 10,000 + 9,000. What’s more, other synth targets can hedge the USD 1,000 risk exposure. Assume there is a concurrent USD 1,000 USD long risk exposure on crude oil. If BTC and crude oil move in the opposite directions, the risk of the debt pool will offset perfectly. Therefore, the more targets a synth protocol has, the weaker the correlation, the smaller the risk exposure and the higher the stability of the system.
Thus, you can see that DeFi synth protocols have the highest asset utilization and produce the most tangible effect and the highest leverage.
The Great Potential of Synths
Two years down the DeFi development path, protocols like MakerDAO and Compound have reached relative maturity. Their logic is simplistic and scalability is limited. They just add new collateral assets or optimise the original model, while synth protocols like Synthetix and Wayki-X have uncovered less than 20% of their potential.
Take non-asset transactions like sports and event predictions for example. They work like financial derivatives. There is a certain event at a certain time and the same principle behind. When Miami Heat and Lakers have a game, I can issue two synths. One is the token for Miami Heat’s victory and the other is for the Lakers’ victory. If both teams have the same odds, I assume that both tokens are worth USD 1 each. If Miami Heat win, the oracle will feed their token price as USD 2 dollars and the Lakers’ token price will become zero. I only need one oracle to realise the sports prediction easily. You can build lotteries and draws with synths like that.
A long time ago, I said that big predictions or big finance must have these four elements: an initiator, participants, a rule maker, and a result source. A perfect decentralised protocol has all four of them decentralised. A synth protocol can be this perfect protocol:
Recently, DeFi tokens had a sharp drop but DeFi does not end here. A bigger wave is waiting for us. As entrepreneurs, we should pay more attention to the meaning of the business. Only when you know the essence can you leave out the noise.