Market Crisis Analysis: DeFi Pseudo-Innovations Leading to Market Failure
TechFlow Selected TechFlow Selected
Market Crisis Analysis: DeFi Pseudo-Innovations Leading to Market Failure
As before, this bull market also ended with a sharp decline. The total market capitalization of the entire cryptocurrency market has dropped 67.5% from its peak.
Navigating Web3 tides with focused insightsAuthor: Solv Research
Author's note: Exactly two years ago, on June 15, 2020, Compound launched what later became known as "yield farming," igniting the "DeFi Summer" and a one-and-a-half-year bull market across the entire crypto industry. As before, this bull market ended with a sharp downturn. By June 15, 2022, the total market capitalization of the cryptocurrency sector had fallen by 67.5% from its peak.
We believe there are five main causes behind this market crash:
● First, global central banks tightened monetary policy.
● Second, widespread opacity in operations among centralized institutions in the crypto industry prevented timely and full awareness of accumulated leverage risks, increasing the risk of sudden market collapse and panic.
● Third, crypto economic products remain largely speculative digital assets; services and products that deliver clear value and meet real needs are rare, and consumer-oriented transformation is still nascent and has not yet become a stabilizing foundation for steady industry growth.
● Fourth, since 2020, collateralized lending has become the primary mechanism for liquidity creation in crypto markets, but this mechanism remains immature and led to a death spiral of liquidity during market declines.
● Fifth, widespread DeFi pseudo-innovations caused market failure, misdirecting significant capital into flawed projects and resulting in substantial losses.
The first issue above is macroeconomic—external to the industry—while the other four are internal. We plan to write four articles discussing these four internal factors and offering recommendations for improvement.
This article focuses on market failure caused by DeFi pseudo-innovation. While this factor played a relatively secondary role in the recent market crash, it cannot be ignored within the DeFi sector itself.
Unprecedented DeFi Decline and Market Failure
During this market crash, DeFi performed particularly poorly. As of June 15, 2022, while total value locked (TVL) in DeFi dropped 69%, roughly in line with the broader market, the market capitalizations of DeFi projects collapsed catastrophically: Uniswap lost 88.5% of its market cap, Compound fell 94.2%, and many once-prominent DeFi projects became nearly deserted with bleak prospects. Even so-called DeFi "blue-chip" projects, once hailed as the future of finance, saw declines exceeding 95%.
We argue that such a collapse in DeFi is abnormal. DeFi is the first purely on-chain application category with a clear revenue model. Compared to traditional finance and CeFi in crypto, it offers greater openness, transparency, security, and overall efficiency. For a time, many believed not only that DeFi’s breakout was inevitable, but also that its success would endure—that it could not only drive bull markets but also withstand bear markets.
Given this, why did DeFi perform especially badly during this downturn?
One critical factor that cannot be overlooked is market failure caused by pseudo-innovation—many DeFi projects, driven by distorted incentives, deliberately created complex financial assets, convoluted business logic, and opaque incentive mechanisms, flooding the market with false price signals and leading to massive misallocation of capital.
Market failure is an economic term describing situations where market mechanisms fail to allocate resources efficiently. In most cases, price signals guide participants to spontaneously adjust and optimize resource allocation. However, under certain conditions, market mechanisms fail, resulting in inefficient or wasteful outcomes.
Standard economics textbooks identify three main causes of market failure: externalities, imperfect market structure, and information asymmetry. In this case, the primary cause of DeFi market failure is information asymmetry.
Information asymmetry leads to market failure. George Akerlof demonstrated this in his paper “The Market for Lemons: Quality Uncertainty and the Market Mechanism.” In used car markets, buyers and sellers have unequal knowledge about a vehicle's actual condition. Buyers either overpay due to deception or, to avoid being cheated, offer only rock-bottom prices—rendering price signals ineffective and causing market mechanisms to break down.
Blockchain and DeFi aim precisely to reduce information asymmetry. DeFi’s two key features are permissionless openness and complete transparency—business logic and transaction records are fully visible and auditable by anyone.
If so, why do we say DeFi experienced market failure? Why link DeFi’s extreme decline to market failure?
Early leading DeFi projects like MakerDAO, Uniswap, Compound, and Aave genuinely championed openness, transparency, and reduced information asymmetry. They featured relatively simple, well-documented logic and had operated long enough for their mechanics to be widely understood.
However, in the past two years, many so-called innovations in DeFi have not leveraged technological advantages to reduce information asymmetry—in fact, they’ve actively and inappropriately created new layers of it. These pseudo-innovations failed to solve real problems and obscured DeFi’s core strengths, leading to severe market failure under intentionally manufactured information asymmetry. In DeFi investing and asset trading, investors, traders, and users allocated vast amounts of capital incorrectly. When the market corrected, these misallocations suffered far more severe losses than expected, amplifying market turmoil and triggering the collapse of DeFi project valuations.
Therefore, analyzing DeFi’s recent crash through the lens of market failure is meaningful.
Four Manifestations of DeFi Market Failure
DeFi market failure stems from newly created, deliberate information asymmetry—an idea that initially sounds counterintuitive, given DeFi’s reputation for transparency and trustlessness. DeFi advocates often proudly claim that everything—from transaction records to financial logic to code—is transparent, allowing anyone who chooses to study it to possess information equal to that of the project team.
In theory, this is true. DeFi’s technical infrastructure enforces mandatory transparency. Yet many DeFi projects, for various reasons, have recreated information asymmetry, misleading the market—intentionally or not. There are several specific manifestations of this.
● The first manifestation involves fantastical financial pseudo-innovations, masking fatal flaws with complex logic, code, and yield farming incentives.
Centuries of financial practice have produced many ingenious ideas, most of which were discarded due to serious flaws. After the 2020 “DeFi Summer” boom, thousands rushed into DeFi—many lacking relevant expertise or historical knowledge—launching DeFi projects fueled by gold-rush enthusiasm and superficial cleverness. Most of these projects lacked rigorous theoretical foundations, skipped market testing, and some even violated basic financial principles, harboring severe vulnerabilities. Their apparent success depended entirely on rising token prices or favorable market conditions. Once reality diverged—especially under extreme market stress—they quickly unraveled and were exposed in spectacular fashion.
Yet these pseudo-innovations excel at creating complexity to manufacture opacity and hide their flaws. They often use elaborate mathematical formulas to “justify” magical outcomes, then copy large portions of code from mainstream protocols, mixing, modifying, and stirring them into incomprehensible smart contract soups. During that period, we studied many such projects—many with bizarre designs and tangled code—even experienced smart contract developers like us struggled to grasp their full logic or assess their legitimacy.
Faced with such complexity, the market lacks the ability to evaluate risk, resulting in massive venture capital flowing into pseudo-innovative projects. Many secured funding and achieved high valuations. But after time passed, most were proven invalid by the market, wiping out nearly all invested capital.
Worse, to compete for funds and traffic—and to cover up weaknesses—nearly all such projects implemented highly complex yield farming incentives involving three or more asset types, deeply entangled rules, and arbitrary, frequently changing governance models. Even relatively simple operations become opaque and unpredictable when buried under such chaotic incentive structures, making evaluation impossible.
Value investors naturally avoid such projects. Project teams can only attract gamblers by building highly speculative Ponzi-like structures—deliberately blurring governance token rights and benefits, creating cascading “second pools,” “third pools,” enabling leveraged vote-buying, and encouraging multi-layered recycling to inflate nominal yields. Naturally, these high returns are unsustainable, and miners know this. One side tries to inflate the scheme as much as possible; the other acts like a shark swarm—fast-moving, scent-driven—both hoping to profit before abandoning the project instantly. This creates a vicious, deceitful game structure, diametrically opposed to DeFi’s original ideals.
Within these effectively fraudulent structures, deception becomes the explicit goal. Information symmetry becomes an illusion—how can the market function properly?
● The second manifestation is treating “governance tokens” as equity shares and equating governance token valuation with project market cap, leading to widespread capital misallocation.
To avoid being classified as securities, most DeFi governance tokens are described as having only voting or governance rights—“political rights.” But we all know these tokens are rarely used for voting and primarily serve as tradeable assets. This raises a fundamental question: How do you value a voting right? There’s no clear answer, making the actual value of these tokens extremely difficult to determine and highly volatile.
We don’t criticize this situation per se—it’s an inevitable outcome under uncertain regulatory environments. Whether such assets suffer from information asymmetry is debatable. Both project teams and traders may equally lack insight into their true value. In this sense, the asset is opaque but informationally symmetric—a better description might be price speculation on an asset whose valuation logic no one understands. That isn’t inherently problematic—Bitcoin is such an asset.
The problem lies in a widespread misleading narrative: treating governance tokens as company stock and using their market cap to represent the project’s value. This misled many investors into allocating capital to governance tokens—or even leveraged positions based on them—suffering unexpected losses. It also creates an imbalance between rights and responsibilities: project teams enjoy market cap bubbles during bull runs but bear no obligation to support token prices with real earnings during downturns.
For example, at its lowest point on June 15, Compound’s TVL remained above $4 billion, generating solid interest income. Yet the market cap of $COMP was only $212 million. If valuing the Compound project itself, many might assign a higher worth. But as a governance token, the relationship between $COMP and Compound’s underlying value is unclear, and Compound’s operational income cannot support $COMP’s price.
Such misleading narratives led many investors to believe they were investing in DeFi projects directly, when in fact they were merely buying ambiguous voting rights. When markets crashed, the healthy profitability of these projects failed to translate into governance token value, offering little market support.
● The third manifestation involves creating long chains of nested, complex structures that appear safe but are actually high-risk, sending false interest rate signals to the market.
Many DeFi projects post-2021 weren't solving real financial problems—they focused entirely on constructing assets with fake risk-return profiles. Unlike the first case, these “innovations” don’t rely on code complexity to create information asymmetry but exploit DeFi’s open infrastructure to build extremely long financial chains—often involving multiple third-party protocols and dozens of assets—layered and combined into increasingly opaque instruments. No matter how they’re packaged, these assets are fundamentally leveraged on top of highly volatile assets and are inherently high-risk. But due to their complexity, few—if anyone—can fully trace or understand their mechanisms and dynamics. Add a compelling story branding them as high-yield, low-risk innovations, and they attract massive capital inflows. Sustained long enough, they can override rational judgment.
These structures have another harmful effect: distorting the risk-free rate signal and causing pricing chaos across primary and secondary markets. Vast sums flow unknowingly into high-leverage assets disguised as safe investments, while many promising early-stage projects struggle to raise funding due to their inherent risk profiles.
We’ve seen how these assets end. When systemic correction hits, these supposedly risk-free instruments collapse rapidly and unexpectedly. Many investors who thought they were safely earning high yields suddenly find both yield and principal gone.
Such widespread misallocation of capital into hidden high-risk assets—only realizing the truth upon collapse or total loss—is a defining feature of this market crash, unprecedented in prior cycles.
● The fourth manifestation involves artificially stimulating artificial demand via yield farming and inflated APYs under competitive pressure, creating false prosperity and misleading market signals.
Since Compound’s successful launch of yield farming, nearly every DeFi project has introduced similar incentive programs. When used appropriately, such mechanisms can help projects rapidly grow user bases and achieve network effects. But yield farming should be limited to real business objectives—driving genuine usage. Once detached from real demand and used solely to incentivize artificial activity, it accumulates massive risk and fosters destructive game dynamics.
For instance, some complex derivatives protocols lacked real demand in DeFi’s early stages. Yet teams, eager to boost trading volume, engineered intense short-term incentives to create illusory growth. Without real demand, once incentives waned, volumes immediately collapsed.
A typical example: many DeFi protocols split ~4% APY from Aave into senior and junior tranches, then boosted yields to 10–20%+ using governance token incentives to fabricate high-volume illusions. This game structure was clearly unsustainable. After distributing large amounts of governance tokens, these protocols were ruthlessly dumped. Unable to build loyal user bases or accumulate operating capital through early incentives, they died as soon as yields dried up.
Learning From the Crisis
Our Recommendations: Return to Simple, Principle-Based Innovation
DeFi is destined to be a transformative force in human finance and economics. This movement entered a new cycle amid the brutal 2022 downturn. The flashy tricks and trendy concepts that once dazzled have now been exposed by the market winter. Yet in the financial universe—an environment that infinitely amplifies human flaws—they will never truly die, only hibernate. In the next crypto spring, they will re-emerge in new forms. Though the spotlight may shift to Web3, DeFi—as an essential and core infrastructure—will remain center stage. Two things are certain: First, DeFi will shine again. Second, all manner of deceptive schemes will return.
The DeFi industry must learn from this crisis to avoid repeating past mistakes. Our recommendations:
● First, promote a new philosophy of DeFi innovation: clear, simple, principled, and focused on fundamentals. The market should cultivate a culture that rejects convoluted technical showmanship, resists manipulation of human greed and fear, and despises obfuscation through unnecessary complexity as much as it despises fraud.
● Second, explain DeFi innovation through economic principles. As the latest technological tool of free-market systems, all blockchain and DeFi innovations must align with basic economic principles: solving real problems, creating real value, improving real efficiency—not just redistributing slices of the pie. Such innovations should be explainable via core economic theories—e.g., enabling finer division of labor, expanding collaboration scale, reducing transaction friction, enhancing transparency, lowering barriers to entry, or improving regulatory enforcement.
● Third, reject pseudo-innovations like “loop-mining,” “recursive staking,” and “leveraged vote-buying” that generate no real value.
● Fourth, create more transparent assets with clear valuation frameworks—such as debt instruments—and correct the mistaken narrative equating governance tokens with equity. Reduce active, deliberate leveraging on opaque assets like governance tokens.
● Fifth, establish industry-wide stress-testing mechanisms—for example, simulating markets on testnets—and encourage or require DeFi projects to undergo stress tests to evaluate performance under extreme market conditions.
We know: Crypto and DeFi markets will never fully escape the foolish behaviors driven by human greed and fear. But we also believe DeFi will not stand still. As this industry’s thirteen-year evolution proves, as long as we honestly confront our problems and learn from our mistakes, we can make real progress—and do better next time.
Join TechFlow official community to stay tuned
Telegram:https://t.me/TechFlowDaily
X (Twitter):https://x.com/TechFlowPost
X (Twitter) EN:https://x.com/BlockFlow_News
Solv Protocol
