Following the meltdown of a well-known stablecoin, a cascade of events took place, including the insolvency of a well-known venture fund, the collapse of a vital lending project, and the aftermath of significant price drops across all major and minor currencies. The total market cap of crypto has plunged to below US$1 trillion compared to May 2022, when it was over US$2 trillion.
Despite being in bearish market conditions, decentralised finance (DeFi), which enables users to trade without intermediaries like banks, has remained steadfast in developments and looks to emerge stronger than before.
The recent events have paved the way for the shedding of weak projects and consolidation of projects with strong tokenomics and business models.
The next growth phase will see DeFi reach greater maturity and achieve long-term sustainability, with protocols having improved revenue models, governance structures and risk management practices, and at the same time receiving greater acceptance across mainstream audiences and finance professionals.
The impact of current events on crypto and DeFi
We saw bailouts ensued with Goldman Sachs leading an investor group to raise US$2 billion to buy Celsius’ assets (the centralised lending company that collapsed). BlockFi, regarded as a blue-chip lender and also a centralised entity, received a US$250 million loan from crypto exchange FTX. Regulators have started to hunker down, paying attention to enforcing guidelines ahead of their roadmaps.
Mainstream investors, many of whom were subscribed to centralised platforms, lost savings and faith in the industry, while crypto projects are impacted by resourcing and their ability to repay debt, with many having to downsize or right-size.
We also saw liquidations of collateral because DeFi applications have suffered due to practices of over-leveraging or over-stacking using the same initial capital. Troubles in one application, therefore, have cascading effects on others.
Though prices have been impacted, DeFi ultimately escaped unscathed from the recent market upset. We also see continuous investments into the space, with Citi recently announcing that it is working on its digital asset custody capabilities, while BlackRock is offering crypto for institutional investors through Coinbase.
On the philosophical front, crucial questions have surfaced: Should bailouts be an expected pattern in downturns, and how does this differentiate crypto from Traditional Finance (TradFi)? How involved will regulators be moving forward, how will their involvement change the landscape, and is this something that is welcomed? How can good DeFi projects be better insulated from the impact caused by bad projects?
Breaking down financial crises and why DeFi matters
If we follow the trajectory of finance, there is a time for new products to be introduced and go through cycles before they can emerge stronger. Similar to the 2008 financial crisis where TradFi institutions failed due to a lack of good governance, the crypto space has seen mismanagement of processes.
Also Read: Is the crypto market dead again?
These risks taken are unacceptable to mainstream investors. Recent events have prompted a deleveraging and “cleaning up” of weaker projects regarding utility, tokenomics, and ideology.
The nature of the crypto market’s downturn in 2017 and 2022 is also vastly different. The phenomenon that took place in 2017, namely the ICO bubble, caused an existential threat to the entire space.
However, the ecosystem in 2022 has significantly matured, with many more blockchains and apps created and used, as well as more financially-savvy professionals like financial institutions and venture capitalists becoming important market players.
The market conditions today are also being affected by a wider market downturn, contributed by interest rate hikes, and markets being overleveraged, which has compounded the effect on a comparably smaller crypto market.
Despite turbulent times, DeFi protocols continue to advance what financial institutions (FIs) are already good at while significantly reducing resources and optimising processes.
Blockchain technology enables protocols to operate with a substantially smaller headcount requirement due to reliance on code for processes rather than people. Developmental blockages typical of FIs are also reduced as there is less manual coordination necessary.
Distinctly different from centralised finance (CeFi) and its opaque black boxes, DeFi’s ability to track user funds on-chain enables users to understand the utility and track movements of their funds. The aforementioned Celsius and BlockFi are examples of CeFi.
The recent downfall of Celsius, which resulted in investors being unable to regain their funds, highlighted a clear lack of transparency in funds and operations. One promising possibility is more open and efficient monitoring of the on-chain activity by regulators that could significantly improve current processes that require extensive research and reporting by audit institutions.
This transparency that is evident in DeFi is the fundamental building block of a financial system that will only see greater adoption in time.
The future of DeFi is bright
We will observe more consolidations taking place through strategic partnerships and new trends emerging, such as projects taking up credit lines to create a greater buffer to secure their customer’s assets. Regulators will take a firmer approach and become more hands-on locally, while anonymity and AML will be bolstered and will aid in the upwards trajectory of DeFi.
We will see institutions continue to pour into crypto. Innovations in DeFi will continue to take place and are already on the horizon, including The Merge for Ethereum, Layer 3, and DeFi 2.0.
Also Read: Are we prepared to embrace the possibilities of Web3 beyond crypto?
While promising a bright future, there is still much more room for DeFi to mature. DeFi in its current form is relatively primitive. DeFi projects need to study and include the sophistication of TradFi that has been tried and tested over decades.
Projects need to put into place TradFI’s more rigorous safety features while creating policies for risk management. They also need to better educate everyday users about their products, not only about the benefits but also the downside risks associated with participating in these opportunities.
Besides upgrading systems, DeFi needs to take an honest look at what good governance really entails. Taking another lesson from TradFi, governance is what well-run and regulated institutions are good at, with rules and guidelines put in place to ensure investors are not defrauded.
On the jurisdictional front, certain approaches have stood out more than others. Singapore, for instance, took a strict stance before May’s events, intending to protect ordinary investors while bolstering the support of institutional investors. There is wisdom here for other jurisdictions to learn from and implement while DeFi moves forward in its maturation cycle.
The end of one era, the beginning of a new one
We have seen a significant impact on crypto and DeFi alike. However, DeFi has remained relatively unscathed and will survive the next uptake, as it was largely centralised projects that took a major hit. The recent events have sparked interest from serious institutional investors and more regulation worldwide.
It has also invigorated new DeFi possibilities, more diverse protocol segments, and new players and talents entering the space. While the journey towards recovery for projects, developers, and investors will be a continual process, the future of DeFi looks bright. These events were the catalyst for strong projects to stand the test of time, like gold being refined through a furnace.
–
Editor’s note: e27 aims to foster thought leadership by publishing views from the community. Share your opinion by submitting an article, video, podcast, or infographic
Join our e27 Telegram group, FB community, or like the e27 Facebook page
Image credit: Canva Pro
The post Spiraling DeFi sector still promises investors a bright future appeared first on e27.