The cryptocurrency market has had a rough time this year, with the collapse of multiple projects and funds setting off a contagion effect that affects just about everyone in the space.
The dust has yet to settle, but a steady stream of details has allowed investors to piece together a picture that highlights the systemic risk of diversification and poor risk management.
Here’s what several experts have to say about the reasons behind DeFi’s collapse and what they need to do for the industry to make a comeback.
Failure to generate sustainable income
One of the most frequently cited reasons for DeFi protocols to struggle is their inability to generate sustainable revenue that adds meaningful value to the platform’s ecosystem.
Basic design principles of DeFi:
– If the protocol cannot function without reward tokens, it is a Ponzi scheme
No reward tokens are required to run the protocol. This means that the agreement is not a revenue-generating business.
— Joseph Delong* (@josephdelong) May 23, 2022
In their attempt to attract users, deliver high yields at an unsustainable rate with insufficient capital inflows to offset spending and provide potential value to the platform’s native token.
This essentially means that the backing token has no real value and is used to pay for the high yield offered to users.
When users start to realize that their assets aren’t really getting what they promised, they withdraw their liquidity and sell reward tokens. This, in turn, caused the token price to drop along with a drop in Total Value Locked (TVL), which further caused panic among protocol users who likewise pulled their liquidity and locked in the value of any rewards received.
Token Economics or Ponzi Economics?
A second flaw highlighted by multiple experts is the poorly designed token structure of many DeFi protocols, which often have extremely high inflation rates used to attract liquidity.
High rewards are great, but if the value of the tokens paid out as rewards doesn’t exist, users are basically taking a lot of risk as they give up control of their funds with little or no reward.
Much of this has to do with DeFi’s revenue generation issues and the inability to build sustainable national debt. High inflation increases token supply, and if token value cannot be maintained, liquidity leaves the ecosystem.
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Excessive use of leverage is another common problem in DeFi, a flaw that became apparent as Celsius, 3AC, and other platforms that invested in DeFi last month began to unravel.
Users who bet on these inflationary tokens to overexploit their positions were liquidated as the market sell-off caused prices to drop.
This led to a death spiral of the protocol. @Wonderland_fi is one such protocol where users borrow $MIM with $TIME and get liquidated
— Magik Invest ✨ (@magikinvestxyz) June 28, 2022
These liquidations have only exacerbated the downtrend already experienced by many tokens, setting off a death spiral that has spread to CeFi and DeFi platforms, as well as some centralized cryptocurrency exchanges.
In this sense, without a solid game plan in a market downturn, the onus for overleveraging really falls on the user. While it can be a challenge to think about these things during the peak of a bull market, it should always stay in the minds of traders as the cryptocurrency ecosystem is known for its wash-and-run volatility.
The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Cointelegraph.com. Every investment and trading move involves risk and you should do your own research when making a decision.