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Decentralized finance (DeFi) has come under the spotlight in recent weeks, largely because of the shocking collapse of the Terra ecosystem. The network's breakdown wiped out tens of billions of dollars in a matter of days and sent tremors through the whole crypto market.
One of the most severe aftershocks so far has been Celsius, a crypto lending platform that paused withdrawals amidst rumors of insolvency. Another is the crypto hedge fund Three Arrows Capital, which appears to be in trouble, though we don't yet know the details.
What's behind DeFi's difficulties?
DeFi -- an umbrella term for a host of applications that take the middleman out of traditional finance -- is a cornerstone of the crypto market. It encompasses lenders, decentralized exchanges, interest-earning platforms, among other things. Before it collapsed, the Terra blockchain was a stablecoin-based payment network that also hosted the high-interest-paying Anchor protocol.
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There are many industry experts who would say that some aspects of the DeFi industry have long been a ticking bomb. The only question was what would set it off, and how much damage it would do. Anchor's 20% APY on stablecoin deposits was exactly the type of thing those insiders were concerned about. It simply wasn't sustainable, and when things started to go wrong it quickly spiraled out of control.
But it isn't so much the specifics of any one platform that is the issue. It's a kind of crypto fairy dust that causes people to believe that anything is possible simply because it is on the blockchain. That and the fact that when you take out the middleman, you also take away a lot of safeguards and consumer protections that have evolved over decades.
A report from BIS -- the Bank for International Settlements -- at the end of last year warned of the dangers of "high leverage, liquidity mismatches, built-in interconnectedness and the lack of shock absorbers such as banks." Some of these DeFi protocols are extremely experimental and once one domino falls, it can start a cascade. For example, if Celsius and Three Arrows Capital fail, others could follow.
Is DeFi doomed?
DeFi is definitely in trouble. One useful metric in looking at smart contract cryptos and decentralized finance platforms is total value locked (TVL). According to DeFi Llama, the TVL for most of the top DeFi chains is down by 30% or more in the past month. At the start of April, the total TVL across all blockchains was over $170 billion. That figure is now around $60 billion -- 65% less than before the Terra collapse.
Some insiders think this is a necessary step, as it will cut out the extreme projects and leave the industry better placed to move forward. Others think it highlights deeper issues with decentralized finance, which won't be easily resolved. These current problems may also spur lawmakers to act faster in putting stronger regulatory frameworks around crypto and DeFi, which will cause more short-term pain but might build investor confidence in the long term. Ultimately, it's too early to tell, but there are some real risks to consider.
Bottom line
These are uncertain times and investors would be wise to brace for more turbulence. If you have money on decentralized finance platforms, make sure you fully understand how the platform works and how it's generating any rewards. If you've moved any of your savings onto a high-interest DeFi protocol, tread carefully and look into what might happen to your funds if the platform collapses. Unlike a traditional savings account which has FDIC insurance against bank failure, investors may lose everything.
While DeFi may not be doomed, there may well be more trouble on the horizon. Right now, the aftershocks from Terra's collapse are still being felt and it's hard to know how far they will spread. If more projects go the same way, it will destabilize the market even more and have a further impact on the rest of the crypto market.
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