The DeFi craze is in full swing and there are shades of the ICO bubble that brought crypto crashing down in 2018. Are we making the same mistakes?
Despite a crash in early September, decentralized finance (DeFi) continues to make waves. DeFi is bringing the advanced financial instruments necessary to help cryptocurrency mature into a fully-fledged financial ecosystem.
There are a number of worrying signs that the community may be headed for a repeat of the ICO crash of 2018. The crypto market has moved past the negative consequences of that crash with investment and retail trading going strong. And it would be bad for the entire crypto ecosystem if DeFi led to another crash.
What is DeFi anyway?
Traditionally financial services need to be accessed via middlemen, such as banks and are heavily regulated. Decentralized Finance (DeFi) projects look to disrupt this norm by leveraging the power of smart contracts to cut the middleman out and make it easier for users to access vital services, such as lending or leverage trading, creating new opportunities.
One of the most prominent examples of this is the explosion in DeFi lending platforms, and that is where our problems begin.
Lack of regulations is a double-edged sword
A regulatory vacuum was a key factor in the ICO boom of late 2017 and early 2018 and is still a key factor in the DeFi explosion we’re witnessing today. In many ways, this is positive as it has accelerated change. But as with ICOs, it opens the door to sloppy projects, scams, and bad practices.
Let’s start with security. Smart contracts are far from perfect and even small problems with the code can, and have been, exploited by bad actors.
Crypto lending platform bZx has been hacked 3 times in 2020 alone, with over $8.1 million lost. Another platform, Bancor, left a bug in their code that enabled anybody to withdraw unlimited amounts of funds. This problem has been found to be common in Ethereum DeFi apps.
99.99% of DeFi tokens on the market are scams designed to steal your wealth.
Anyone who disagrees likely wasn’t around during the last ICO bubble which resulted in 99.99% of coins popping, and crashing over 99%
— Mr. Whale (@CryptoWhale) September 10, 2020
There are also a number of DeFi projects that are outright scams. One of the more recent examples is the $20 million exit scam by YfdexfFinance. In the absence of a regulatory body, many investors have been left holding the bag. The prevalence of exit scams in DeFi is similar to the many high profile scams during the ICO craze.
Yield farming could bring DeFi crashing down
An additional problem is the economics of DeFi. In order to ensure liquidity DeFi apps are offering interest rates significantly higher than the market average. This is paid for using a practice known as yield farming or liquidity mining.
Essentially, a DeFi project creates new tokens to reward those who provide liquidity to the service in exchange for them locking an existing token, for example, Ether, into the service.
This has significantly reduced the supply of Ether and other tokens as users look to take advantage of high yields, which contributed to recent price surges for ETH. Currently, over $11 billion in crypto assets are now locked in yield farming operations. While this is great news for speculators, the potent combination of inflated DeFi tokens and Ethereum could prove deadly.
Sadly, as DeFi degens are rushing to farm DeFi tokens for high returns, only a handful of them can read smart contracts and understand the associated risks, according to a CoinGecko survey.
Eventually, DeFi projects will be forced to drop yield farming. As a result, returns for locking crypto could vanish overnight. This could mean that many projects lose the liquidity necessary to make good on their loans and lead to panic as investors attempt to transition out of risky DeFi projects — potentially causing a major crash.
The ICO crash was painful for the cryptocurrency industry and hardened attitudes against crypto. Another major crash for similar reasons could lead many to write off crypto as a scam yet again and set back the community for years.
Can a crash be avoided?
The Decentralized Finance boom neatly represents the contradiction at the heart of the crypto community. It is naturally leery of regulation, wants to see cryptocurrency mature, yet is still primarily driven by greed and FOMO. Crypto is also inherently complicated, so it is difficult for many investors to see through the technobabble into the true value of a project.
Government intervention is a blunt tool, and too slow to be useful now. But the crypto community may be building new ways to govern itself. Evai.io is working to build a decentralized rating system for DeFi projects that would help investors avoid exit scams and poorly built projects, without the need for government intervention.
OKEx CEO Jay Hao believes that if the DeFi bubble burst, it will be good for Bitcoin and Ethereum. However, he is confident that DeFi will survive and it is not going away.
A number of major corrections, as happened in early September, are inevitable. But if investors can be steered into the right projects, the crypto community may be able to avoid a repeat of the ICO crash and the bad press that followed.
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