Why Does DeFi Need a Completely New Infrastructure?

Traditional assets have emerged, and they require a completely different infrastructure.

Written by: Vaidik Mandloi

Compiled by: Chopper, Foresight News

Between 2020 and 2022, a group of astute crypto investors bet on a series of protocols that built on-chain fixed-rate lending products, allowing users to lock in yields similar to government bonds. Element.fi raised $32 million from a16z crypto and Polychain Capital, while Notional.finance secured $10 million in a round led by Pantera Capital, followed by at least five other similar projects.

Today, all of these projects have inevitably met their demise. The yields they attempted to package into products were entirely fabricated, primarily because DeFi in 2021 relied on protocol-generated token rewards and leveraged cycles to create yields. Once users concentrated their exits, the entire system collapsed.

In this round of industry cleansing, the only surviving protocol is Pendle.finance. Its survival can be attributed to the on-chain treasury assets from RWA.xyz, which brought real cash flow, allowing developers to build products around genuine yields. I believe a similar transformation is about to impact all existing DeFi foundational components.

Various Workarounds

To understand this transformation, we first need to grasp the market environment at the inception of DeFi.

Looking back at the on-chain financial market of 2018 and 2019, the tradable assets were all crypto-native tokens, devoid of cash flow, with no legal entities behind them, and subject to extreme price volatility, potentially losing 90% of their value in a single afternoon.

Market participants were anonymous wallet addresses, lacking credit histories or legal identities, and in the event of default, there was no accountability mechanism. At that time, Ethereum could only process 7-8 transactions per second, with block intervals of 13-15 seconds. The primary participants were retail speculators, along with a few crypto-native funds willing to take on extreme risks for high returns.

The foundational conditions required for a normally functioning financial market were entirely absent in the on-chain market at that time. A mature market needs market makers willing to place bilateral orders and provide continuous quotes, with the price movements of the underlying assets being predictable to facilitate risk hedging; it also requires lenders to assess borrowers' repayment capabilities, necessitating knowledge of the borrowers' true identities.

DeFi back then fell far short of these standards. Asset volatility was too high, and professional market makers were unwilling to participate; borrowers were anonymous wallets, and the user base showed no interest in financial products with fixed maturity dates.

Consequently, developers at that time began designing various workaround solutions. For instance, Uniswap invented the automated market maker (AMM) not because it was a better trading method, but because no one was willing to provide liquidity for tokens that could plummet 90% within minutes. The solution at that time was to embed the pricing logic directly into smart contracts, allowing anyone to inject funds into the liquidity pool, with the constant product formula automatically completing price discovery, and each transaction adjusting the exchange price based on the token ratios within the pool.

Many DeFi native users still do not fully understand: this mechanism is fundamentally different from traditional market making. Traditional market makers earn from the bid-ask spread. However, AMM liquidity providers (LPs) are doing something entirely different. Whenever arbitrageurs identify price discrepancies between the liquidity pool and the external market and trade to eliminate the spread, the counterparty LP is effectively paying the arbitrageurs, completing the rebalancing of their own portfolio.

For example: you deposit an equivalent value of ETH and USDC into a Uniswap pool. Suppose ETH rises by 20% on Binance, but the liquidity pool has not yet sensed this price change. Arbitrageurs will discover the undervalued ETH in the pool, buy it, and then transfer it to Binance for profit. In the liquidity pool, USDC increases, and ETH decreases, effectively meaning you sold ETH during the price rise.

When ETH declines, the reverse operation occurs: arbitrageurs dump ETH into the pool and withdraw USDC. With each transaction, your asset portfolio automatically returns to a 50/50 ratio, and the arbitrageurs pocket the spread as profit. The underlying mathematical logic is quite interesting; even under extreme assumptions, if every transaction in the liquidity pool is purely arbitrage with no retail trading, after collecting small fees from each transaction, liquidity providers can still achieve positive returns.

Aave and Compound in the lending sector also follow this design logic under constrained conditions. Traditional banks typically rely on credit scores and income records to assess your repayment ability. However, on-chain anonymous wallets cannot do this. Therefore, these protocols adopt an over-collateralized lending model.

Perpetual contracts replacing traditional fixed-term futures are also due to the same reason. Quarterly futures contracts require counterparties to fulfill obligations on fixed delivery dates. However, in the crypto market, anonymous funds rotate between various protocols in pursuit of the highest yields, making such long-term commitments impossible to guarantee.

Of course, these makeshift solutions have produced usable products. But from a broader perspective, the issues with the financial system they collectively built become very prominent: the collateral supporting all products does not generate any yield.

We can apply Hyman Minsky's theory to stress-test any financial arrangement: examining whether the income generated by the borrower's collateral is sufficient to cover the debt. Financial relationships can be divided into three categories.

The first category is hedge financing, the safest: asset income simultaneously covers interest and principal. For example, a salaried worker repaying a mortgage is a typical case.

The second category is speculative financing, an intermediate state: income can cover interest, but when the principal matures, refinancing is needed. Rolling issuance of corporate bonds by companies falls into this category.

The lowest tier is Ponzi financing: income cannot cover either interest or principal. The only hope for maintaining payments is that the asset prices continue to rise; once the prices stop rising, the entire system collapses.

Now, looking at the scenario where users borrow on Aave, the borrower deposits $10,000 worth of ETH and borrows $6,000 in USDC, freely using this stablecoin. However, the ETH in the Aave treasury does not generate any income to repay the loan. The only condition for maintaining the safety of this loan is that the market price of ETH remains above the liquidation threshold. Once the drop is significant enough, the protocol will liquidate the collateral and close the position.

The entire lending arrangement relies entirely on the asset prices being able to hold until the borrower exits. Almost all DeFi over-collateralized lending using crypto-native tokens falls into this category.

How the Transformation Will Occur

Let’s replace the collateral in the scenario with tokenized U.S. Treasury bonds. The lending protocol and borrower remain unchanged, but the collateral is no longer ETH; instead, it is a tokenized U.S. Treasury bond worth $10,000, with an annual yield of 4.5%, allowing the borrower to borrow stablecoins at a cost of 3%. The collateral generates $450 in income annually, while the loan cost is only $300. The cash flow from the collateral can cover the debt cost. This income is unrelated to the crypto market cycle; it comes from the coupon of U.S. government bonds, and regardless of whether the price of Bitcoin is $100,000 or $30,000, cash flow will continue to flow in. The longer the loan position is held, the more robust the borrower's position becomes. This stands in stark contrast to ETH collateralized lending: with each market downturn, the borrower moves closer to liquidation, and the collateral itself does not generate any cash flow.

When the vast majority of collateral in DeFi yields zero and relies entirely on price appreciation, all positions are exposed to the same one-way risk. When one type of asset declines, it triggers liquidation; the selling pressure from forced liquidations further depresses prices, leading to more liquidations and creating a chain reaction. Since 2020, we have witnessed this process in almost every crypto downturn cycle. People often regard it as a black swan event, but the fact that the collateral itself does not generate cash flow makes this outcome entirely predictable. However, when a significant portion of the collateral consists of income-generating assets like U.S. Treasury bonds, even if the crypto market crashes, positions remain stable because their cash flow is independent of the crypto market.

For the first time, the lending system has a safety net that does not rely on a bull market. The scale of tokenized money market fund shares has grown from $770 million at the end of 2023 to $14.82 billion by October 5, 2026, an increase of approximately 19 times in less than three years.

This model also has precedents. In 1955, the Midland Bank in London began accepting dollar deposits. At that time, the U.S. Q Regulation limited the maximum interest rate on deposits by U.S. banks, while British banks were not subject to this constraint. Dollar funds flowed overseas in pursuit of higher yields, giving rise to a parallel dollar system, which reached a scale of approximately $4.7 trillion by the early 1980s.

However, the Federal Reserve did not suppress the Eurodollar market but chose to adapt to it. A parallel market born out of the limitations of the existing system will continue to expand until the original restrictions are eliminated. Thus, the Q Regulation was gradually abolished, and money market funds emerged as a competitive product in the U.S. domestic market, ultimately integrating this parallel dollar system into the mainstream.

Stablecoins are the Eurodollars of this generation, while tokenized U.S. Treasury bonds are the money market funds of this generation.

The protocols that have perished attempted to build an interest rate market when there were no real interest rates on-chain, using token issuance and leveraged cycles to simulate real yields. However, you cannot rely on yields that can be shut down at any time through governance votes to construct a complete interest rate curve.

Pendle has survived because it waited for the emergence of tokenized U.S. Treasury bonds and income-generating stablecoins, finally providing the market with real cash flow backed by the government to build products on this basis. Pendle's Boros is now the first functioning on-chain interest rate swap product.

The same logic applies to the trading sector. In liquidity-rich trading pairs, AMM liquidity providers lose about 11% of their funds annually due to arbitrage losses; for tokens not listed on centralized exchanges, bearing this

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