Victor Ugochukwu · Dec 14, 2020 . 5min read
Is DeFi Really a Bubble? History will Decide
Many have said it's just a hype and like the 2017 ICO bubble, it will burst. But is DeFi really a bubble? Have a look at the data from Dune Analytics
By Victor Ugochukwu · Jul 30, 2020 . 12min read
Nothing short of a “meteoric rise” is the fitting term to describe the growth of the DeFi sector in 2020. An innovation otherwise called open finance has allowed its users to experiment as well as earn. The gains recorded just within the first half of the year has attracted the institutional eyes and criticisms. Many have said it’s just a hype and like the 2017 ICO bubble, it will burst. But is DeFi really a bubble?
This question will elicit different responses depending on your school of thought should you decide to wade into the debate.
Famous figures like Bill Gates and Warren Buffet have dismissed Bitcoin and other cryptocurrencies calling it a greater fool’s investment. But beyond the criticisms, we have seen profound advancement in the area of finance with blockchain technology.
The figures that matter
Data from Dune Analytics shows a total number of DeFi platform users are 275,998. This the total figure when you consider platforms like MakerDAO, Compound, Aave, Synthetix and the rest.
Another critical factor is the present capitalization with respect to the overall market cap of the cryptocurrency industry. As at 23rd July, Messari reported a $4.1 billion market cap of the overall DeFi market. Comparing this with cryptocurrency industry overall market cap and you get:
Active Ethereum addresses have been growing significantly over the years. And since Ethereum is the number one blockchain fuelling the DeFi growth, it’s safe to assume that part of this uptick in active Ethereum addresses is associated with the DeFi boom. However, a more in-depth look at the chart below from Glassnode shows the metric in consideration is still yet to match the ATH of Jan17, 2018. For those who may not know, this was the glory days of Ethereum during the ICO bubble that climaxed in January of 2018. The active number of Ethereum addresses reached 700,017 then. And of course, ETH was priced as much as $1,271 per unit.
The Concerns as to DeFi being a bubble
The rise and fall of COMP governance token
The common denominator in most of the DeFi projects is their native token as a tool for governance. Protocol users decide how they want their platform to run. Their holdings of the native token give them this power. Compound Finance, one of the leading DeFi protocols having released their governance token, the COMP saw a sharp rise in price. However, not even DeFi governing token like COMP could defy gravity. From its ATH at $372, price correction continues even till date. It has seen a correction XX% as it is $132 as at press time. This kind of horrific rise and drop contributes to the scare and the categorization of DeFi growth as a bubble. Aave, another leading DeFi platform, recently released its governance plan and the future swap from LEND to AAVE, we may be expecting another similar pattern if history doesn’t prove otherwise.
PE ratios for DeFi Governance Tokens
PE ratio means the $x the market is willing to pay for every $1 generated by the company. We understand DeFi protocols like to call themselves decentralized, which is right in the technical sense when compared with legacy financial systems. But finance tools like PE ratios help to understand if a particular company’s share is overvalued. In this case, we focus on the native tokens, which are either directly distributed to participants in the ecosystem or used to burn the native token to drive scarcity.
The chart below shows the PE ratio for selected DeFi governance tokens.
PE ratio is calculated in units of years, which can be interpreted as the number of years of earnings it would take to pay back an asset’s purchase price. From the chart above, the lesser the calculated PE ratio, the healthier the firm. The higher the PE ratio implies most of the DeFi protocols may be overvalued. They would, therefore, take investors a more extended period to make what they invest in the companies if we are to regard these decentralized protocols as firms. However, when compared viz-a-viz with traditional companies like Netflix and Amazon, even MakerDAO seems to be doing well.
Vitalik’s recent view on DeFi users underestimating smart contract risk
Even the poster boy of Ethereum network, Vitalik Buterin thinks DeFi hard fans may be underestimating smart contract risks. In a recent Unchained podcast interview, he said
“I think one big one is just that a lot of people are underestimating smart contract risk.”
Therefore, like those with absolutism mindset about DeFi and decentralization as the silver bullet to all centralized financial woes, Vitalik had this to say:
“DeFi is still fine, but don’t act like it’s a place where you should advocate for a lot of regular people to put their life savings into.”
bZx flash loan exploits by hackers and the Bancor bug which led to the network shutdown are ready examples corroborating Buterin’s claims.
Perhaps there are the elements of a bubble in the sudden growth of DeFi in 2020. Still, the fact remains that legacy financial systems and their abysmally low-interest rates continue to give the impetus for DeFi to keep growing as an alternative to their long-held hegemony.
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