Can Crypto Overcome the Issues Plaguing DeFi?
Summary:
- This year saw a severe collapse in the value of cryptocurrencies, losing almost $2 trillion in value from the peak of a significant surge in 2021
- Due to the advent of centralized lending schemes and decentralized finance, the cryptocurrency market is now oversaturated with debt
- The demise of the stablecoin TerraUSD and the ripple effects of the liquidation of hedge fund Three Arrows Capital emphasized how firms and projects were closely interrelated during this cycle
The recent decline in the cryptocurrency market has shocked many, including seasoned professionals. The phrase “DeFi Summer” is developing meaning in 2022, 180 degrees out of sync with the heady times that gave rise to the phrase just two years prior.
This indicates that the entire cryptocurrency industry is currently experiencing stress testing at a level not witnessed since the COVID-driven crash in March 2020, when most DeFi protocols were not yet in use. Additionally, numerous significant crypto assets are overleveraged and underwater due to cascading liquidations.
With the dramatic collapse of the stablecoin TerraUSD and several centralized crypto lenders failing and declaring bankruptcy this year, DeFi has come to be noticed for all the wrong reasons. Since a large portion of DeFi was developed during the summer of 2020, the industry was burdened with several incorrect assumptions.
The recent crisis has wiped out trillions of dollars from the cryptocurrency market and tarnished its reputation among regular investors. DeFi platforms were remarkably unharmed by this carnage and kept operating as designed.
While the industry has seen billions of dollars in TVL losses, protocols and teams are still committed to laying the groundwork for an open, permissionless, decentralized, and multi-party peer-to-peer financial system.
The 2008 financial crisis made it abundantly clear that our existing financial system is highly vulnerable. Considering that the financial infrastructure has not undergone many fundamental changes since the Industrial Revolution, it is still highly dependent on banks and other financial organizations. This system, which deals with intermediaries and high entry barriers, opacity, high transaction costs, and ineffective processes, has had little innovation.
This is where DeFi came in, promising open finance accessible to all. DeFi first rose to prominence in the summer of 2020 and represents a pivotal moment in financial history. In the last two years alone, the number of unique addresses as a proxy for users using DeFi applications grew over 40x to more than 4 million.
Here’s a rundown of the recent market incidents that put crypto in a downward spiral:
The fall of Celsius: In June, cryptocurrency lender Celsius suspended withdrawals and transfers from its platform because of market turbulence and severe price reductions.
The Canadian bitcoin lender Voyager Digital filed for bankruptcy in New York. Although the company’s connection to a hedge fund was a factor in its collapse, the volatility of the cryptocurrency market also had a significant influence. For example, in November of last year, the stock was trading at around $20, but the crypto meltdown in June caused it to drop below $1.
The fall of Luna: An algorithmic stablecoin, TerraUSD (UST), was intended to be pegged 1:1 to the US dollar. It operated via a sophisticated mechanism controlled by an algorithm. But when UST lost the dollar peg, its sister token, Luna, also collapsed.
This shocked the cryptocurrency market but also had repercussions for businesses exposed to UST, particularly hedge fund Three Arrows Capital, or 3AC.
The fall of 3AC: 3AC is a Singapore-based crypto-focused hedge fund that has been one of the most affected by the market downturn. As 3AC had exposure to Luna, it suffered incredulous losses after the collapse of UST.
According to reports, 3AC failed to meet a margin call from crypto lender BlockFi and had its positions liquidated. Then the hedge fund defaulted on a $660 million loan from Voyager Digital, resulting in liquidation, after which 3AC plunged towards bankruptcy under Chapter 15 of the US Bankruptcy Code.
Hacks and breaches: In addition to the above occurrences, other frequent hacks and breaches also played a role in the decline of cryptocurrency.
The most recent significant heist in DeFi saw hackers steal $100 million in cryptocurrencies from Horizon, a so-called blockchain bridge, in one of the most recent attacks. It comes after a slew of comparable assaults on blockchain bridges, including the theft of $320 million from Wormhole and $600 million from Ronin Network.
What does the future hold for CeDeFi?
The DeFi space has paved the way for rampant innovation, starting with loans, borrowing, stablecoins, assets, yield farming, and trading.
Synthetic assets are one of DeFi’s fastest-growing subsectors, and compared to traditional securities, these synthetic securities benefit from 24/7 liquidity, borderless transfers, censorship resistance, and liquidity pool farming.
DeFi offers a tremendous chance to upend any financial contract, including the $6 trillion insurance sector, the $90 trillion stock market, and the enormous $1 quadrillion derivatives market. Moreover, with DeFi, trade execution and settlement may occur concurrently, reducing inefficiencies further and doing away with the need for intermediaries and the hefty fees that reliable third parties often charge, even for simple transactions.
DeFi is also, by definition, very competitive and motivated to provide its customers with superior services. Not to add, everyone is treated equally, and there is no discrimination between players in the DeFi.
Even in these trying circumstances, DeFi has exhibited tremendous fortitude and grit. In actuality, the industry keeps innovating and growing. It wouldn’t be far off to say that DeFi will revolutionize finance, much as the internet did for information.
How a unified regulatory framework can enhance innovation
The idea that excessive regulation will inhibit innovation by hindering the capacity of enterprises to find novel solutions to issues is a recurrent theme in public policy discussions. That’s accurate. However, an ambiguous regulatory environment is just as harmful since it makes it difficult for enterprises to commit significant amounts of time, energy, and money to projects that governments ultimately deem prohibited.
The crypto regulatory landscape in the United States has been egregiously poor, sending many of the most creative businesses outside. The Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), the US Federal Reserve, the US Treasury Department, and others are just a few independent organizations that govern the financial markets in the United States.
The SEC’s approach to regulating the cryptocurrency industry has been to merely state that projects must follow the Howey Test, a nebulous guideline based on the 1946 Supreme Court decision SEC v. W. J. Howey Co. Many entrepreneurs operating in good faith are unsure as to whether the SEC will wake up one day and decide that they want to shut them down because so much of crypto innovation transcends securities law from the 1930s and because the SEC has refused to provide clear guidance about their approach to cryptocurrencies.
Along with the US, the EU has been working to provide a legal framework for the cryptocurrency and blockchain sector. However, Bitcoin and other currencies, however, have the potential to upend the status quo and usher in a new age of purchasing, selling, trading, and handling financial assets. Therefore, the effects of new technologies must always be carefully considered. While the aforementioned strategy was implemented in 2021, additional advances didn’t materialize until March 2022, when the European Parliament advanced a cryptocurrency regulation proposal. Since this idea would outlaw proof-of-work-based cryptocurrencies like bitcoin, there were early reservations about it.
Conclusion
DeFi does, of course, have certain hazards. Bugs, rug pulls, and temporary losses are a few of the particular problems. But since DeFi is still in its infancy, this is only the beginning. Nonetheless, it is impossible to overlook its advantages in boosting productivity, cutting expenses, providing privacy and transparency, promoting financial inclusion, and adding more value to their communities.
Indeed, a significant amount of cash has already poured into the industry, and as use grows, this will only climb. In addition, as technology develops, more innovation will be seen in the DeFi market, leading to exciting new prospects.
