A look back on major developments (good and bad) in the last year
by Chris Powers
Despite 2022’s market carnage (#1 on this year’s list), DeFi remains a strong brand that is embraced by projects big and small. It’s still a catchy rallying cry for a transparent, global, and digitally-native financial system.
Unfortunately, the crypto meme is in very bad shape in the eyes of normies; it’s pretty hard for DeFi to grow when anything crypto is labeled a scam. Yet this will pass. In the meantime, there’s still a lot of work to be done to propel DeFi forward, from the infrastructure (#4) to app layer (#5), all the way to basic market structure (#3). Through it all, 2022 may be most remembered as the year where DeFi regulatory conversations – particularly around stablecoins (#2) – became much more serious.
The memes
1. Market collapse(s)
It’s been a straight line down for nearly all crypto assets and DeFi metrics in 2022. This was punctuated by two major implosions: first the fall of Luna and the Terra stablecoin, and then, just last month, the massive fraud at FTX. Yet neither of these struck at DeFi’s core. The FTX collapse actually renders a stronger case for non-custodial exchanges and a transparent loan book. Terra’s failure, meanwhile, concluded that algorithmic perpetual motion machines are a fantasy.
The ignored narrative is that the market collapse did not lead to a DeFi protocol failure. DeFi, in fact, performed flawlessly, in contrast to March 2020 and Black Thursday. Still, the massive decline in ETH and huge stablecoin outflows greatly reduced DeFi TVL and fee-generating abilities. This has slowed investment into the space, and made any product launch an uphill battle. This, however, could be a healthy development, by encouraging longer periods of building rather than trying to rush out products and ideas before the music stops.
2. Regulation
It’s fitting that in a jam-packed year of regulatory scrutiny, just this week Elizabeth Warren dropped a bombshell piece of legislation. This proposed law is an all out assault – KYCing all wallets and literally going after node operators – that has very little chance of passing. And this seems to be the theme of all proposed regulatory changes: they go nowhere. We admit to being a bit naive in believing that the bipartisan appeal of crypto would translate into legislation. What is true this year is that regulators have smartened up to the in’s and out’s of DeFi and the crypto ecosystem.
Nowhere is this more true than for stablecoins. The large centralized ones (Tether, USDC, and BUSD) are getting so big that they’re now being considered as a shadow banking arm, with potentially hidden systemic risk to the global financial system. Meanwhile, the blowup of stablecoin Terra makes us wonder if regulators will pay closer scrutiny to anything claiming to be $1.00. For the industry, this means stunted growth (see chart below, supply dwindling even before the market fall) and a shift towards “safer” centralized stablecoins like USDC and BUSD, and away from Tether. Still, the long-term tailwinds on stablecoins are strong.
Looking at the current market chaos and regulatory confusion, it’s hard to imagine that something won’t be done, but regardless we’re bracing ourselves for another year of regulatory stagnation. While it may seem obvious that a shift is needed, regulatory clarity around DeFi and stablecoins will likely move at a glacial pace.
3. Cosmos, appchains, and modular blockchains enter the DeFi arena
At its beginning, DeFi was only on Ethereum mainnet, then in 2020 and 2021 expanded to other EVM-compatible chains, including Layer 2s. This lowered costs for users but had the same composable market structure as Ethereum mainnet. In 2022, with DeFi’s advances and bottlenecks, the industry began to explore entirely new infrastructure. Cosmos has been around for years now, yet only in 2022 did it finally build up the ecosystem of wallets, blockchain explorers and DEXs to offer an experience on-par with more established blockchains. As we explored in our Cosmos deep dive in April, its defining feature is its ability to bridge different blockchain networks, which is built into the network itself. Projects to watch next year: Agoric (which supports smart contracts written in JavaScript) and Archway (which distributes incentives to developers directly from smart contracts).
dYdX, one of the oldest DeFi projects, bolted for Cosmos this year and launched its own chain. It now offers free transactions for unexecuted orders, and optimized its validator set to store the orderbook. dYdX was arguably the first successful appchain, a competing vision to the composability-centric EVM model. Now, many are suggesting that all major DeFi protocols, like Uniswap, will inevitably launch their own appchains.
This vision has been furthered with the rise of modular blockchain design, which we examined in detail in November. This vision has not reached fruition, but received a lot of attention in 2022. Celestia and Polygon Avail are two new blockchains that have been created to address the issue of data availability through the use of modular blockchain architecture. Unlike existing blockchains, these networks don’t verify transactions, but instead focus on ensuring that new blocks are added to the network through consensus and are available to all nodes. Celestia’s first partners demonstrate potential use cases: dYmension (allows rollups to issue tokens and choose a data availability layer), AltLayer (high-throughput ‘disposable’ rollups, where NFTs are minted and then bridged to an L1), and Eclipse (rollups using the Solana VM and the IBC Protocol).
4. The entrenchment of MEV
MEV professionalized in 2022. Yes, there are still anonymous developers combing the dark forest, but it’s now seen as the playground of the most sophisticated traders in the world. Flashbots, the starring character in the MEV saga, grew even more successful in 2022 with the shift to PoS (nearly 90% of Ethereum validators are running MEV-boost). Yet with this success also came a realization of the centralization and censorship threats from this market design.
The status quo – with Flashbots as a trusted intermediary – isn’t sustainable. What’s clear, as we investigated in our deep dive just last week, is that the MEV arena will move off of Ethereum and onto a standalone network that can balance the benefits of MEV profit extraction and the need to democratize and decentralize that market.
Flashbots’ answer is SUAVE, an entirely new blockchain for block building on any chain. It’s ambitious, but not dissimilar to competing efforts to limit MEV extraction from CoW Protocol through batch auctions, or Chainlink’s Fair Sequencing Service. All recognize that transaction ordering is crucial to ensuring blockchains retain their credible neutrality and limit rent extraction.
5. Where are the cool, new DeFi apps?
Dose of DeFi launched in June 2019, just when people and projects started congregating under the DeFi banner. 2020 was a coming out party, with validation of the core concepts. 2021 and 2022 saw a rush of new projects and funds into the system, but as we said in March’s “Has DeFi innovation stalled?”:
It’s surprisingly hard to point to a major DeFi innovation in 2021 that can compare to the likes of the Uniswap launch (November 2018), Synthetix (January 2019), MakerDAO multi-collateral Dai (November 2019), Curve (January 2020), COMP farming (June 2020), or YFI governance distribution (July 2020).
It appears that the most important and promising DeFi projects right now were almost all launched more than two years ago.
This perspective, while not completely inaccurate, focuses entirely on the app layer, or the end-user experience. It sells DeFi short in our opinion, because it treats it like fintech, which is just a modern application wrapper (and meme!) for the traditional financial system. DeFi is bigger than the app layer. It also includes an infrastructure layer and a market structure layer. And in those areas, as the #3 and #4 memes of 2022 show, there’s been an awful lot of progress. The current slot of DeFi apps were built on the infrastructure and market structure of crypto in 2018. And while the industry spent 2022 researching and building the next generation of DeFi infrastructure and market structure, more progress will be needed before innovation can move back to the app layer.