One of the most notable events of the year in the cryptocurrency industry has been the explosive growth of the DeFi market. By the beginning of September, in just a few weeks, the volume of funds blocked on DeFi services more than doubled – from $ 4 billion to $ 8.75 billion. DeFi project tokens have become one of the most profitable assets on the market: some of them show incredible ROI, making xxx profit for investors.
Optimists are confident that DeFi has huge prospects. Pessimists suggest that DeFi is another bubble, which will repeat the fate of ICOs. Bit.News has figured out what is behind the rise of DeFi and what the future of this market will be.
The most popular segments of the DeFi market are lending and decentralized exchanges. As of the end of September, each of them accounted for just over 35% of blocked funds.
Crypto credit platforms operate on the principle of crowd-lending services. Participants in the system can deposit funds into it – deposit assets at interest, which are distributed among those wishing to issue a loan secured by security.
The loans themselves are issued in cryptocurrency. In DeFi services, which, with rare exceptions, operate on the Ethereum blockchain, ERC-20 tokens are used for these purposes. These are smart contracts containing the rules for conducting transactions within the network.
The first successful token was Maker’s DAI stablecoin. It was Maker and its competitor Compound that for a long time remained the leaders in the DeFi market in terms of the amount of blocked funds.
The DAI rate is not directly pegged to the dollar, but it constantly stays near this mark. The rate adjustment is provided by the system itself: with a decrease in the value of DAI, the issue of tokens decreases, which increases the demand for the asset and leads to an increase in its price, and vice versa. Thus, the value of the token is kept at around $ 1.
Lending platforms calculate two types of rates: on deposits – the percentage that the investor receives, and on loans – the percentage that the lender must return. Their size depends on many factors – on the platform, the size of the loan, the cryptocurrency in which the loan is nominated, and the demand for it, as well as the asset that acts as collateral.
In decentralized finance, loans are also backed by cryptocurrency. This feature determined another important difference between the DeFi market and the traditional bank lending industry. It is the over-collateralization of loans, which can exceed the size of the loan itself several times.
The need for oversupply is associated primarily with the high volatility of the cryptocurrency exchange rate and the lack of credit history among users who are applying for a loan. It is the high size of the collateral that is designed to guarantee the return of funds to the investor. In case of a sharp change in the value of the cryptocurrency in which the loan was issued, the position can be liquidated, and the funds from the collateral will be used to pay off the debt.
In the future, analogs of user credit histories will surely appear in DeFi: perhaps even users themselves will be able to independently decide how much information about their transactions they will have to disclose in order to receive a discount.
There are several factors that influenced the explosive growth of interest in crypto lending. The first is the issue of realizing the liquidity of crypto assets, similar to the one that faced their owners in 2016-2017 against the backdrop of the boom in ICO projects.
Another reason for the attractiveness of crypto loans was the possibility of simultaneous operation of various DeFi projects on the Ethereum blockchain.
At the same time, at this stage of development, the market cannot be called ideal, it is just beginning to develop. Therefore it is still associated with great risk.
One of the main reasons for the explosive growth of the decentralized finance market in 2020 was the boom in yield farming. In a broad sense, this is the name for a set of strategies that allow you to make money on investments in DeFi projects, that is, to get a “yield” from the “sown” investments. It includes various types of interaction with projects, among which the most common is the same cryptocurrency lending.
Earning funds on such lending, crypto farmers generate their income from “sowing”, that is, from participation in the work of the system. It can be very high – as noted earlier, the size of lending rates can reach tens or even hundreds of percent.
An additional motivation for the adherents of “profitable farming” is liquidity mining – the ability to earn native tokens of DeFi projects in exchange for interacting with the system. For example, for providing cryptocurrency for a loan. Owning native tokens allows you to directly participate in the development of the project by voting for various changes. For example, it is through voting that the maximum amounts of collateral and leverage are established, and the lists of assets that can be used as collateral are expanded.
Following DeFi lending, decentralized exchanges (DEX) began to gain popularity, which differs from centralized exchanges (CEX) in that they do not store personal information about users and their funds on their servers, functioning only as a platform that processes buy and sell orders.
On the one hand, unlike CEX, decentralized exchanges allow players to avoid dependence on a specific intermediary and create additional competition in the market. On the other hand, they practically exclude the KYC procedure, which carries additional risks for players.
According to the service Dune Analytics, over the past 30 days, the trading volume on decentralized exchanges has grown by 193%, exceeding the $ 14 billion mark. Potential competition from DEX is forcing major cryptocurrency exchanges to enter this market – for example, Binance has already done so.
“Yield farmers” strive to make a profit from investments in the project at any cost. Because of this, the object of their interest is often unaudited projects, the sole purpose of which may be to quickly attract and withdraw funds from investors.
In mid-August, the DeFi project YAM, which bills itself as “an experimental protocol with elements of programmable money issuance and management,” managed to raise $ 76 million in less than an hour. At the same time, the founders of the project deliberately refused to audit their smart contracts, but this did not bother the crypto farmers who continued to invest money in it. A day later, the capitalization of the asset reached $ 475 million, but after the publication of a tweet about the discovery of a critical bug in the protocol management system, it collapsed by 99% within a day, gradually reaching zero.
The startup yearn.finance has become very famous. The creators of the project accompanied the release of the token with a message, which repeated several times that their cryptocurrency is completely useless, there is no value in it, and investors should stay away from it.
The result is an increase in the value of the asset by 100,000% within five weeks, from $ 35 to $ 35,000. At the press-time, the token dropped in price to $ 22,900, but even this price allows yearn.finance to confidently stay in the ten largest DeFi projects in the world.
The token is to manage the platform. If you aren't interested in managing the platform, stay away from the token. pic.twitter.com/KE0dk24s3z
— yearn.finance (@iearnfinance) July 21, 2020
Exchanges are increasingly listing such tokens, not wanting to miss the opportunity to make quick and easy money, which is why they become the object of criticism from market participants. For example, Binance was accused of listing a token of the SushiSwap platform, whose value collapsed after its administrator sold most of its own cryptocurrency. In response, the head of the exchange, Changpeng Zhao, only urged users to be more competent in assessing their own risks.
One-day projects are the main, but not the only problem of the DeFi market. It is the activity of users of decentralized services who conduct a huge number of microtransactions that are named among the possible reasons for the unprecedented rise in gas prices in the Ethereum network. In this regard, there are concerns that an increase in its value may at some point make transactions on the blockchain impossible.
Besides, the problem of platform security is quite acute: for example, in April 2020 alone, five major attacks on decentralized services were recorded. In one of the cases, hackers managed to steal $ 25 million, and, albeit in a much smaller amount, funds from users of one of the largest decentralized exchanges Uniswap were stolen.
Another important feature of the decentralized finance market, as strange as it may sound, is its excessive centralization. Research shows that in the ten largest DeFi platforms, at least 90% of funds are concentrated in the 500 largest wallets. Such an accumulation of funds can hurt the future of projects because all decisions on their development will be made by a limited number of users.
— Simone Conti (@simoneconti_) August 6, 2020