Decentralized finance is a core part of crypto, but parts of it are unsustainable.
- The collapse of Terra sent ripples through the decentralized financial market.
- There are question marks over the future of Terra and Three Arrows Capital.
- The amount of money on DeFi platforms is down 65% since early April.
Decentralized finance (DeFi) has taken the spotlight in recent weeks, largely due to the shocking collapse of the Terra ecosystem. The collapse of the network wiped out tens of billions of dollars in a matter of days and shook the entire crypto market.
One of the most severe aftershocks so far has been Celsius, a crypto lending platform that paused payouts amid bankruptcy rumors. Another is crypto hedge fund Three Arrows Capital, which appears to be in trouble, although we don’t know the details just yet.
What is behind the difficulties of DeFi?
DeFi — an umbrella term for a variety of applications that cut the middle man out of traditional finance — is a cornerstone of the crypto market. It includes lenders, decentralized exchanges, interest rate platforms, among others. Before its collapse, the Terra blockchain was a stablecoin-based payments network that also hosted the high-yielding Anchor protocol.
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There are many industry experts who would say that some aspects of the DeFi industry have long been a ticking bomb. The only question was what would trigger it and how much damage it would do. Anchor’s 20% APY on stablecoin deposits was exactly the kind of thing these insiders were worried about. It just wasn’t sustainable, and when things went wrong, it quickly spiraled out of control.
But it’s not so much the specifics of a single platform that pose the problem. It’s a kind of crypto pixie dust that makes people believe that anything is possible just because it’s on the blockchain. That and the fact that with the elimination of the middleman, you also take away many safeguards and consumer protection measures that have grown over decades.
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A report by the BIS – the Bank for International Settlements – late last year warned of the dangers of “high leverage, liquidity mismatches, built-in interconnectedness and the lack of shock absorbers like banks”. Some of these DeFi protocols are extremely experimental and once a domino falls, it can start a cascade. For example, if Celsius and Three Arrows Capital fail, others could follow.
Is DeFi Doomed?
DeFi is definitely in trouble. A useful metric when looking at smart contract cryptos and decentralized finance platforms is Total Value Locked (TVL). TVL is down 30% or more for most top DeFi chains over the past month, according to DeFi Llama. As of early April, the total TVL across all blockchains was over $170 billion. That number is now around $60 billion — 65% down from before Terra’s collapse.
Some insiders believe this is a necessary move as it will rule out the extreme projects and better position the industry to move forward. Others think it reveals deeper issues with decentralized finance that won’t be easy to solve. These current issues may also spur lawmakers to act faster and create stronger regulatory frameworks for crypto and DeFi, but this will cause more pain in the short term could strengthen investor confidence in the long term. Ultimately, it’s too early to tell, but there are some real risks to consider.
These are uncertain times and investors would do well to brace for further turmoil. If you have money on decentralized finance platforms, make sure you fully understand how the platform works and how it generates rewards. If you’ve transferred your savings to a high-yield DeFi protocol, tread carefully and consider what might happen to your funds if the platform crashes. Unlike a traditional savings account that has FDIC insurance against bank failures, investors can lose it all.
While DeFi may not be doomed, more trouble could be on the horizon. At the moment, the aftershocks from Terra’s collapse are still being felt, and it’s difficult to estimate how far they will spread. If more projects follow the same path, it will destabilize the market even more and have further repercussions for the rest of the crypto market.
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