The decentralized finance ecosystem’s key performance metric, the Total Valued Locked (TVL), took a significant hit in 2022. It lost $127.57 billion during the year, declining from $166.78 billion at the start of the year to $39.21 billion.
The 76.49% decline was the most recorded since the industry’s inception.
Total Value Locked (TVL) is the sum of the value of all assets deposited in a DeFi product. While the Total DeFi TVL has trended down in 2022, however, the new floor sits far above the level seen before the most recent bull market.
DeFi yield rates and DeFi TVL are connected. Investors can contribute funds to DeFi protocols and receive a return on their investment. Investors rush to put money in DeFi protocols when yields are high to receive lucrative returns. At the same time, investors would also divert their funds to other possibilities, where they can earn higher returns when yields are low.
At the beginning of 2022, the median DeFi yield experienced a significant decline, and shortly afterwards, the DeFi TVL experienced a significant decline. We can therefore conclude that the reason for the crash is as a result of the decline in DeFi product yield rates.
DeFi 101: Decentralized Finance, or DeFi for short, is the name of a new financial system based on blockchain technology that runs without the assistance of traditional financial intermediaries like banks and governments. Decentralized and open-source applications that are built on smart contracts and operate on blockchain networks like Ethereum are used in DeFi to carry out financial transactions.
No matter where you live or how much money you have, DeFi wants to make financial services more accessible, transparent, and secure for everyone. Due to its potential to upend conventional banking and grant financial independence to people who have been shut out of it, DeFi has drawn a lot of interest in recent years.
The DeFi industry has experienced rapid expansion in recent years. The total value locked in DeFi protocols first topped $1 billion in 2020, and it has been steadily increasing ever since. The total value locked in DeFi protocols exceeded $60 billion by the end of 2021, demonstrating the rising interest in and acceptance of DeFi among both institutional and retail investors.
The growth of DeFi has been driven by several factors, including the increasing demand for decentralized financial services, the rise of yield farming, and the launch of new protocols and applications that offer new financial products and services. Yield farming, in particular, has been a key driver of growth in DeFi, as it allows investors to earn high returns on their investments by lending, borrowing, and staking digital assets.
What Caused the Crash: Several interconnected factors contributed to the ups and downs in DeFi yield that we observed over the 2020–2022 crypto market cycle, along with the boom and bust in TVL that followed. The increase in US inflation brought on by the US government’s aggressive monetary expansion strategy was one of the cycle’s main drivers.
One of the greatest groups of cryptocurrency owners in the world is American, and they have a comparatively high level of purchasing power. Because of this, Americans have a disproportionate impact on the cryptocurrency markets.
To offset the economic downturn brought on by the Covid 19 outbreak in 2020, the US government printed money with stimulus packages. That year, the quantity of US dollars increased by 26%. Due to increased consumer spending power and increased demand, prices for products and services increased. As a result, inflation shot up dramatically in 2021.
To avoid inflation as it increased, savvy investors purchased risky assets like growth stocks and cryptocurrencies. The story went like this: “Inflation is making my money worth less. I must invest in assets that are increasing in value more quickly than inflation.” Due to the stimulus, retail investors had more money to spend, which led them to invest more in riskier assets.
As a result, demand for cryptocurrency increased significantly. Crypto token costs skyrocketed. Rising cryptocurrency asset prices increased the value of the tokens investors received as a yield through DeFi protocols. The harvest was therefore more valuable. Inflation was fueled by monetary expansion, which raised the cost and yield value of crypto tokens. Defi protocols received funding to profit on that yield. The bull market got going in full force because of this process.
Sadly, the good times weren’t meant to last, as the US Federal Reserve increased interest rates in 2022 as a result of excessive inflation. Investors and consumers were then compelled to cut back on spending when interest rates are high because borrowing money is more expensive. Investors move money from other assets into treasuries because high-interest rates also result in greater treasury yields. The Fed’s objectives of reducing spending and combating inflation were met. However, the action of the Feds decreased token prices, which decreased DeFi yield and ultimately the ecosystem’s TVL.
Terra Chain’s Crash: Terra chain gained a lot of traction from late 2021 into early 2022. Terra’s most popular product was a stablecoin called UST, which was backed by the chain’s native token, LUNA.
The cause of this growth was that Terraform Labs deployed a massive incentive program in the form of Anchor Protocol. Users could deposit their UST in Anchor to earn a fixed 20% savings rate. The Anchor Reserve Fund heavily subsidized the yield. A small portion of the yield came from interest paid by borrowers on the Anchor lending market and the rewards from staking borrower’s collateral. This incentive resulted in Terra seeing a huge influx of users and capital who wanted this impossibly good, fixed savings rate.
Unfortunately, while this may have seemed a good idea, however, backing a stable asset with a volatile endogenous asset (one originating from the same system) proved unsustainable.
In early May 2022, UST lost its peg and started trading below $1 following a weekend of large UST sales. UST holders could redeem their UST, which was worth less than $1, for $1 worth of LUNA. As more users redeemed and the supply of LUNA rose, its value fell. In the following week, UST and LUNA holders race to exit their positions. As the price of UST fell, more Luna was printed. As the price of Luna fell, confidence in UST was decimated. The resulting death spiral shot the value of both tokens to ~0.
The crash of Terra’s ecosystem wiped $20B of TVL out of DeFi. At its peak, right before the crash, Terra had a 15% market share. The effects of this collapse echoed throughout the rest of the year. The Terra contagion contributed to the failure of multiple centralized crypto businesses, such as Celcius and Voyager, that mismanaged their risk and were not prepared for a downturn.
What You Should Know: Maker accounted for most of the Collateralized Debt Position (CDP) TVL in 2022. In early 2020, at that time, getting DAI as a loan against crypto collateral was the best DeFi option for borrowing against cryptocurrencies. In December 2022, Maker held 15% of all the TVL in DeFi.
In 2022, the Liquid Staking category attracted considerable market share, primarily driven by the success of the Lido Protocol. On blockchains that use Proof of Stake (PoS) consensus, validating nodes stake the blockchain’s native token to earn the right to process blocks of transactions and win block rewards. Liquid Staking protocols allow users to stake the native assets of a blockchain in exchange for both staking rewards and a tradeable tokenized representation of the staked position. This got traction and hence saw Lido Protocol’s rise.
The Ethereum blockchain accounted for $23.26 billion of the TVL at the end of 2022. This represents approximately 60% of the total TVL at the end of 2022. Binance came in second, accounting for 10.53%, representing $4.13 billion.
Bottomline: The rapid growth of DeFi and the hype surrounding it led to a high level of speculation and irrational exuberance, which created a bubble that eventually burst. This was then compounded by the fact that many DeFi protocols and projects were not fully developed or tested, which led to technical issues and outages that further eroded investor confidence.
The crash of 2022 served as a wake-up call for the industry, highlighting the importance of regulatory compliance, technical stability, and the need for more sustainable growth. The DeFi space has since matured, and many protocols and projects have taken steps to address the issues that led to the crash, which has helped to restore investor confidence and pave the way for a more sustainable future for DeFi.