Defi’s hot ball of money and an outlook for 2022

Retrospectives on defi’s capital rotation game and an outlook for 2022. None of this is financial advice.
In April 2021, Polygon announced a $150m defi incentive program, essentially giving out free MATIC tokens to incentivise users to use their decentralised applications (dApps). Since the incentives were given out in the MATIC token, the more people used the chain, the higher the price of MATIC went. The higher the price of MATIC, the higher the incentives became, again attracting more users to the chain. This positive feedback loop attracted a wave of new defi users (one of them being me) and allowed polygon to capture around 10 billion dollars in total value locked (TVL) at its peak.

Anyone who held the token on the day of the announcement till the peak of their TVL would have seen more than a 5x on their money in a short time. This to me was what kicked off the defi capital rotation game.
Ethereum vs the rest of the world
The stars aligned for alternate layer 1s
Throughout 2021, a lot more layer 1 blockchain started capturing billions of dollars in TVL. Projects like Avalanche, Fantom, Luna, Solana have all seen massive growth in 2021. To understand the defi capital rotation game, we must first understand what allowed these alternative layer 1s to thrive in the first place.

Ethereum, one of the first chains to introduce smart contracts, allowed the creation of the first wave of defi dApps (decentralised applications). It currently has a TVL of around $150 billion, a whole magnitude higher than any other chain. Seen as the most “safe” and trustworthy chain, it suffers from one major flaw, scalability.
Throughout 2021, Ethereum has been experiencing record-high gas fees, in some cases even reaching hundreds of dollars in fees for a single transaction. This simply makes it unusable for average retail investors with a small wallet. If you think about it, how decentralised can the blockchain be if the average person cannot transact on it?
Beyond its technical limitations, the speculative nature of cryptocurrencies also attracts market participants which are looking to invest in the “next big thing”. Within the cryptocurrency space, people aren’t early to Ethereum anymore. While Ethereum still has lots of potential in the long run, it simply isn’t going to 100x anytime soon. Early Ethereum users have mostly already made it back in the “Defi Summer of 2020” and these new speculators don’t want to be told to wait just so that they can double their money. As crazy as it sounds, new users want to be early, new users want to 10000x their money, and they want it now.
The Great Capital Rotation(s)
Creation of the hot ball of money, the age of “yield maxi’s”

With this understanding of Ethereum’s limitations, market participant psychology and incentive programmes, we can see that Polygon was positioned in a good time and space to succeed. However, as the size of Polygon’s ecosystem grew, it took more and more money to maintain the positive feedback loop. Eventually, incentives start to be diluted. Another wave of users, previously attracted by Polygon’s incentives, naturally start to look outwards again for opportunities.
Following Polygon’s success, Avalanche announced a $180m incentive programme. Fantom announced a 350m FTM incentive programme. One by one newer blockchain started to announce bigger and bigger incentives programmes, all trying to gain a spot in the growing market of defi. Slowly but surely, a “hot ball” of money is created. Market participants old and new, start to understand the opportunities of newer defi ecosystems. A whole new generation of “yield maxi’s” jumping from chain to chain, hoping to front-run the masses and capture as much of each chains liquidity incentives before they eventually get diluted again. 2021 was the year of “The Great Capital Rotations”
Out of luck, out of incentives
A possible bear case for defi 2022
But, this can’t go on forever, right? While most incentive programmes are successful in bootstrapping the initial liquidity on the chain, the ecosystem still has to innovate and carve its own unique space in defi. I argue that a lot of the defi activity has been hyped up by these massive programmes, eventually, the incentives will run out, and what happens then?
In 2021, market participants were spoiled by a constant inflow of incentive programmes. First, it was Polygon, then Avalanche, then Fantom. But I’m not too sure if this can continue in 2022. For a defi ecosystem to be truly sustainable, these layer 1s have to find innovative ways to create “sticky” liquidity and create flagship products that are uniquely theirs.
In the mid-long term, more innovation has to start happening on these blockchains (beyond just forking Uniswap). Until then, we are stuck playing musical chairs with each other in this capital rotation game.
A multi-chain future
New chains such as Harmony one, Atom and NEAR have already started to gain traction in the first week of the year.

As Ethereum’s scaling solutions continue to be delayed, and alternate layer 1s continue to develop, it seems more and more likely that a multi-chain future will play out. I think we will see existing layer 1s start to carve out their own niches in the space, whether it be NFTs, gaming etc. Like it or not, we cannot ignore the billions of dollars in alternate layer 1s.
Through at least the first half of 2022, I expect chains that continue to incentivise new users to do well. Besides new layer 1 chains, I think that cross-chain infrastructure will likely do well in 2022. As more and more chains appear, it makes sense that protocols building out cross-chain adaptability will become more and more important.
Closing thoughts
In the short term, I think open-minded “yield-maxi’s” that understands how the capital rotates will continue to be rewarded in 2022. As alternate layer 1 blockchains start to find their footing in the space, more and more infrastructure will be built to promote cross-chain adaptability. While I’m cautious about incentives running out, I am bullish defi in the long-term and can’t wait to see what it will become in the future.
Reference
https://blog.polygon.technology/the-defiforall-fund-a-150m-defi-fund-db34f66be3ec/ (Polygon’s incentive announcement)
https://defillama.com (Infographics from defillama)
https://readmedium.com/avalanche-foundation-announces-180m-defi-incentive-program-d320fdfafff7 (Avalanche’s incentive announcement)
https://fantom.foundation/blog/announcing-370m-ftm-incentive-program/ (Fantom’s incentive announcement)
https://twitter.com/HsakaTrades (Twitter user @ HsakaTrades)