Coin Metrics’ State of the Network: Issue 223

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By: Tanay Ved & Matías Andrade Cabieses


Lending’s roots date again to 3000–2000 BC in historical Mesopotamia, when the capital-intensive nature of agricultural society (and a non secular elite hungry for wealthy and numerous harvest) impressed the want for loans, typically collateralized with cattle, agricultural implements, and treasured metals. Though monetary devices have considerably advanced and diverged from these early types, these practices persist as basic pillars of world financial enlargement. These origins underscore the enduring significance of collateral as a threat pivot, safeguarding lenders in opposition to borrower defaults. The 2008 monetary disaster—exacerbated by subprime mortgages backing collateralized debt obligations (CDO’s)—infamously evidences the crucial of meticulous collateral evaluation for a strong and resilient monetary system. 

In immediately’s monetary markets, frequent types of collateral vary from actual property and capital belongings like equipment, to monetary securities like equities and treasuries or company bonds. Every asset class carries a definite threat profile, considerably influencing the structuring of mortgage agreements, together with rates of interest and Mortgage-to-Worth (LTV) ratios. Technological developments have prolonged the venerable establishment of lending onto public blockchains akin to Ethereum, the place digital belongings function main types of collateral. Whereas decentralized finance (DeFi) lending functions like Aave and Compound have unlocked vital advantages and efficiencies, in addition they introduce distinctive threat vectors, as elaborated in our current report DeFi’s Double-Edged Sword.

However, the clear nature of public blockchains has enabled steady, real-time monitoring of DeFi protocol steadiness sheets, affording a novel benefit in due diligence. On this subject of State of the Community, we use a mixture of Coin Metrics’ Community Information (DeFi Balance Sheets) and Market Data to evaluate predominant types of collateral in DeFi, inspecting their distinctive threat traits to grasp what makes collateral roughly fascinating.

What are the Predominant Collateral Sorts in DeFi?

Inside peer-to-pool programs akin to Aave and Compound, capital equipped by lenders is aggregated into liquidity swimming pools, embodied by sensible contracts. Debtors have interaction with these swimming pools by offering collateral to safe loans. To safeguard in opposition to defaults, these protocols stipulate overcollateralization, guaranteeing that the collateral worth exceeds the worth of debt. This setup affords an extra layer of safety to lenders, even throughout unstable market situations. 

Source: DeFi Balance Sheets

Since the instantiation of these protocols, the complete worth of deposits has elevated to round $20B at their peak in 2021. Nevertheless, together with prevailing world macroeconomic situations and an total droop in digital asset markets, deposits on Aave and Compound have fallen to $3.3B and $1.6B respectively, as individuals search greater yields from much less dangerous securities, akin to US Treasuries. Regardless of this ebb in exercise, we will take this second to guage the use of collateral throughout these protocols all through the bull/bear cycle.

Source: DeFi Balance Sheets

The chart above exhibits the breakdown of liabilities (deposits) for the Aave and Compound protocols as of August 30th. Amongst digital belongings used as collateral, three main classes emerge: Stablecoins, Wrapped/Staked belongings and Mission/Decentralized Autonomous Group (DAO) tokens. These asset varieties differ in goal and traits, akin to conventional types of collateral like money and securities as in comparison with illiquid belongings like real-estate. 

  • Stablecoins: Stablecoins function a steady retailer of worth and medium of change amongst a number of different use circumstances, providing an identical degree of certainty to money. 

  • Wrapped/Staked Belongings: Wrapped/staked tokens perform as “derivatives” of their underlying belongings, usually to allow compatibility with one other blockchain community or utility. For instance, wrapped ETH (WETH) is an ERC-20 token that represents the worth of ETH for use in DeFi protocols. Equally, stETH is a token issued upon staking ETH, representing possession of the stake offered. This class of tokens are overwhelmingly used as collateral and are inherently on-chain native. 

One other class of collateral that’s more and more gaining utilization is real-world belongings (RWA). RWAs embrace the illustration of bodily and conventional monetary belongings on the blockchain. MakerDAO is an instance of a DeFi protocol with a collateral base increasingly composed of RWAs, akin to US Treasuries. 

Some vital components that assist guarantee protocol solvency are parameters akin to Mortgage-to-Worth ratios (the quantity that may be borrowed in opposition to deposited collateral), and liquidation thresholds (which sign under-collateralized positions). Though at outset influenced by elements like liquidity and volatility, they’re usually adjusted via governance proposals, which suggests they might be gradual to adapt to exterior market situations after issuance of a mortgage. In the following sections, we’ll assess the liquidity and volatility traits of every collateral sort to gauge their desirability on the collateral spectrum.

Volumes, Liquidity & Slippage

To successfully handle credit score and manipulation dangers, DeFi protocols should take note of liquidity indicators and prevailing liquidity situations that exist each on-chain and off-chain. Buying and selling volumes are an necessary market issue to contemplate when figuring out collateral high quality, because it signifies how actively traded is an asset, serving as a proxy for liquidity. The aggregated 30-day spot buying and selling quantity by collateral sort showcases stablecoin dominance in buying and selling exercise. At the moment about $11.5B (> 90%) of buying and selling quantity is in stablecoins, as in comparison with $345M for wrapped/staked belongings and undertaking/DAO tokens. Stablecoins, significantly Tether (USDT), are sometimes employed as quote belongings on centralized exchanges in opposition to different crypto belongings—contributing to greater volumes.

Source: Coin Metrics Formula Builder

Going a step additional, we will get a extra granular view of an belongings liquidity profile by market depth. The chart under shows the order guide depth of chosen DAO tokens inside 2% of the mid-market value in USD throughout main centralized exchanges, together with Binance and Coinbase. In different phrases, it showcases how a lot of the asset must be purchased or offered to maneuver the market value by 2%. Given the low market depth noticed, it is clear that governance tokens are comparatively illiquid with solely about $400k in bid depth required to trigger vital market influence.

Source: Liquidity Metrics

Skinny liquidity noticed amongst these tokens also can translate to elevated slippage. Slippage happens when there’s a distinction between the anticipated value and precise value for a bid/ask order. That is significantly necessary in the context of liquidations on lending protocols. Heightened market volatility may cause customers’ positions to change into under-collateralized, thereby triggering a liquidation the place liquidators promote the collateral asset to repay the debt. As seen under, there have been circumstances when slippage skilled on a $100k promote order could be very excessive for tokens like CRV and UNI. As seen in November 2022 when CRV collateral on Aave was in focus as a result of an tried exploit, slippage on CRV ask orders was at 14%—drastically impacting profitability for liquidators and threatening solvency. Because of this overcollateralization is so necessary.

Source: Liquidity Metrics

DeFi protocol parameters akin to Mortgage-to-Worth ratios, liquidation thresholds and bonuses—usually adjusted manually by way of governance—can issue on this information to adapt dynamically to altering liquidity situations. This could defend lenders and the protocol itself from incurring unhealthy debt.

On-Chain Dominance of Wrapped/Staked Belongings

Together with liquidity indicators it is also essential to contemplate the venues the place these belongings are primarily traded. Belongings like wrapped Ether (WETH), wrapped Bitcoin (WBTC) and staked Ether (stETH) are largely on-chain native, with a big presence on decentralized exchanges. At the moment, 68% of WBTC buying and selling quantity is on decentralized exchanges (DEX’s) like Uniswap & Sushiswap—a characteristic that has prevailed via most of its historical past. Moreover, WETH additionally has a dominant presence on DEX’s as seen here

Source: Coin Metrics Formula Builder

Most of staked Ether (stETH) liquidity is present in Curve Finance’s ETH-stETH pool. Though the token has a robust secondary market, notably as the top-deposited token on Aave V2 ($1.1B in deposits), its on-chain liquidity seems to be deteriorating whereas its presence on centralized exchanges is comparatively rising. Stablecoins akin to USDC and DAI even have a big on-chain presence as a result of their utility as collateral and as a quote asset for buying and selling pairs on decentralized exchanges. The Curve 3Pool has been a serious supply of liquidity for these Stablecoins traditionally.

Volatility Traits

Understanding the volatility of collateral can be a vital issue because it instantly impacts credit score threat. Fluctuations in the worth of collateral will increase the threat of under-collateralization and probability of liquidations, incurring further prices for each debtors and depositors whereas additionally probably affecting the wider ecosystem. To grasp the distinct volatility traits, we will discover the realized volatility distribution of constituent belongings broadly used as collateral. Stablecoins exhibit the lowest volatility, reflecting their design to take care of steady worth outdoors of outliers like Frax and TUSD. On the different finish of the spectrum, median volatility for DAO tokens lies at 90%, indicative of larger value sensitivity.

Moreover, a realized volatility index (weighted by market capitalization) supplies a standardized measure of volatility over time, validating our findings from the distribution above. Regardless of variations in magnitude, volatility amongst collateral belongings tends to be extremely correlated throughout time. This raises necessary issues for threat administration and portfolio diversification, since assumptions that volatility and liquidity throughout belongings and asset lessons are independently distributed seems to not maintain true. Implications for liquidations are additionally price contemplating, as collateral being liquidated can in flip have an effect on correlated belongings, probably resulting in cascading liquidations and impoverished liquidity throughout the board.

This evaluation showcases the distinct traits and threat profiles of collateral utilized in DeFi lending protocols. As portrayed via elements like buying and selling quantity, liquidity and value volatility, it’s evident that these belongings varieties differ broadly on the spectrum of desirability as collateral. Due to this fact, it’s necessary for stakeholders and customers of DeFi protocols to be conscious of the collateral utilized and their associated traits.

Apparently, regardless of the real-time information accessible to DeFi protocols, most mortgage parameters to-date depend on information set with massive delay. In different phrases, immediately as soon as a LTV is ready for a mortgage, it’s encoded on-chain for the life of the place. Future iterations of DeFi protocols would possibly profit from dynamically adjusting these parameters in response to altering market situations.

Moreover, an evaluation of the possession focus, provide dynamics and nuances of DAO based mostly governance are additionally vital elements to contemplate which we hope to cowl in future editions. Nevertheless, it is clear that efficient threat administration in DeFi requires a holistic understanding of exterior market situations, thereby impacting the potential to dynamically adapt to always altering market situations.

Supply: Coin Metrics Community Information Professional

Ethereum energetic addresses rose 11% week over week to 488k per day. Bitcoin every day energetic addresses additionally rose 6%. MKR switch worth rose 141% week over week, after MakerDAO founder Rune Christiansen proposed a reimplementation of the Maker protocol on “NewChain”, a fork of Solana. This is able to mark a major change for one of the oldest DeFi tasks on Ethereum. Ethereum co-founder Vitalik Buterin was fast to react, selling half one million {dollars} price of MKR and suggesting “MakerDAO is torpedoing itself in weird directions.”

Coin Metrics Updates

This week’s updates from the Coin Metrics crew:

  • Try the newest subject of Coin Metrics’ State of the Market that includes a brand new web page with DeFi Steadiness Sheet metrics to maintain tabs on lending protocol well being

  • Coin Metrics was recognized as Wealth & Finance’s finest crypto information firm (USA) of 2023

As at all times, when you have any suggestions or requests please let us know here.

Coin Metrics’ State of the Community, is an unbiased, weekly view of the crypto market knowledgeable by our personal community (on-chain) and market information.

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