The cryptocurrency market has been through a rough patch this year and the collapse of multiple projects and funds caused a contagion effect that has hit almost every token in the space.
Things seem far from calm, but a steady stream of details is allowing investors to piece together a picture that highlights the systemic risks of decentralized finance and poor risk management.
Here is a brief summary of what various experts are saying about the reasons for the DeFi sector crash and their perspectives on what needs to be done for the sector to recover.
Not being able to generate sustainable income
One of the most cited reasons for the difficulties of DeFi protocols is their inability to generate sustainable revenues that add significant value to a platform’s ecosystem.
Fundamental Design Principles for DeFi:
– If the protocol doesn’t work without a reward token, it’s a Ponzi scheme
A reward token should not be necessary for a protocol to function. That means the protocol is not a revenue generating business.
—Joseph Delong* (@josephdelong) May 23, 2022
Fundamental design principles for DeFi:
– If the protocol doesn’t work without a reward token, it’s a Ponzi scheme.
A reward token should not be required for a protocol to work. This means that the protocol is not a revenue-generating business.
In their attempt to attract users, they offered high returns that are virtually unsustainable, while there was not enough influx to offset payments and provide underlying value for the platform’s native token.
This essentially means that there was no real value backing the token that was used to pay the high returns offered to users.
When users began to realize that their assets were not actually earning the promised returns, they withdrew their liquidity and sold the reward tokens. This, in turn, caused a drop in the price of said tokens, along with a drop in the total value locked (TVL), further inciting panic among protocol users, who were similarly rushing to recover their liquidity and ensure the value of the rewards received.
Tokenomics or Ponzinomics?
A second flaw highlighted by multiple experts is the poorly designed tokenomic structure of many DeFi protocols that often have an extremely high rate of inflation that was used to attract more liquidity.
Everyone likes high rewards, but if the value of the token being paid out as a reward isn’t really there, then users are essentially taking a huge risk by relinquishing control of their funds for little or no reward.
This is largely related to the revenue generation problem of DeFi protocols, and the inability to create sustainable treasuries. High inflation increases the number of tokens in circulation, and if the value of the tokens is not maintained, liquidity leaves the ecosystem.
Excessive user leverage
Excessive use of leverage is another endemic problem within the DeFi sector, and this flaw was made abundantly clear when Celsius, 3AC, and other DeFi-invested platforms began to unravel last month.
Users who staked these inflationary tokens to over-leverage their positions got liquidated as prices dipped due to market sell-offs.
This led to a death spiral for the protocol. @Wonderland_fi is one such protocol where users leveraged $TIME to borrow $MIM and got liquidated
— Magik Invest ✨ (@magikinvestxyz) June 28, 2022
Users who locked up these inflationary tokens to over-leverage their positions were liquidated when prices fell due to market sell-offs.
This led to a death spiral for the protocol. Wonderland Money is one of those protocols where users leveraged TIME to borrow MIM and got liquidated
These liquidations only worsened the downward trend that many tokens were already experiencing, triggering a death spiral that spread to both centralized and decentralized finance platforms, and to a few centralized cryptocurrency exchanges.
In this sense, the onus is on users for being over-leveraged without a solid strategy on what to do in the event of a market crash. While it can be challenging to think about these things during the boom of a bull market, it should always be something on a trader’s mind because the crypto ecosystem is well known for its volatility.
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