Are there still Alpha opportunities in the DeFi market?
Declining DeFi
Decentralized Finance (DeFi) was once the starting point for the development of the blockchain world and an important pillar of on-chain liquidity. However, since the total value locked (TVL) in the DeFi sector reached a historical peak of over $180 billion in 2021, the DeFi track has begun to decline due to a series of black swan events. Although the recent surge in inscriptions and factors like ETFs triggered a new bull market at the beginning of this year, as of August 2024, the total TVL of DeFi has fallen back to around $40 billion, far from its peak.
From the user's perspective, the initial DeFi market was full of Alpha opportunities. Whether it was liquidity mining, lending, or the emerging on-chain derivatives market, users were offered substantial returns. For example, during the summer of 2020, liquidity mining annualized returns reached hundreds or even thousands of percentage points, leading to a massive influx of capital. However, since 2023, with the rise of narratives like DePIN, RWA, and AI, the DeFi story has gradually faded from view, becoming a forgotten part of the rotation in the crypto world. As the overall narrative of DeFi has weakened and remained unchanged, intense competition within the industry has severely shrunk user returns, further exacerbating capital outflow. Currently, the annualized returns of lending protocols have dropped to 5%-10%, a significant decline compared to earlier periods.
DeFi is becoming a red ocean market, with many DeFi protocols struggling to develop. For instance, Fuji Finance and Gro Protocol, which were once highly regarded, have ceased operations due to difficulties in maintaining operations. Meanwhile, different blue-chip DeFi projects face various challenges. Protocols like Uniswap and Curve have seen daily trading volumes drop by over 50% from their peak, while Aave and Compound are struggling to address debt crises and yield distribution issues. MakerDAO is attempting to innovate its lending system by introducing RWA assets and launching a new NST stablecoin to capture market growth.
Regardless, when investors look back, they find that the vast majority of the DeFi ecosystem struggles to attract new capital and users due to outdated narratives and a lack of innovation in products. At this stage, market participants' attention is often focused on more mature markets, making it difficult for investors to find new Alpha opportunities.
"Looking Forward"
However, if we "look forward," if a DeFi ecosystem possesses a more novel narrative capability, a more innovative product system, and is significantly undervalued while still in its early stages, it will undoubtedly be a new treasure for discovering Alpha opportunities. In this direction, we believe that Pencils Protocol, a leading project in the Scroll ecosystem, is one of the few examples that meet the above criteria.
Pencils Protocol itself is a comprehensive ecosystem that provides financial services such as auctions and yield aggregation. Users can capture on-chain native yields through methods like Farming and Vault (an advanced strategy library), while the protocol also supports users in capturing additional pre-market rewards, including a series of points. In addition to being able to combine with various LSD protocols, it can also serve as a liquidity underlying facility. Furthermore, its novel sections, including Shop and auctions, allow users to further explore yields through NFTFi, RWA, etc., and retain multifunctional interfaces for combinations with more narratives.
While the vast majority of DeFi protocols continue to build their DeFi systems around DEX, lending, and perpetual derivatives in the red ocean market, Pencils Protocol is no longer confined to the framework of classic DeFi protocols, making significant breakthroughs in both product and narrative, and aiming to burst into the blue ocean market.
Since Pencils Protocol entered the market, it has continuously achieved highlights. Just a few months ago, it secured $2.5 million in funding at a valuation of $25 million from top investors including OKX Ventures, Animoca Brands, Galxe, Gate.io Labs, Aquarius, Presto, and Agarwood Capital, as well as several individuals including Scroll co-founder Sandy Peng, V Fund partner Ashely Xiong, Inception Capital co-founder David Gan, Cyberconnect founder Ryan Li, and Arcanum Capital co-founder Lucia Zhang.
In September, Pencils Protocol received a new round of strategic financing at an $80 million valuation from well-known investment institutions such as DePIN X, Taisu Ventures, Black GM Capital, and Bing Ventures.
At the same time, Pencils Protocol has also joined a series of official plans in the Scroll ecosystem, including Scroll Sessions. The project has maintained a high level of attention in the crypto market.
Pencils Protocol's TVL has also soared with the progress of the market, especially from July 22 to 23, when its TVL skyrocketed from $200 million to $300 million within just 24 hours, breaking the historical record of DeFi protocols achieving capital growth on a single chain. The valuation represents expectations for the ecosystem's development potential and imagination, while the market's valuation of the emerging Pencils Protocol, which is still in its early development stage (not yet TGE), is clearly undervalued.
Let us delve deeper into Pencils Protocol and seek potential Alpha opportunities.
Pencils Protocol's Product Sections
As mentioned earlier, Pencils Protocol is not a DeFi platform focused on a single function but has built a multifunctional comprehensive service platform that encompasses numerous basic and novel functions, providing a series of returns for investors in various ways. The product sections of Pencils Protocol include Farming, Vault, Auction, and a series of expansion functions.
Farming
Farming is a pre-market incentive yield market with leverage characteristics. This section mainly involves staking assets to provide users with multiple incentives in different points. Users staking different assets will receive varying effects in points. Currently, the assets supported for staking in the Farming section mainly include several categories: ETH LRT tokens, BTC LRT tokens, and stablecoins.
Some potential pre-market points that can be mined include: Pencils Protocol's points, Pencils Points; Scroll chain's points, Socrll Marks; Eigenlayer's points, Eigenlayer Points; and points from some LRT projects like Stone Points, Kelp Miles, Puffer Points, Etherfi Loyalty Points, Solv XP, Mind XP, etc. The multiples for different tokens vary from about 1x to 8x, allowing users to achieve a "one fish, multiple eats" effect with high efficiency.
Thus, from Pencils Protocol's perspective, it provides staking direction incentives for LRT assets in a combinable manner, encouraging more users to participate in LRT protocol staking. From Pencils Protocol's viewpoint, by supporting staking incentives for various LRT assets, it quickly attracts potential holders of these projects and assets.
On the other hand, from the perspective of pre-market incentives, this field is currently in an early growth stage, with a series of pre-market incentive trading markets emerging, including Whales Market and Pendle. Leveraged pre-market incentive output like Pencils Protocol is highly popular and attracts attention. Currently, staking is the main section open in Pencils Protocol, and under the promotion of this section alone, its single-chain TVL can achieve explosive growth and quickly surpass $300 million, making it not only the project with the highest TVL in the Scroll ecosystem but also firmly positioned at the top of the LRT track and pre-market incentive market. Currently, Pencils Protocol can still provide various pre-market incentive rewards in a leveraged manner, allowing users to continuously capture numerous Alpha opportunities in this direction.
Vault
The Vault section is a native yield market centered around a liquidity mining model, but it further incorporates leverage factors into the original LP model, allowing users to obtain LP yields multiple times through borrowing + leverage.
The Vault section connects to the staking pool, supporting users in borrowing assets from the staking pool. Meanwhile, the Vault 1.0 version will connect to the liquidity pools of various DEXs in the Scroll ecosystem, allowing users to become LPs through liquidity mining and capture liquidity mining yields.
In this model, users can achieve higher returns with less capital through leverage and only need to pay a portion of their earnings as interest to Pencils Protocol. Additionally, early active participants in Vaults can not only receive basic rewards for deposit staking and LP staking but can also obtain high multiples of points and token rewards, significantly enhancing user participation in the Vault section.
Users can borrow funds through the vault to increase their returns. For example, users mining ETH-USDC LP:
- Users hold a small amount of USDC and can choose to borrow more USDC.
- The vault allocates assets as 50% ETH and 50% USDC.
- These assets are deposited into the DEX liquidity pool, and rewards are obtained after staking the LP tokens.
The interest on the borrowed funds will be automatically deposited into the staking deposit pool to pay depositors' rewards. The Vaults pool releases funds by evaluating principal and leverage multiples, effectively ensuring the safety of depositors' funds. Unlike classic lending protocol models, there is no liquidation risk for the funds themselves.
By connecting with various DEX liquidity pools, the Vault can continuously provide liquidity services to these DEXs, significantly improving the quality of liquidity captured by these DEXs and lowering the threshold. Meanwhile, on the staking side, funds deposited in the staking pool will be further mobilized, greatly increasing the utilization rate of these funds, especially for various LRT assets, which can effectively capture liquidity in the Scroll ecosystem and better establish a value circulation system for these LRT ecosystems.
In fact, in the previous two market cycles, representative yield aggregation platforms like Yearn Finance and Alpaca Finance emerged. The former had an early market valuation between $3 billion and $5 billion, while the latter's market cap was around $1 billion at its peak. Before the appearance of Pencils Protocol's Vault product, there had been no pioneering yield aggregation platform. The Vault product is deeply bound to the LRT market and pre-market incentive market, providing users with a series of yield capture tools through leveraged mining.
In the long term, the Vault will focus on user asset management as its main development direction, such as integrating more quality assets and launching various asset yield methods like on-chain delta-neutral strategies, on-chain synthetic yields, and on-chain exotic options to further broaden yield channels. Based on the valuations of Yearn Finance and Alpaca Finance, the valuation of the Vault product section alone is highly promising.
It is also worth noting that the Vault section, backed by hundreds of millions in TVL, will have a massive business volume, and it plans to continuously use 20% of its revenue for buybacks and burning of $DAPP tokens, which will provide a foundation for the sustained rise in token value.
Overall, from the perspective of the Vault section, many of its designs are quite novel and form differentiated competition with other DeFi protocols. The competition across different dimensions can not only bring high-speed growth momentum to Pencils Protocol and provide continuous and considerable income for the platform but is also expected to become an important entry point for users to explore Alpha opportunities.
Auction
The auction is one of the core functions of the Pencils Protocol section, including LaunchPad functionality and the auctioning of NFT and RWA assets.
In fact, Pencils Protocol was initially positioned as a LaunchPad, inheriting a series of advantages from the Scroll underlying layer to build a quality asset launchpad for the Scroll ecosystem. Users can discover quality assets and good projects in the Scroll ecosystem through this LaunchPad platform, while project parties can leverage the large user base of the Pencils Protocol ecosystem to capture users, capital, and attention more broadly, further achieving early launches of the ecosystem. From the perspective of the Scroll ecosystem itself, most quality projects in the ecosystem have not yet undergone TGE (including the Scroll project itself), such as Kelp DAO, which collaborates closely with Pencils Protocol. Therefore, as the largest and earliest LaunchPad platform in the Scroll ecosystem, Pencils Protocol is expected to become an important value entry in this direction.
In addition to the conventional LaunchPad functionality, Pencils Protocol has further introduced auction functions for some RWA and NFT assets. This functionality can derive a series of scenarios, such as some real-world assets being RWA-ified or NFT-ified, which can be expanded to a broader user base through auction functions to enhance the efficiency of value circulation. At the same time, the entire process can ensure fairness based on the transparency of contract execution. Similarly, some assets with certain value but lacking liquidity can also be further endowed with liquidity through auctions.
The auction function can expand to various scenarios and achieve combinations while reserving interfaces for the ecosystem to expand towards broader narratives (Web2 + Web3).
Expansion Functions
Pencils Protocol has also built some expansion functions aimed at better driving the ecosystem's value flywheel. Currently, there are mainly two directions: one is the points system, and the other is the Shop function.
- Pencils Points System
The points system is centered around Pencils Points, which records user behavior, such as contributions to ecosystem development (joining the community for construction and helping with ecosystem promotion and marketing, etc.), using a series of platform functions, and issues Pencils Points to users as an incentive to encourage them to participate in ecosystem construction.
From the perspective of Pencils Points themselves, they are not just a pre-market incentive asset, as they can be used to redeem the ecosystem token $DAPP after TGE. Holding these points also grants a series of ecosystem rights, including:
- More token allocations and discounts for projects launched on Pencils Protocol in the future.
- Purchasing various items, NFTs, and virtual or physical goods through the Pencils Protocol Shop.
- Obtaining higher leverage positions in the Pencils Protocol Vault.
- Priority access to Pencils Protocol airdrops.
Thus, from the perspective of the points system itself, the points will promote and incentivize more users to join the ecosystem, driving users to contribute to the ecosystem and use the platform's products, further expanding the user base. The platform's development will continuously empower the points in terms of value across multiple dimensions, significantly enhancing the effectiveness of incentives, thereby increasing user stickiness and achieving a positive value cycle.
- Shop
The Shop section is also an innovation point for Pencils Protocol. The Shop section will launch some non-standard quality assets for ecosystem users to purchase. The asset types in the Shop section are quite broad, including some NFT assets (game items, rights cards, artworks, collectibles, etc.), RWA assets (traditional financial products, auction assets, etc.), and even some physical assets. The Shop function allows the Pencils Protocol ecosystem to expand into more directions, including gaming, social, traditional finance, and other potential fields, becoming a new comprehensive Web3 trading window.
When users use Pencils Points to redeem or pay with $DAPP tokens, they can receive some discounts, further broadening the application scenarios for Pencils Points, $DAPP tokens, etc., while bringing considerable revenue opportunities to the ecosystem.
Pencils Protocol's Narrative Potential
Ecosystem Moat
In fact, the Pencils Protocol ecosystem has built a relatively wide moat for its long-term development. We believe the elements of this moat system include novel narrative capabilities, bilateral network effects, and the platform's revenue-generating ability.
- Novel Narrative
As mentioned earlier, each product section of Pencils Protocol has differentiated and innovative designs. For example, in the Farming and Vault sections, it breaks the conventional DeFi framework, allowing users to leverage Farming to mine quality points while also enabling risk-free borrowing models to achieve leveraged mining. In either direction, users can achieve "twice the result with half the effort," providing good liquidity effects for the B-side.
For sections like Auction and Shop, they further reserve interfaces for combinations of DeFi with potential fields like SocialFi, GameFi, and RWA, continuously broadening the narrative direction of DeFi through new combinability and attracting users and capital from external markets rather than solely focusing on the classic DeFi red ocean market.
- Bilateral Network Effects (Dual Value Flywheel)
The bilateral network effects of Pencils Protocol are reflected in two aspects: one is the mutual promotion and growth between the Farming section and the Vault pool, and the other is the mutual promotion between Pencils Protocol and external liquidity markets.
From the first perspective, the Farming section essentially acts as a borrowing pool for different assets, continuously promoting the depth of the pool through highly attractive incentive mechanisms. For example, it currently supports users in mining pre-market incentive points through leverage, attracting users to continuously stake LRT assets in the pool and mine pre-market incentive points through leverage.
From the Vault pool's perspective, the better the asset thickness and depth of a single asset Farming pool, the better the borrowing experience for users on that asset (liquidity, cost), and the higher the potential leveraged mining returns for users, which in turn provides higher yield distribution for that asset in the Farming pool. Thus, the "Farming side" and "Vault side" are in a bilateral network relationship, forming an internal value cycle flywheel.
From the second perspective, there is a bilateral network relationship between Pencils Protocol and external liquidity markets.
From the perspective of token liquidity markets, the "Farming side" of Pencils Protocol serves as the liquidity entry, while the "Vault side" serves as the liquidity exit. Users stake assets through the "Farming side" and leverage mine through the "Vault side," impacting external liquidity markets (DEX, etc.).
For project parties, they prefer users to provide liquidity for their tokens through the Vault pool (especially since leveraged mining can bring double liquidity effects) to establish a healthier token market.
Project parties may adopt measures such as providing better incentive effects for Pencils Protocol's "Farming side" and "Vault side," calling for more community users to join the staking in the "Farming side," etc. The increase in the scale of staking in the "Farming side" is expected to further promote the income of "Vault side" users, thereby motivating users to leverage mine in the "Vault side" based on the project token, bringing better liquidity effects for the project token. This process will also continuously drive up Pencils Protocol's TVL.
Thus, the DeFi section of Pencils Protocol and external liquidity markets will continue to generate bilateral network relationships, forming an external value flywheel.
The internal value flywheel and external value flywheel will continuously achieve mutual promotion and empowerment effects. As an important liquidity engine in the Scroll ecosystem, Pencils Protocol will continuously gain value increments.
Therefore, we see that even in its early stage (only the Farming section is open), Pencils Protocol's TVL can reach $300 million, and with the opening of the Vault product, the dual flywheel operation is expected to continue to soar.
- Platform Profitability
Each section of Pencils Protocol has certain profitability. In the early stages, it will focus on DeFi product sections, including Farming and Vault sections.
In the Farming section, when users stake and withdraw rewards, the platform will charge a small fee. Just from the current $300 million TVL (dynamic staking and withdrawal), it can already generate considerable income for Pencils Protocol.
In the upcoming Vault section, whenever users earn income from leveraged mining and future strategy library products, the platform will take a portion of that as its income. It is worth noting that the income captured by users through the Vault section comes from the external ecosystem of the platform rather than a zero-sum game. For example, providing liquidity for different liquidity markets on Scroll (which will be multi-chain in the future) to earn mining income. Therefore, whenever the Vault section brings profits to users, the Pencils Protocol ecosystem will gain value increments and income.
Especially as the aforementioned dual value flywheel system accelerates, the profitability of Pencils Protocol's DeFi section will continue to enhance.
In addition to the DeFi section, Pencils Protocol's Auction section and Shop section also have certain expectations for sustained profitability.
From the Auction section's perspective, Pencils Protocol itself is the asset launcher for the Scroll ecosystem, providing launch services for quality projects in the ecosystem and is also one of Pencils Protocol's main businesses. Currently, the Scroll ecosystem is still in its early development stage, with many quality projects that have not yet undergone TGE, and the Scroll ecosystem is still in a rapid growth dividend period. As an important value hub in the Scroll ecosystem, Pencils Protocol provides launch services for numerous quality projects, offering users a channel to participate in quality project launches, which will provide extensive direct income opportunities.
Moreover, as a platform that gathers investor attention, by continuously empowering the auction, Shop, and other sections, this attention value will also help Pencils Protocol explore more additional business models and continuously capture income from a wide range of potential markets, including RWA.
Compared to the vast majority of DeFi ecosystems, Pencils Protocol's revenue structure is layered, diversified, and broad. These considerable revenues will continuously provide momentum for the ecosystem's development.
Overall, the novel narrative, bilateral network effects, and considerable profitability are helping Pencils Protocol build a relatively wide value moat, which is the most important foundation for the ecosystem's narrative potential.
Token Expectations
Pencils Protocol currently does not have TGE, which means it is still in an extremely early market stage, and users are more focused on the incentives of Pencils Points. Of course, we can make an early expectation for the $DAPP token.
- Application Scenarios
The $DAPP token itself has many functions. In addition to governance, it can directly relate to users' rights and earnings.
Pencils Protocol has set up a native staking plan for the $DAPP token (to be launched after TGE), allowing token holders to stake $DAPP in Pencils Protocol Farms to receive proof of rights token $pDAPP at a 1:1 ratio. Holders of $pDAPP can obtain subsidies by staking $pDAPP or provide liquidity for $pDAPP on DEX.
In the Vault section, users who want to obtain more points incentives, higher leverage multiples, priority access to exclusive features, and richer strategy products need to stake $DAPP tokens. On the auction platform, sellers wishing to launch assets on the platform must stake $DAPP tokens to prevent malicious activities.
In terms of utility, Pencils Protocol is also planning to integrate the $DAPP token into various DeFi products, including liquidity protocols and lending services, allowing users to optimize asset allocation by providing liquidity, borrowing, or participating in staking, and receive additional rewards from these activities. At the same time, holding $DAPP tokens will further accelerate the rights attributes of Pencils Points holders, allowing them to obtain better income distribution based on different Farming methods, thereby promoting deeper community participation and loyalty.
In the Shop section, users can use $DAPP for margin trading of NFTs, RWA assets, points, and derivatives, thereby expanding the utility and application of their assets within the Pencils Protocol ecosystem.
Thus, from the perspective of application scenarios, the $DAPP token itself has a very broad necessity. Users can convert their holdings, staking, and use of $DAPP tokens into earnings and rights. The broader the business scope of Pencils Protocol, the stronger the necessity of the $DAPP token.
- Token Burn
Pencils Protocol plans to continuously burn $DAPP tokens through platform revenue. Currently, it has been clarified that 20% of the revenue from the Vault section will be used to burn $DAPP tokens. Other sections also have set burning mechanisms, which will contribute positively to promoting the deflation of $DAPP tokens based on their profitability.
Therefore, from the perspective of the application system and the burning plan, the continuous necessity and deflation will continuously boost the value of the $DAPP token, which has good long-term market expectations.
Valuation
Pencils Protocol is a comprehensive platform that encompasses liquidity mining, staking, lending, yield aggregation, auctions, and many other features. The product itself spans multiple tracks and can expand into various tracks such as GameFi, SocialFi, and RWA based on a series of functional sections. Given its narrative, product functionality, overall development potential, wide ecological development moat, and explosive growth in capital and user numbers, it is expected to become a blue-chip in this bull market from a comprehensive DeFi service ecosystem direction.
To better reflect the valuation of Pencils Protocol, we selected representative Alpha blue-chip projects from different tracks in the last two bull markets for comparison.
Yearn Finance
Yearn Finance is the original yield aggregator. Based on its total managed assets (TVL), the number of developed strategies, community participation, and integration with other DeFi projects, Yearn Finance's TVL once exceeded $4 billion, and its entire ecosystem was once valued by the market between $3 billion and $5 billion. From the perspective of tokens, YFI's market cap approached $2.5 billion at its peak.
Uniswap
Uniswap is the largest DEX in the last two bull markets. During the bull market, Uniswap's daily trading volume exceeded billions of dollars. Based on its platform's trading volume and liquidity pool size, as well as its foundational role in the DeFi ecosystem, its ecosystem valuation was once assessed by the market at $20-30 billion. Its token UNI reached a market cap of $22.5 billion at its peak.
Sushiswap
Although SushiSwap was initially a fork of Uniswap, it quickly established a presence in the DeFi space through rapid innovation and community-driven development. In addition to traditional AMM (automated market maker) functions, SushiSwap has expanded products including Kashi (lending market), BentoBox (universal liquidity pool), and Miso (decentralized issuance platform). Considering the ecosystem scale and innovation capabilities, SushiSwap's valuation during the bull market was believed to be between $5 billion and $10 billion, and at the peak of the bull market, the market cap of $SUSHI approached $3 billion.
Aave
Aave is a leader in the DeFi lending sector. Based on the scale of lending on the platform, the usage rate of innovative products like "flash loans," cross-chain expansion capabilities, and its widespread adoption in the entire DeFi ecosystem, its valuation is around $15-20 billion. Its token $AAVE exceeded a market cap of $6 billion at the peak of the bull market.
Lido Finance
Lido is one of the largest liquid staking service providers. Based on its staking market size for Ethereum (at the peak of the bull market, Lido controlled over 30% of the Ethereum staking market share) and the platform's growth potential, Lido's ecosystem valuation reached $10-15 billion, and at the peak of the bull market, its token market cap once approached $10 billion.
The aforementioned blue-chip DeFi markets focus more on a single field and have long maintained their leading positions in their respective tracks. It cannot be ruled out that the impact of the Federal Reserve's unlimited QE on the crypto industry has caused some leading projects to be overvalued. Considering the fundamentals and business aspects of Pencils Protocol, its ecosystem's potential valuation is above $10 billion. In comparison to the peak valuations of the aforementioned project tokens, the $DAPP token's market cap is conservatively expected to be above $5 billion. Therefore, currently, the valuation of the Pencils Protocol ecosystem is severely undervalued, and the market performance of the $DAPP token after TGE is still worth looking forward to.
Conclusion
From the overall development history of the DeFi track, DeFi has also experienced the fermentation of narratives in 2020, the rapid bubble of asset prices in 2021, and the disillusionment phase after the bubble burst in 2022. Currently, with the full validation of product and market fit, it is emerging from the low point of narrative disillusionment, building its intrinsic value with actual business data.
DeFi itself is one of the few tracks in the crypto field with a mature business model, and the market space is still growing. It continues to hold long-term attention and investment value, but the narrative direction of this track needs further innovation.
Pencils Protocol is setting a good example. As a representative of the new DeFi narrative system, it is backed by a layered and differentiated product system, a broad narrative direction, and long-term expected profitability. It has gradually revealed its potential in the Scroll ecosystem. With the comprehensive launch of the ecosystem and multi-chain expansion, Pencils Protocol is also expected to become a new unicorn in this field.
From the investors' perspective, by creating a comprehensive and innovative yield system ecosystem, it is becoming the best entry point for investors to "look forward" and continuously capture Alpha opportunities in the post-DeFi era. For more information: Official website: pencilsprotocol.io/; Official Twitter: x.com/pencilsprotocol