"Efficiency is doing things right; effectiveness is doing the right things." - Peter Drucker
Introduction
In the ever-changing world of DeFi, and more broadly Blockchain and Web3, exploring the digital economy can be an exciting yet sometimes challenging adventure. For investors and tech enthusiasts, staying ahead in this fast-paced industry requires more than just keeping up with the latest trends; it demands a deep understanding of what truly drives success.
One crucial element that has emerged as a guiding light for prosperity in this digital realm is Capital Efficiency.
Understanding the special features of capital efficiency has become incredibly important for anyone looking to thrive in this world, whether you're seeking insights to enhance your investment strategy or a tech enthusiast wanting to dig deeper into the inner workings of Web3.
In this article, we embark on a journey to unravel the importance of capital efficiency in the DeFi protocolos and some of its sectors. We'll not only explore what it means but also why it has become the key measure of success in different protocols ahead of typical metrics that many use to measure their success.
As we navigate the complexities of the “open finance” understanding capital efficiency will be your guiding star.
We are gonna keep it simple for this one:
🔍 Why seek capital efficiency and not others
📈 Efficient Protocols within:
DEXs
Lending
📊 Metrics and Ratios for Measuring Efficiency - A guide for you to do it.
Why Capital Efficiency?
Let’s be clear, there's no shortage of metrics and performance indicators to consider when evaluating the success of a project. But why is capital efficiency, among all these metrics, the one that smart investors and developers are increasingly prioritizing? Let's delve into the reasons behind this strategic shift.
🎯 Simplicity and Focus: Capital efficiency narrows down the evaluation process to one core question: How effectively is capital being utilized? This simplicity allows for a more focused approach when comparing projects, making it easier to identify the most promising ones.
🛡 Risk Mitigation: Optimizing capital efficiency goes hand in hand with risk mitigation. Efficient projects tend to be less exposed to market volatility and operational risks. This is crucial in a space known for its unpredictability.
📝 Note: Capital efficiency doesn't eliminate all risks and, in certain situations, it might introduce an additional layer of risk for a protocol. For instance, in the cases of Restaking and Liquid Staking, while capital efficiency is higher, it can give rise to leverage-related and systemic risks due to the unique nature of these tokens. We'll dive deeper into this later.
🌱 Sustainable Growth: Efficiency is a competitive advantage. In the long run, projects with high capital efficiency are more likely to achieve sustainable growth. They can allocate resources wisely, avoiding excessive spending or waste, which often leads to project longevity and success.
💼 Investor Confidence: As the industry matures, investors are becoming more discerning. They look for projects that can demonstrate not only innovation but also the ability to manage resources efficiently. High capital efficiency can instill confidence in investors.
DEXs | Efficient Protocols
The most saturated category in DeFi hosts a large number of protocols that could honestly be considered unnecessary and inefficient. Most of these projects are forks of previous successes, such as Uniswap, GMX, Curve and Solidly. Often, these protocols incorporate additional functionality or are simply deployed on an emerging chain in an attempt to attract early adopters and capture liquidity
For context:
1º category by number of protocols been built.
3º category by combining the aggregated TVL of all protocols
We see DEXs engaging in intense competition, where numerous protocols are vying for the same capital using incentives. However, these incentives frequently result in a simple rotation of funds into established tokens like stablecoins, ETH, or wBTC. It's evident that we require a fresh approach, one that outperforms previously ineffective or suboptimal methods. What's needed are protocols that can optimize efficiency for every dollar entrusted to their smart contracts. Features like:
Concentrated liquidity (Range AMM) - Uniswap
Stableswap AMM - Curve
Hybrid orderbook-AMM DEX - Woo
Proactive Market Maker (PMM) - DODO
Dynamic Distribution AMM - Maverick
All of these projects are at the top, generating the highest trading volumes within the DEX category.
When Concentrated Liquidity was initially introduced, it swiftly transformed these protocols into a more efficient means of utilizing the capital deployed in the pools. This efficiency can be quantified using the metric: volume/TVL.
💡 When you offer concentrated liquidity, you'll only need to supply the principal for trading within the chosen price range. This means you can earn the same fees with less capital. Capital efficiency quantifies this leverage, indicating how much additional capital you'd need to deposit in a full range position to earn an equivalent amount of fees
The most successful DEX, which also is the one that pioneered CL, is Uniswap with its V3. In terms of volume generated across all DEXs it turns out that within the Top 5 by volume 3 of them use some kind of CL that turns its efficiency much higher than other AMM’s style.
🦄 Uniswap v3 ($3.381b in TVL)
Volume (7d) → $5.637b (91.8% of all Uniswap volume)
Volume/TVL → 0.81 (the higher the most efficient a AMM is with the capital)
🥯 PancakeSwap AMM v3 ($291.21m in TVL)
Volume (7d) → $949.45m (62% of all PancakeSwap volume)
Volume/TVL → 0.96
🏔 Maverick ($41.21m in TVL)
Volume (7d) → $869.59m
Volume/TVL → 3.4 (impressive to be honest)
The way Maverick achieves that 3.4 ratio is by introducing a new dimension to liquidity concentration: a Dynamic Distribution AMM where liquidity providers can stake a range and decide how their liquidity should adjust as prices change. The Maverick AMM smart contract automatically shifts liquidity with each swap, allowing LPs to make the most of their capital, regardless of price fluctuations.
DODO’s case ($31.69m in TVL), which has the highest capital efficient ratio of them all (3.48) is similar to Maverick’s case with a novel implementation called Proactive Market Maker (PMM) which is a market-making mechanism that predicts market and economic changes and adapts accordingly. These adaptations involve adjusting asset ratios, liquidity depths, fee rates, and various other metrics, but being honest Helen Huang from Messari is gonna explain it more in depth than me.
Volume (7d) → $513.95m
Volume/TVL → 3.48
Lending | Efficient Protocols
Unlike traditional financial systems where centralized intermediaries dictate the rules, DeFi embraces decentralization and automation. Borrowers and lenders interact directly, and capital flows freely in this permissionless world. However, this decentralization comes with its unique dynamics, and it's here that capital efficiency becomes not just an option, but a necessity.
In DeFi, borrowers need to provide collateral, and this collateral must exceed the amount borrowed, introducing a peculiar quirk into the lending equation. It's in this environment that the lending protocol's efficiency shines. Imagine a scenario where a user must lock up a significant amount of assets just to borrow a fraction of that value. It's easy to see why efficient capital utilization becomes paramount.
As we delve into the world of lending efficiency, with a spotlight on Utilization Rate, Borrowing and Lending Interest Rates, and Collateralization Ratio, we uncover the keys to a harmonious DeFi experience. These metrics are not mere numbers; they are the cornerstones of trust, security, and opportunity.
💡 In lending markets the higher the token efficiency the higher the collateralization ratio of it, which is one of the most important metrics if not the most (as it allows us to leverage at one level or another, which means we can get more or less for our money).
I prefer to gauge a token's efficiency by considering the following factors:
Market liquidity
Token nature (Liquid Staking Tokens, interest-bearing tokens, etc.)
Integration with other protocols
It's worth noting that a lower efficiency of tokens used as collateral leads to a decreased utilization rate in the protocol, and conversely, a higher token efficiency usually results in a higher utilization rate. We can see this statement in play if we look at which tokens are deposited the most in the Top markets:
Aave v3
🥇+52% of deposits are $wstETH (LST earning interest)
🥈+14% of deposits are $wBTC
🥉+52% of deposits are $wETH
Compound
🥇+52% of deposits are $wBTC
🥈+26% of deposits are $wETH
🥉+5% of deposits are $wstETH
Spark
🥇+60% of deposits are $wstETH
🥈+16% of deposits are $sDAI (DAI at 5% APY)
🥉+9% of deposits are $rETH (LST earning interest)
The trend is clear: users prefer to borrow using high-quality assets as collateral. These assets are characterized by high liquidity, low volatility and the ability to generate interest while being held as collateral. Examples of such assets include rETH, wstETH and sDAI
💡 Liquid Staking brings a dual benefit: it allows for capital lending while simultaneously generating passive income. This presents a valuable opportunity for DeFi users, as it eliminates the dilemma of choosing between locking capital in staking or seeking lending opportunities. Instead, it combines both strategies within a single asset.
Which platforms offer the best rates, and how do they compare?
Fortunately for me, who writes this, and for you, who reads it, there is a protocol that offers the best from the best. Morpho
Specifically, it improves Aave and Compound (for the moment) by offering better interest rates for both lenders and borrowers through a Peer-to-peer mechanism , as opposed to the Peer-to-pool of the other protocols. Without going into more detail, as I already did in my Twitter (follow me if you don't do it yet), this mechanism offers an efficiency improvement when connecting lenders and borrowers. That's why if we compare Morpho's markets with the others, we will get better deals (in general) than other markets:
Utilization rate - 53.5% (Active Loans / Net Deposits)
Collateralization Ratio - Same as Compound and Aave (it can benefit from what Compound and Aave offers like E-mode)
Borrowing and Lending Interest Rates - Same as Aave & Compound but when the engine match liquidity P2P it offers better interest for both parties 👇
Metrics and Ratios for Measuring Efficiency.
Ratios hold the power to distill complex data into meaningful insights, offering a sharper view of efficiency. While metrics provide valuable information, they can sometimes fall short in delivering a comprehensive understanding. Some ratios I like to use:
DEXs: Taking Uniswap as an example and using TokenTerminal for analysis
Volume/Marketcap or TVL: Compares trading volume to Total Value Locked (TVL) in DEXs, reflecting how efficiently capital is being utilized
Fees/TVL: This ratio highlights the effectiveness of a protocol in generating fees relative to the total value locked within it. It quantifies how efficiently the protocol utilizes its locked assets to generate revenue.
Fees/Volume: showcases the proportion of fees earned by the protocol in relation to its trading volume. It provides insights into the revenue generation efficiency based on the trading activities occurring within the protocol.
Lending Markets: Taking Aave as an example and using TokenTerminal for analysis
Asset Utilization Rate (Loans Taken/Net Deposit or TVL): This metric calculates the proportion of assets being actively borrowed compared to the total assets deposited in a lending protocol. It's a key indicator of how effectively a lending platform maximizes the use of its deposited assets
Loan-to-Value (LTV) Ratio: Calculates the ratio of the loan amount to the collateral's value. It's crucial for assessing the safety of lending and the risk associated with the borrowing market. You can use Warden to see the LTV of borrower’s positions.
I hope you've found this article enjoyable and gained valuable insights to enhance your DeFi journey. I encourage you to stop looking for the “shiny thing“ and start looking into that protocols that do things for onboarding the next billion people. That's where the capital is gonna flow.
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