There are a lot of questions being asked about DEFI right now. There is a lot of worry and doubt. There have been recent disasters involving popular DEFI chains that have collapsed and disappeared. The Total Value Locked (TVL) in DeFi has dropped from $250 Billion to $75 Billion. Investors are asking, ‘will DEFI still be a popular choice for investors in the future?’
What is DeFi?
DeFi stands for Decentralized Finance. It is a sizable financial infrastructure on the blockchain that focuses on decentralization. The DEFI network aims to avoid the traditional financial system of using banks. Some people refer to this idea as being ‘disruptive.’ It circumvents the usual financial process and offers a new way of dealing with finance. You can borrow, lend, and stake cryptocurrencies outside the standard banking system.
In May 2022, one of the most popular stablecoins, TerraUSD or UST, and its sister coin, Luna, collapsed. Luna plunged from $119 to $0 in less than a week. Today, UST fluctuates between 2 and 3 cents. The effect on the DEFI market was catastrophic, with the value across all significant DEFI protocols falling from $195 billion at the beginning of May to $112 billion in just a few days.
Putting All Your UST in One Basket!
So what happened? Some people would say pure human greed. Others would say over-ambitious targets. The problem started when the TerraLuna network offered a massive 20% annual yield to investors who bought UST and then loaned it back to another protocol operating on the platform, called Anchor. The Anchor was also borrowing and lending on the chain. Terra was using Anchor to attract capital. By offering such a substantial return, investors bought in! Very soon, 75% of UST coins were parked in Anchor. That is a precarious position because the losses would be unsustainable if anything were to go wrong.
Things did go wrong. First, BTC plunged, taking down most of the crypto market, including Luna. That hit UST hard, as UST used Luna to absorb price volatility shocks. The result was that UST dropped below a dollar in value. As a stablecoin, pegged to the dollar, that is not supposed to happen. Confidence sank. Investors panicked and sold. Anchor’s weight dropped 99%. The TerraLuna protocol suddenly had no value.
This was the first major crash in the DEFI network. The situation is still tricky today with protocols such as Aave, the third largest DEFI, with a TVL of $5.07 Billion, crashing 78% this year.
So What Was the DeFi Problem?
Finding the right balance is crucial because you have to earn enough interest to pay out savers, and you also need to have enough reserves to pay investors when they make a withdrawal. For example, Celsius promised interest of up to 18 percent. Investors were, of course, worried that very little liquidity was left to make payouts. When TerraLuna collapsed, investors bailed out of Celsius too.
DeFi Is A Vampire
Defi is not dead. It’s just sleeping. It’s waiting to return with a vengeance. There are many financially solid, lower-risk protocols that will not play the dangerous game that TerraLuna played, i.e., If you offer too big a return, you are playing a dangerous game.
A valuable lesson has been learned, and investors will be more diligent in the future and seek more conversative opportunities. Likewise, DEFI protocols will be more cautious with their offers and estimated returns.
Just be careful with your choices. For example, DeFi protocols based on the Ethereum platform may be more risk averse, but the more risky investment choices will be hit the hardest during a panic. Do your research, and remember, if it sounds too good to be true, it probably is.