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 liquidity in the on-chain world. 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 have sparked 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 crypto world’s sector rotation. As the overall narrative of DeFi has weakened and remained unchanged, severe internal competition within the industry has led to a significant shrinkage of 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, and many DeFi protocols are 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 increments.
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look back, they find that the vast majority of the DeFi ecosystem struggles to attract new capital and users due to outdated narratives and a lack of innovation in products.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"
But if we "look forward," if a DeFi ecosystem possesses a more novel narrative capability, a more innovative product system, and is significantly undervalued in its early stages while continuously having incremental growth, it will certainly 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. Additionally, it can serve as a liquidity underlying facility, combining with various LSD protocols. Furthermore, its novel sections, including Shop and auctions, allow users to explore yields further through NFTFi, RWA, etc., and retain multifunctional interfaces for combinations with more narratives.
While the vast majority of DeFi protocols continue to build their systems around DEX, lending, and perpetual derivatives in the red ocean market, Pencils Protocol breaks free from the classic DeFi protocol framework, making significant breakthroughs in both product and narrative, and aims 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 leading capital 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 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 series, especially from July 22 to 23, when its TVL skyrocketed from $200 million to $300 million in 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 and early-stage (not yet TGE) Pencils Protocol is clearly undervalued.
Let’s explore Pencils Protocol in more depth and seek potential Alpha opportunities.
Pencils Protocol's Product Sections
As mentioned above, 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 yields 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 leveraged characteristics. This section primarily stakes assets through Staking and can provide users with multiple different point incentives. Users staking different assets will receive different point effects. 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 of points obtained from staking different tokens vary, ranging from about 1x to 8x, allowing users to achieve a "one fish, multiple eats" effect with high efficiency.
From the perspective of Pencils Protocol itself, it provides staking direction incentives for LRT assets in a combinable manner, encouraging more users to participate in staking LRT protocols. From Pencils Protocol's perspective, it supports staking incentives for various LRT assets and quickly attracts potential holders of these projects and assets.
On the other hand, from the pre-market incentive perspective, 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, its single-chain TVL can achieve explosive growth and quickly surpass $300 million, making it not only the highest TVL project 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 and leverage.
The Vault section connects to Staking pools, supporting users in borrowing assets from the Staking pool. On the other hand, 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 yields with less capital through leverage, only needing to pay a portion of the earnings to Pencils Protocol as interest. Early active participants in the Vaults can not only receive basic rewards for deposit staking and LP staking but can also earn high multiples of points and token rewards, significantly enhancing user participation in the Vault section.
Users can borrow funds through the vault to increase yields. For example, for 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 borrowed funds will be automatically deposited into the Staking deposit pool to pay depositors' rewards. The Vaults pool releases funds by assessing 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's 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. On the Staking side, the funds deposited in the staking pool will be further mobilized, greatly enhancing the utilization 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 first two market cycles, representative yield aggregation platforms like Yearn Finance and Alpaca Finance emerged. The former's early market valuation was estimated between $3 billion and $5 billion, while the latter's market cap was around $1 billion at its peak. Before the emergence of Pencils Protocol's Vault product, there had been no pioneering yield aggregation platform, and the Vault product is deeply bound with 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, integrating more quality assets and launching various asset yield methods such as 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 repurchasing and burning $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 create differentiated competition with other DeFi protocols. The competition across different dimensions can not only bring rapid growth momentum to Pencils Protocol and generate sustained and considerable revenue for the platform but also is 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 the LaunchPad function and the auction functions for NFT and RWA assets.
In fact, Pencils Protocol was initially positioned as a LaunchPad, leveraging a series of advantages from the Scroll underlying to build a high-quality asset launchpad for the Scroll ecosystem. Users can discover high-quality assets and good projects in the Scroll ecosystem through this LaunchPad platform first, while project parties can leverage the large user base of Pencils Protocol 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 had 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 function, Pencils Protocol has also introduced auction functions for some RWA assets and NFT assets. This function can derive a series of scenarios, such as RWA or NFT assets from the real world, which can be expanded to a broader user base through the auction function 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 numerous scenarios and achieve combinations, while retaining interfaces for the ecosystem to expand towards broader narrative directions (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 the ecosystem's development (joining the community for construction and helping with ecosystem promotion and marketing, etc.), and using the platform's various functions, and issues Pencils Points to users as an incentive to promote their participation in the ecosystem's construction.
From the perspective of Pencils Points themselves, they are not just a pre-market incentive asset for redeeming 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 various dimensions of value, 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 high-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 can allow the Pencils Protocol ecosystem to expand into more directions, including potential fields like gaming, social, and traditional finance, becoming a new comprehensive Web3 trading window.
When users use Pencils Points to redeem or pay with $DAPP tokens, they can receive some discounts, which will further broaden the application scenarios for Pencils Points, $DAPP tokens, etc., while bringing considerable revenue opportunities to the ecosystem.
The Narrative Potential of Pencils Protocol
Ecosystem Moat
In fact, the Pencils Protocol ecosystem has built a relatively wide moat for its long-term development. We believe that the elements of this moat system include novel narrative capabilities, bilateral network effects, and the platform's revenue-generating ability.
- Novel Narrative
As mentioned above, each product section of Pencils Protocol has made 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 achieving leveraged mining through a risk-free borrowing model. In either direction, users can achieve "twice the result with half the effort," allowing the B-end to obtain good liquidity effects.
For sections like Auction and Shop, they further retain 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 merely focusing on the classic DeFi red ocean market.
- Bilateral Network Effects (Dual Value Flywheel)
The bilateral network effect of Pencils Protocol is 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 lending 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 achieve pre-market incentive points through leverage.
From the Vault pool's perspective, the better the asset thickness and depth of the single asset Farming pool, the better the user experience for borrowing that asset (liquidity, cost) on the Vault side, and the higher the potential leveraged mining returns for users. This, in turn, will provide higher yield distributions for that asset in the Farming pool, creating a bilateral network relationship between the "Farming side" and the "Vault side," forming an internal value cycle flywheel.
From the second perspective, the 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 (DEXs, 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 take 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 on the "Vault side" based on the project token, bringing better liquidity effects for the project token. This process will also continuously push 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 promote and empower each other, with Pencils Protocol serving as an important liquidity engine in the Scroll ecosystem, continuously gaining value increments.
Therefore, we see that even in the 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, initially focusing 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 revenue 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 revenue. It is worth noting that the income captured by users through the Vault section comes from external ecosystems rather than zero-sum games, such as providing liquidity for different liquidity markets on Scroll (which will be multi-chain in the future), so whenever the Vault section brings profits to users, the Pencils Protocol ecosystem will gain value increments and revenue.
Especially as the aforementioned dual value flywheel system accelerates, the profitability of the Pencils Protocol 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, Pencils Protocol itself is the asset launcher for the Scroll ecosystem, providing launch services for quality projects in the ecosystem, and it is also one of the main businesses of Pencils Protocol. Currently, the Scroll ecosystem is still in its early development stage, with many quality projects that have not yet had 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 have extensive direct revenue 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 revenue 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, and these considerable revenues will continue to provide momentum for the ecosystem's development.
So overall, novel narratives, 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 the very early market stage, and users are currently 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 yields.
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 at a 1:1 ratio to obtain proof of rights token $pDAPP. Holders of $pDAPP can earn subsidies by staking $pDAPP or provide liquidity for $pDAPP on DEXs.
In the Vault section, users who want to obtain more point 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 list assets 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 earn additional rewards from these activities. Meanwhile, holding $DAPP tokens will further accelerate the rights attributes of Pencils Points holders, allowing for 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 its utility and application within the Pencils Protocol ecosystem.
So from the perspective of application scenarios, the $DAPP token itself has extremely broad essential demand. Users can convert staking, holding, and using $DAPP tokens into yields and rights. The broader Pencils Protocol's business scope, the stronger the essential demand for $DAPP tokens.
- Destruction
Pencils Protocol plans to continuously destroy $DAPP tokens through platform revenue, currently specifying that 20% of the Vault section's revenue will be used to destroy $DAPP tokens. Other sections also have destruction mechanisms set up, which will contribute positively to promoting the deflation of $DAPP tokens based on their profitability.
Thus, from the perspective of the application system and destruction plan, the continuous essential demand and deflation will continuously boost the value of $DAPP tokens, 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. Its products span multiple tracks and can expand into various fields such as GameFi, SocialFi, and RWA based on a series of functional sections. Given its narrative, product functionality, overall development potential, broad 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 the entire ecosystem's valuation was once estimated by the market to be between $3 billion and $5 billion. From the perspective of tokens, YFI's market cap was nearly $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 tens of 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 to be as high as $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 place 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 estimated to be between $5 billion and $10 billion, and at the peak of the bull market, the market cap of $SUSHI token was nearly $3 billion.
Aave
Aave is the leader in the DeFi lending space. 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. The market cap of its token $AAVE exceeded $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 was nearly $10 billion.
The aforementioned blue-chip DeFi markets focus more on a single field and have long maintained a leading position 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 expected to exceed $10 billion. Compared to the peak valuations of the aforementioned project tokens, the market cap of $DAPP token is conservatively expected to be above $5 billion. Therefore, it currently appears that the valuation of the Pencils Protocol ecosystem is severely undervalued, and the market performance of $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 narrative fermentation of the 2020 genesis, the rapid bubble of asset prices in 2021, and the disillusionment phase after the bubble burst in 2022. Currently, as the product-market fit is fully validated, it is emerging from the valley 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 continues to grow, maintaining long-term attention and investment value. However, 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. Backed by a layered and differentiated product system, a broad narrative direction, and long-term expected profitability, it has gradually revealed its brilliance 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 building 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