The crypto currency market has had a rough year, with the collapse of multiple projects and funds triggering a contagion effect that affects nearly everyone in the space.
The dust has yet to settle, but the constant revelations have allowed investors to piece together a picture that highlights the systemic risks posed by decentralized finance and poor risk management.
Several experts below discuss the reasons behind the DeFi collapse and share their thoughts on how the crypto industry can recover.
Inability to generate sustainable income
One of the most frequently cited reasons for DeFi protocols to struggle is their inability to generate sustainable revenue that adds meaningful value to the platform’s ecosystem.
DeFi basic design principles:
If the protocol can’t run without reward tokens, it’s a Ponzi scheme
Reward tokens should not be necessary for the protocol to function. This means that the agreement is not a revenue-generating business.
— Joseph Delong* (@josephdelong) May 23, 2022
To attract users, they offer unsustainably high yields without sufficient capital inflows to offset payments and provide underlying value to the platform’s native token.
This essentially means that there is no real value to back the token, which is used to pay for the high yield offered to users.
When users start to realize that their assets are not really getting the promised yield, they withdraw liquidity and sell reward tokens. This, in turn, led to a drop in token prices, as well as a drop in total value locked (TVL), which further caused panic among protocol users, who likewise withdraw their liquidity and lock up the value of any rewards received.
Token Economics or Ponzi Economics?
A second flaw highlighted by many experts is the poorly designed token economics of many DeFi protocols, often with extremely high inflation rates, which are used to attract liquidity.
High rewards are nice, but if the value of the token being rewarded doesn’t really exist, then users are basically taking a huge risk by giving up control of their funds for little to no reward.
Much of this has to do with DeFi’s revenue generation issues and its inability to build a sustainable treasury. High inflation increases token supply, and if token value cannot be maintained, liquidity leaves the ecosystem.
Users who use excessive leverage
Excessive use of leverage is another pervasive problem in DeFi, a flaw that became apparent last month as Celsius, 3AC, and other platforms investing in DeFi began to unravel.
Users who staked these inflationary tokens to overleverage their positions were liquidated as the market sell-off caused prices to drop.
This led to a death spiral of the protocol. @Wonderland_fi is one such protocol where users borrow MIM using TIME and then get liquidated
— Magik Invest ✨(@magikinvestxyz) June 28, 2022
These liquidations simply added to a downtrend already experienced by many coins, setting off a death spiral that spread to CeFi and DeFi platforms, as well as a handful of centralized cryptocurrency exchanges.
In this sense, the blame lies with users over-leveraging without a solid investment plan to deal with the market downturn. While it can be a challenge to think about these things during the peak of a bull market, it should always be one that traders should consider as the cryptocurrency ecosystem is known for its repeated volatility.