Decentralized finance (DeFi) is considered the next big opportunity among blockchain technologies. But money is fleeing the sector amid a cryptocurrency market decline and fears of regulatory scrutiny.
Recently, red flags are starting to appear more often in the DeFi sector, one of the most profitable and volatile fields of the crypto world this year.
The steep 60% decline in the decentralized finance sector following the general flow of funds leaving the market of cryptocurrencies, like Bitcoin and Ethereum. But looking closely, it suggests some other factors.
According to Novum Insights, a DeFi yield-optimization firm, many of the tokens in DeFi applications, which allow users to borrow, lend, and trade crypto funds without a middleman, are underpinned by stablecoins that don’t fluctuate much in value like most common cryptocurrencies. That would suggest the decline is being driven by more than daily price fluctuations and too much leverage.
Nic Carter, a founding partner at Castle Island Venture, uses data from Richard Chen of venture fund 1confirmation to measure the decline. By his research, the sum of new daily users has shrunk to the lowest numbers since the sector started its rise in September 2020. The recent data shows, only a few thousands of new accounts are opened daily compared to about 40,000 in mid-May.
“DeFi is going to be challenged because it relies on this injection of new liquidity, and ultimately a lot of DeFi yields are a function of new buyers supporting token prices,” warns Carter. “I don’t think DeFi is going away, it just might be a less attractive place to park capital in the next few months.”
The intake of new users into the DeFi sector aided investors to achieve incredible returns overnight on tokens of DeFi apps, such as Compound and SushiSwap. Most DeFi applications let users lend out their coins to new users, earning returns by the loan. If there aren’t fresh users demanding the tokens, the yield falls.
According to data tracker DeFi Pulse, the sum of funds locked in Defi apps is already lost more than 40% than in mid-May. The fall of capitalization in the sector to $51 billion from $87 billion effectively shows the money reflux.
Investors’ attention has been drawn to the DeFi sector because of its triple-digit returns seen in the past year, often outran even the quadruple gains in Bitcoin.
“These experiments are very interesting and very promising, but that’s still all they are,” predicts Gil Luria, director of research at D.A. Davidson. “Just like any category of start-ups, I would expect most of the new financial services delivered through crypto technology to fail.”
Another big problem of the sector is the many DeFi apps have plenty of inherent issues till now. By Luria’s words, many projects have lacked the regulatory and financial controls and compliance processes, which makes them vulnerable to regulatory scrutiny. Some of these projects, such as Yearn.Finance, has also suffered hacks and lost millions of funds.
Billionaire crypto investor Michael Novogratz wrote on Twitter Wednesday that the sector could be facing a tougher regulatory crackdown.
Also, the lion’s share of the coin supply often owned by a small group of several investors and developers, such as the popular DeFi exchange Uniswap, which shared about 40% of its Uni token supply among its team, backers and advisers.
Moreover, the DeFi tokens have been subject to front-running using bots – autonomous software agents. Users of many DeFi apps, which run on the Ethereum blockchain, can choose to pay a higher fee to have their transactions processed faster. That makes front running possible when someone can see transactions in a queue and pay more to have his own transaction processed beforehand, making money on a difference in a coin’s price.
The major part of DeFi exchanges has suffered from front running, which is considered as a realistic threat to Ethereum today. The front-running risk deters users from joining decentralized exchanges, thinks Klaus Kursawe, a consensus researcher at Vega, who is trying to fix such problems.
“I could essentially be the middleman with no risk,” he says.
But even despite technology, regulatory and other issues, many investors still see DeFi as a promising field. As Aaron Brown writes for Bloomberg Opinion, “I’d say the frenzy in DeFi is fading, but the long-term prospects remain strong.” “This is not a bubble that popped leaving nothing behind, it’s a market that got a little ahead of itself and is now retrenching a bit,” a crypto investor claims.