How Can Decentralized Finance Survive the Current Crisis?

Decentralized Finance (DeFi) has been in the spotlight lately, primarily because of the shocking collapse of the Terra ecosystem.  Its debacle cost tens of billions of dollars in a matter of days, creating violent shocks across the crypto market, and resulting in a loss of credibility among retail investors.  In 2021 DeFi provided investors with high rates of return, a too-good-to-miss opportunity. Now as Terra's shock waves continue to bring down DeFi liquidity, investors are also considering their trust in crypto. One of the worst domino effects triggered by Terra came in the shape of Celsius, offering high-yielding interest accounts to 1.7 million users with $12 billion held. Now this crypto lending platform is currently rumored to be facing bankruptcy and has suspended user withdrawal requests to stabilize its operations.  To cap it all, the notable crypto hedge fund Three Arrows Capital is also facing an insolvency crisis. Clearly DeFi appears to be in trouble. But what has caused this current crisis, and why?

DeFi is an umbrella term for a set of financial activities that eliminate the need for intermediaries in traditional financial services. Loans, savings, remittances, insurance, and cryptocurrency transactions are all included. For example, some people will use DeFi to lend a friend $100 in Bitcoin, and as the lender they will earn interest on the loan without traditional intermediaries. As the FT explained DeFi is, “an umbrella term for a collection of crypto asset projects that aim to do away with a centralized intermediary — like a bank or an exchange — to provide financial services. They use DApps to execute common services like lending, savings accounts, and trading coins”. Before its collapse, Terra was considered a star product of DeFi, a payment network based on its TerraUSD stablecoin.

A skeptical view of the DeFi. Source: @ChainLinkGod.eth

Terra's high interest bearing Anchor protocol was also supposed to resist the market downturn and be a tool for high profits whether in the bull or bear market.  But as Terra collapsed and tens of billions of dollars evaporated, those hopes were dashed. As Elizabeth Lopatto, deputy editor with The Verge explained, “Kwon’s rise and fall was fairly rapid, even by cryptocurrency standards. Luna emerged as a bright spot in the markets in December and reached its peak valuation, a touch over $116, in April; Luna was worth more than $40 billion, all told. During that time, a lot of crypto, including Bitcoin and Ethereum, was sliding. Luna’s popularity was due to a lending program, Anchor, that promised annual percentage yields (APY) of almost 20 percent — obscenely high.”

Over the past ten days, Celsius has prevented all of its estimated 500,000 users from withdrawing their money because of “extreme market conditions”. with no word on when it will be available again. As much as $8 billion in deposits is frozen. If that wasn't enough it was reported that a week after the withdrawal freeze Celsius warned its community of a rise in fake social media accounts claiming to be from Celsius. At the same time, it paused its Twitter Spaces and AMA's to focus on its liquidity crisis. "As has been a priority since our company’s inception, we maintain an open dialogue with regulators and officials. We plan to continue working with regulators and officials regarding this pause and our company’s determination to find a resolution," a June 20th Celsius blog post confirmed. However, the comments to the blog post further underline how this has severely dented user trust. “I wonder how this is in the interest of the community when you didn't ask them if they'd like to pause all chain activities. Everything you've said so far is lies and you will know that when the functions resumes, I'd rather be in meme coin hype with 50/50 chances than this,” being typical of the overwhelmingly critical set of responses.

Hong Kong-based crypto lender Babel Finance paused withdrawals and redemptions, citing “unusual liquidity pressures”, while Singapore-based crypto hedge fund Three Arrows failed to meet margin calls from lenders. On Monday, another Hong Kong-based crypto exchange Hoo announced a halt on transactions after customer withdrawals became so great that they risked exhausting the company’s available funds, reported the FT.

In our view, problems with protocols like Terra don't lie in the details of any one platform.  Because the current crisis was the result of a faulty model, Terra's debacle was also fed by the belief that nothing like what has happened in the traditional finance world would ever happen in the blockchain market.  But the fact is that when you purposely remove the intermediaries which come with the traditional financial model, you also remove the safeguards that traditional finance has worked so hard to build over the past few decades, and especially after the 2007-08 credit crunch.  

As it stands, DeFi is already in trouble.  According to data from DeFi Llama, the TVL of most top DeFi blockchains has dropped by 30% or more in the past month.  At the beginning of April, the total TVL (total value locked) of all blockchains was over $170 billion, and that number is now down to around $60 billion, which is a 65% decrease from before Terra crashed. “Moreover, since December 2021, the top smart contract platform tokens have lost 70% in value against the U.S. dollar as well, sliding from $823 billion to today’s $245 billion,” reported Jamie Redman in Bitcoin.com.

Some in the industry believe this change in the DeFi market capitalization is a tough but necessary step, as it will significantly reduce the emergence of risky projects and allow the industry to stabilize. However, others believe that the decline in TVL highlights deeper problems in DeFi that are not simple to solve.  And these current issues could prompt lawmakers to act sooner rather than later to create a series of more robust regulatory frameworks. An obvious example in the US is the recently tabled Responsible Financial Innovation Act which while not explicitly mentioned DeFi does seek to establish agency oversight and regulations according to which assets are securities.

As Bitcoin BTC/USD and Ethereum ETH/USD continue to fall in value despite the efforts of bulls to shore up their value, making the cryptocurrency market more uncertain, there are some smart moves investors can deploy to prepare for more market volatility.  If you have funds on a DeFi platform, make sure you fully understand how the platform works and how it generates any rewards.  If you have moved all of your funds to a high-interest rate DeFi protocol, then please proceed with caution and think carefully about the consequences of a platform freeze or even crash, as this will be critical to the safety of your funds.

"While it's far from certain the DeFi sector in its current form will fail, it's likely to have more trouble before its problems are over.  The domino effect after the Terra crash is gradually playing itself out, and it remains difficult to predict how far it will spread.  If more major projects and institutions collapse however, it will no doubt impact on the wider crypto market. Already we’ve seen signs of this with FTX helping BlockFi with a $250 million loan, and crypto broker Voyager Digital with an even larger loan of $485 million." Anndy Lian, Best Selling Book Author and Chief Digital Advisor to Mongolian Productivity Organization commented. 

While we are all worrying that DeFi is heading downwards, we also need to remember that DeFi is created to eliminate banks and financial institutions as central intermediaries in various financial transactions. There is not stopping for DeFi. New projects are popping up during these bearish times. DeFi projects are still trying to innovate and do more.

Pollen for example, has started their second token sale and hope to have their first indox product launched by the end of the year. Pollen Virtual, a trading simulator that lets you create and manage virtual portfolios, is now on mainnet to give every trader — DeFi degen or crypto newcomer alike — a level playing field to test and showcase their trading capabilities, building reputation and earning PLN token rewards. Pollen COO William Vandyk explains:‘’The signals generated from Pollen Virtual are being used to build an Index Factory, constructing indices that anyone can buy which will hold real assets, their composition determined by collective intelligence and free from any fund management or performance fees”

Ledger is one of the most popular hardware wallets on the market are partnering with Alkemi Earn. They are integrated into Ledger Live’s Discover section. This is the first time a DeFi lending and borrowing app is available to Ledger users.

“DeFi continues to grow as we speak. Nothing is going to stop us.”