IOSG Report: A New Financial System Will Be Built on Rollups
A Deep Dive Into What Comes Next for DeFi
By: Momir Amidzic •DeFi Research
- After five years of expansion, the DeFi market is largely consolidating around the winners in each sector.
- With the lack of new primitives, multichain DeFi became the main narrative with most chains replicating the Ethereum DeFi map.
- While the multichain narrative combined with saturated Ethereum led to increased activity on other chains, large capital holders have shown a strong preference for safety. The largest Ethereum protocol Curve.fi alone still has more TVL than the aggregated TVL of all the apps built on top of Avalanche and Solana
- On the other hand, more scalable chains led to the inclusion of user groups priced out of Ethereum. However, the contribution of such users to the general on-chain activity is rather marginal.
- Nevertheless, it is clear that none of the monolithic blockchains in their current forms are able to support the global adoption of DeFi.
- In the long term, we expect most applications to be built on top of rollups which are the only solutions that could eventually support billions of users in an economically sustainable way without sacrificing fundamental principles such as decentralization, censorship resistance, security, and trustlessness.
The slowing pace in DeFi innovation gives us the opportunity to step back and recap the advance of DeFi over the past five years as well as build a thesis about the future of DeFi in an environment driven by a multichain narrative e.g. solunavax.
From Birth to Adoption
In the last five years, the Ethereum DeFi has grown out of infancy.
The period from 2017 to 2018 is what we call the embryonic period of DeFi. Most leading DeFi projects such as Uniswap, Compound, AAVE, dYdX, etc. were established during that period of time.It was only in 2020 (or 2021 in the case of dYdX) that these protocols started gaining market recognition.
Source: IOSG Ventures
Looking at the DeFi map from today’s perspective, at the core, there are three main directions i.e. primitives:
- Spot DEXes,
- Lending markets, and
Today, the spot market is very saturated, with a high barrier to entry for new players, and most of the activity is concentrated around the leading protocol. What originally started with experiments around on-chain order books and constant product market makers is now filled with all sorts of trading mechanisms:
- Concentrated liquidity AMM, with Curve.fi pioneering the concept for stablecoin trading. Later, DODO, Uniswap v3 and Curve v2 expanded the concentrated liquidity approach to volatile coins, each with significantly different designs.
- AMMs supporting more than two assets in the pool e.g. Balancer’s constant mean market maker
- IL protected AMMs e.g. Bancor
- Constant product AMMs e.g. Uniswap v2, Sushiswap
- MEV resistant DEXs
- DEXs customized for small or large traders, etc.
Looking back, investing in spot market DEXs on Ethereum was a good opportunity only until late 2020. From 2021 onwards, there were several great teams entering the market. However, with the design space explored to a great extent, incremental innovations weren’t enough to capture substantial market share.
The introduction of Uniswap v3 and Curve v2 further increased the barrier to entry, rejecting additional attempts to build a DEX from scratch.
Source: IOSG Ventures, Footprint Analytics (https://www.footprint.network/chart/DEX-Trading-Volume-fp-17021)
Source: IOSG Ventures, Footprint Analytics
Money market protocols are a magnet for liquidity due to the fact that liquidity providers don’t have to assume directional exposure, but are able to earn yield with their principal being protected. Among lending protocols, two players stand out: Compound and AAVE, with more than $25B in combined TVL on Ethereum alone.
Source: IOSG Ventures, Footprint Analytics
Compared to the spot DEX sector, the design space is still relatively unexplored and new entrants could differentiate themselves by lowering collateral ratios, incorporating decentralized identity and credit scores to offer customizable terms, dynamic parameter updates, and more diverse collateral offerings (including NFT collateral), etc.
Recently, Euler and Beta Finance have made attempts to permissionlessly add assets eligible for borrowing. The practical effect of this measure would be enabling traders to short a broad range of altcoins.
Nevertheless, the existing behavior of money market borrowers suggests that users are primarily interested in borrowing stablecoins against their collateral, essentially using lending protocols to trade altcoins with leverage. This implies that introducing more diverse collateral options without increasing systemic risk should take priority over supporting a larger number of assets. AAVE v3 and Silo Finance have publicly announced plans towards working in this direction.
Source: IOSG Ventures, Footprint Analytics
Broadly speaking, synthetic assets cover several important directions such as financial derivatives, synthetic real-world assets, and stablecoins.
When it comes to derivatives, with the exception of dYdX, it is hard to claim any of the protocols has truly taken off. It is so, as most of the players in this sector have just recently introduced their first / newest version. Moreover, many of these protocols rely on scalability solutions e.g. rollups which haven’t been fully optimized at this point in time.
In a similar way it took two to three years for spot DEXes and lending protocols to reach wider market adoption, derivative exchanges built over the past 12 months may become relevant only in the next 12-24 months once the tech stack matures, and protocols find the right product-market fit.
Synthetic real-world assets (RWA) also struggled to find the product-market fit, despite having a great narrative of democratizing the exposure to the US stock markets, commodities, etc. Most of the protocols working on decentralized futures could easily incorporate synthetic RWA once the timing is more suitable i.e. when there is a more heterogeneous user base in DeFi.
Finally, decentralized stablecoins remain an area that attracts talented people throughout the years. The failure of many algo stablecoins hasn’t stopped new protocols that push the boundaries of what was considered possible.
Some of the notable (not necessarily successful) experiments in the synthetic asset direction over the recent period include::
- dYdX Starknet exchange
- Opyn’s SQUEETH
- Liquity’s zero interest rate synthetic stablecoin
- FEI’s stablecoin backed by POL
- Primitive’s Replicating Market Maker
- Ribbon’s option vaults
- Perpetual Protocol v2
- SynFutures & MCDEX permissionless futures AMM
- Deri’s everlasting options
- Pods Finance Permissionless Options AMM
Second layer DeFi protocols
In the Ethereum DeFi ecosystem, which is relatively mature compared to other Layer 1s or sidechains, second layer DeFi protocols have taken the stage in 2021. They are the second layer in the sense that they leverage composability and couldn’t exist without the underlying DeFi primitives.
In this respect, some of the DeFi primitives such as Uniswap, AAVE, Opyn or Synthetix became ecosystems on their own and attracted a large number of protocols to build on top of them.
For instance, Uniswap v3 introduced a need for active liquidity management, hence a range of protocols has been developed with the idea of optimizing liquidity provision while allowing end-users to enjoy a passive experience. Some examples are Gelato’s G-UNI, Charm’s Alpha vaults, Visor Finance, Teahouse, etc.
Similarly, Izumi Finance is building tools that help protocols launch liquidity mining incentives and achieve desired liquidity distribution on top of Uniswap v3. Such tools are not only important for the launch of new tokens, but also for the protocols using Uniswap v3 as a base layer, e.g. Perpetual Protocol v2 or Sense Finance, that will also aim to provide incentives for liquidity providers to efficiently make markets.
Tokemak and Convex are among other notable protocols that are building on top of the spot market primitives. The former one is trying to position itself as the meta liquidity aggregator, while the latter one is part of the Curve.fi ecosystem and is one of the largest shareholders of CRV tokens.
Among second layer protocols we can also classify interest rate derivatives built on top of lending protocols, insurance protocols providing coverage for the TVL on other applications, treasury management tools helping DAOs efficiently manage treasury, MEV tools, DEX aggregators, structured products, etc.
DeFi Map. Source: IOSG Ventures
Creating Sustainable Yield
Structured products have made their first breakthrough in 2021, primarily because of Ribbon finance. Ribbon is building option vaults on top of Opyn, where it is regularly underwriting options and providing passive yield to its liquidity providers. The success of Ribbon has inspired several teams to build in this direction, however, most are purely replicating Ribbon’s options vaults. Thus, structured products are still an unexplored area with vast potential going forward. We expect expansion in the structured product offering from underwriting options only to products that would incorporate different DeFi primitives such as lending markets, interest rate derivatives, perpetual futures, options, etc.
Ribbon Finance TVL Source: DeFiLlama.com
For example, Vovo Finance aims to eliminate reliance on centralized market makers, and builds principal-protected products on top of existing spot and derivatives exchanges. As mentioned above, lending protocols are able to lure billions of dollars as they provide stable yields without risking the principal of the LPs. Hence, due to the principal protection Vovo has the potential to attract significant TVL while allowing users to take leverage on their yield.
Finally, structured products have wider implications and importance for the general DeFi economy. Namely, the growing supply of capital in DeFi protocols drained the yield. For instance, at the time of writing the stablecoins APY on Compound and AAVE are generally below 3%. APR on Curve.fi 3pool is estimated at around 0.5% while including CRV mining rewards at 1.18%.
As the above protocols are DeFi versions of the risk-free rate, it is no surprise that the capital has been flooding their smart contracts and pushing yields towards the level offered by the tradFi banks.
At the current level of activity in DeFi, there is a limited opportunity to absorb the larger influx of new capital.
Federal Funds Effective Rate, Historical Data Source: https://fred.stlouisfed.org/series/FEDFUNDS
What happens if the central banks start tightening monetary policy? Assuming, that most of the new capital that entered DeFi in 2021 in search of the yields is institutional, an increase in the interest rates level would make the current TVL in DeFi unsustainable, and resultingly there would be a significant outflow of capital to the off-chain economy.
For DeFi to maintain the current level of TVL it would have to find additional sources of yield.
Currently, the yield in DeFi comes primarily from the following activities:
- Spot trading (earning yield by providing liquidity to spot DEXs)
- Demand for leverage long (lending protocols, perpetual swaps)
- Short selling demand (lending protocols, perpetual swaps)
- Yield farming e.g. borrowing a particular token that is necessary to yield farm protocol X while still maintaining exposure to collateral
- Other (generating yield as a consequence of ponzi-like economics, borrowing against collateral to support operations, etc.)
Structured product protocols have the opportunity to bootstrap new markets such as options markets, exotic products, and potentially new primitives that could attract more trading demand to decentralized financial markets, hence also the ability to absorb a larger amount of TVL (or at least maintain the current level of TVL) even in the environment of tighter monetary policy.
The multichain expansion has been the highlight of 2021, with BSC, Polygon, Terra, Avalanche, and Solana dominating the discussion. While most of these chains positioned as the competitor of Ethereum, Polygon leadership and community chose to support the Ethereum maxi narrative, even announcing an ambitious rollup roadmap and positioning as one of the leaders in the modular blockchain approach.
The main driver for the multichain expansion has been the slower progression of Ethereum native scaling solutions, which opened a window of opportunity for the competitors/sidechains to capture some of the market shares.
Although TVL has been used most widely to illustrate the activity of individual chains, the metric is somewhat flawed as often the large percentage of TVL is in the native token of particular L1, hence the price appreciation of the token naturally leads to the growth in TVL, which further leads speculators to inflate the token prices.
As The Block has illustrated below, Avalanche had the largest inflow of fresh capital.
Source: The Block
Despite the increasing activity on other chains, Ethereum is still the dominant solution when it comes to absolute TVL and the number of dApps built on top of it. To put things into perspective, the largest Ethereum protocol Curve total TVL is larger than the combined TVL of all the apps built on top of Avalanche and Solana.
Source: Footprint Analytics
Other chains lag behind Ethereum development for 12+ months. To prove secure enough for large capital providers, new chains will have to face the test of time. The perception of the risk is evident if we compare the yields on stablecoins on Solana vs Ethereum. For instance, the largest money market protocol on Solana – Solend, offers 2-3x larger APY on USDC and USDT than AAVE. This gap suggests the larger implied risk premium of interacting with the novel protocol on a novel chain.
Any chain that seeks to compete with Ethereum, will have to rebuild the Ethereum DeFi map. Hence, while the Ethereum DeFi ecosystem has been trying to explore new primitives and building vertically, most of the other L1s have been replicating the Ethereum DeFi map.
Ethereum DeFi dominance is evident also if we observe the market cap of DeFi tokens, where among the top 20 assets only 4 are non-Ethereum.
Being the pioneer in decentralized applications helped Ethereum accumulate soft power where all alternative L1s are adopting EVM compatibility in some form e.g. Avalanche’s C-chain, Polkadot’s Moonbeam, NEAR’s Aurora, Solana’s Neon, Fantom, Polygon, BSC, etc.
The emergence of well-capitalized EVM compatible chains led to Ethereum native apps expansion on multiple fronts. Sushiswap was the first protocol to champion the aggressive expansion.
It is present on 15+ chains, however, it has struggled to become the dominant DEX in the new ecosystems, where generally speaking, DEXes solely focused on one particular chain tend to attract more interest. As a result, Pancake Swap, Trader Joe, Quick Swap, and SpookySwap have positioned as the No 1 DEX on BSC, Avalanche, Polygon, and Fantom, respectively, while Sushi is generally the second-best venue. It is so, as each of these protocols are solely focused on one particular chain, hence they are able to allocate all the resources including new token rewards to attract users and build communities on the new chain, while Sushiswap has diluted attention across numerous venues.
Regardless, it is safe to say that the expansion strategy was the right choice for the Sushiswap community. More than 30% of Sushiswap’s TVL is outside of Ethereum L1, and their flexible approach helped them become the largest DEX on some of the new chains such as Moonriver, as well as the leading protocol on Ethereum’s L2 solution – Arbitrum. Finally, a significant share of Sushiswap volumes comes outside of Ethereum L1, where for example in February, around 50% of the volume was generated on other chains.
Source: IOSG Ventures Data Source: The Graph
(Non-Ethereum chains covered: Fantom, xDai, BSC, Avalanche, Arbitrum)
Part 2: Have Scalability Solutions Lived Up to Their Promise?
The main promise of the scalability solutions is to make blockchains usable for everyone. To test how well this objective has been fulfilled by alternative chains, we observe the activity on Polygon.
We use $500 as a threshold to determine smaller traders and observe on a daily basis how many of the traders fit into this category.
Charts below suggest that Polygon, indeed, managed to attract a new audience, where traders executing less than $500 transactions per day are the large majority of Polygon users (roughly 80% of the traders) while on Ethereum the same group of users is much less represented, generally, being below 30%.
Source: IOSG Ventures, Dune Analytics
Deriving conclusions based on the Polygon example, we could positively answer the question above: yes, alternative chains have lived up to their promise.
BUT, what is the real contribution of these smaller-scale traders? As illustrated below, the marginal value of these users is very low. Even on Polygon DEXes, these users daily contribute only about 1% of the trading volume, while on Ethereum they account for 0.1% of the trading volume at best.
Source: IOSG Ventures, Dune Analytics
One Whale is Worth Thousands of Turtles, 90-4 Rule
On Ethereum, whales (classified as addresses that generate $100k+ volume daily) account for less than 4% of the traders (roughly 3k addresses daily), yet they contribute almost 90% of the total volume on Ethereum DEXes.
Likewise, whales represent only about 1% of Polygon users, however, these accounts still generate the majority of the volume on Polygon DEXes, historically 74% of the total volume.
Source: IOSG Ventures, Dune Analytics
Despite in certain months, Polygon DEXs recorded the larger number of traders, the Ethereum DEXs combined still generate several times the larger volume. The primary reason for Ethereum’s dominance is not having the most users, but being the chain of choice for large capital.
Conclusively, large capital manifested in liquidity providers and traders still shows strong preferences for Ethereum, and while alternative solutions managed to provide imminent scalability, changing the public perception of safety will be a long-term process.
Source: IOSG Ventures
The End Game
When it comes to financial applications and high-value transactions, security can’t be compromised.
While some competing chains managed to create a narrative and bootstrap their own DeFi ecosystem by navigating the spectrum of blockchain trilemma, Ethereum remained focused on being decentralized and secure. The critics have, often with a reason, attacked the inflexibility of Ethereum, pointing out that with the existing level of scale Ethereum won’t be able to become a global settlement layer.
This problem led to a large level of innovation from sharding blockchains e.g. Near, Zilliqa, over app-specific chains such as Polkadot, Cosmos, to one-shard highly scalable solutions such as Solana, EOS, etc.
Nevertheless, despite each of these solutions leading to certain improvements in scaling, it is impossible to claim that any chain alone is a feasible solution for global/mass adoption. The following questions remain:
- Economic sustainability: Huge discrepancy between inflationary rewards and transaction fees bringing into question the ability to maintain low fees long term
- Scaling out: Supporting high throughput on single chains will inherently lead to increasing the requirements for node operators which will naturally exclude many from being able to keep up with the hardware requirements, ultimately resulting in a small set of trusted parties.
Secured by people for whales vs secured by whales for people
In 2022, the irony is that highly decentralized blockchains e.g. Ethereum, are the same ones that price out regular users from participating, while the less decentralized chains such as BSC, Solana, or Polygon open up the usage to the masses.
- Composability frictions: Relevant for application-specific chains and sharding mechanisms which imply a certain level of friction between different shards/chains.
The Magic of Zero-knowledge Proofs
Traditionally, blockchains achieve trustlessness by increasing redundancy and having numerous computers performing the same computation. The larger the number of computers performing the calculation the more decentralized the network, however, creating a burden on the network’s scalability.
What if it is possible to have computation performed by one computer only while still keeping the security assumptions of the most decentralized and battle-tested blockchain?
“Any sufficiently advanced technology is indistinguishable from magic.”
The modular blockchain thesis powered by rollups achieves exactly the above. Positioning on the spectrum of blockchain trilemma becomes an obsolete issue as applications in the future will be able to get the best of all three aspects: scalability, decentralization, and security.
Moreover, the modular blockchain thesis may be the largest paradigm shift in the industry, being the only feasible solution that can propel blockchain technology to mass adoption without sacrificing its fundamental principles.
Rollups can achieve scalability without having to worry about economic sustainability, scaling out, and composability frictions.
Namely, as rollups are responsible for execution-only they don’t have to worry about consensus, decentralization, and security. Moreover, one rollup could theoretically scale up to the millions of TPS without breaking the composability as it can scale across multiple shards.
Source: IOSG Ventures
The Catalyst for the Adoption of DeFi on One Particular Rollup Solution
If a new global financial system serving billions of people is ever to be fully built on blockchains, the rollups seem like the only reasonable option that can support instant transactions at low cost without sacrificing security and decentralization assumptions.
Yet, for this vision to realize will take at least 10+ years. In the meantime, rollups have to fight over the existing crypto audience and applications. What’s more, some authors predict difficulties in the short-term adoption of rollups, particularly due to the sidechains that offer extremely low fees which helped them attract lower-income users that may not be sensitive to the questions of decentralization and safety.
Nevertheless, for the larger adoption of one particular rollup solution, fees may not be the critical factor i.e. it is possible that the rollup with the lowest fees doesn’t end up with the dominant market share. From an L2 project perspective, the network effect should be prioritized over the low fees.
There are several prerequisites to achieve a network effect:
- The long-term vision should be aligned with Ethereum
- The deployment of the Ethereum mainnet code should be a smooth experience for developers
- Battle-tested technology that would make large capital providers indifferent between participating on mainnet or rollup
- Token incentives that should attract whales who are not concerned with the gas fee reduction
Fat Applications Thesis
In regards to rollups, short to medium term are relatively blurred and uncertain, with clarity on the long-term.
Monolithic chains have options to:
- Adjust their roadmap to incorporate modularity and rollup-centric approach: while some blockchains such as Near Protocol could serve well as a data availability layer, the others that are focused on execution could unlock vast potential by becoming a rollup themselves
- Rely on memetics, store of a value play…
- …or risk of becoming obsolete.
In some creative scenarios, we can even imagine some centralized exchanges such as FTX becoming decentralized, calculating ZK proofs, and posting them on data availability layers. The best thing about this technology is that it completely opens up the design space, which is not anymore limited by particular smart contract language.
In the era of monolithic chains, Fat Protocols thesis has been more than relevant where layer 1’s market cap tends to significantly outsize the combined market cap of applications built on top of it.
It is so, not only due to the speculative reasons but also because of the fundamental causes which are tightly related to the monolithic blockchains. Namely, if we value layer 1 in a similar way we value equity, fundamentally the market cap should be equal to the present value of the expected future cash flows.
For simplicity, assume a $5k transaction on Sushiswap. Sushiswap would charge a $15 transaction of which only $2.5 is accounted for the protocol revenue, while the rest is revenue of the liquidity providers. Such transaction, depending on the network congestion, could generate even more than $100 in fees for miners which would be almost 50x larger than the protocol revenue.
In such situations, it is almost impossible that protocols to capture more cash flow than Ethereum miners (although theoretically, this may happen if the average transaction size is extremely high).
Yet, the modular blockchain thesis breaks the above relationship:
- Due to superior technology we expect a much larger ecosystem of projects built on rollups, validiums, etc., and because of economies of scale associated with ZK rollups, in thriving ecosystems projects would pay minuscule fees to the security layer.
- With fixed fees charged by the base layer, the combined value of applications could become several times larger than the base layer value.
Finally, if we were to expect blockchains to host the world’s most valuable companies worth trillions of dollars it is reasonable to assume that eventually, the market cap of the base layer won’t be able to follow up with the combined value of applications/companies built on top of it.
Source: IOSG Ventures. Illustration inspired by the original Fat Protocols thesis
Momir Amidzic is a senior associate at IOSG Ventures.