An introduction to DeFi
If you have any interest in cryptocurrency, NFTs, and other digital assets, you’ve likely heard about DeFi. The open alternative to traditional banking has taken off spectacularly in recent years, with almost $60 billion worth of cryptocurrency invested into it as of last month, according to the latest data from Statista. At its peak in October of last year, DeFi held more than $100 billion.
But what exactly is DeFi? And what are the advantages and disadvantages to using it? Here’s what you need to know if you’re a newcomer — including the latest on the rapid collapse of the Terra blockchain and its TerraUSD (UST) and Luna cryptocurrency tokens.
What is DeFi?
DeFi is short for decentralized finance, the term used to describe a financial system based on secure distributed ledgers, much like those used for cryptocurrency.
Use of the term DeFi dates back to 2018, when a group of software developers came up with an alternative to traditional financial services that would be automated and built on the blockchain. DeFi is a little like a bank, providing a way to invest your money and earn returns. However, it is also free (for now, at least) from the laws and regulations that govern traditional banks, as well as free from the control normal banks possess.
Because DeFi is decentralized and powered by the blockchain — the same technology used by cryptocurrency — no single person or entity has control over it. This brings some significant advantages, but there are disadvantages, too. And because DeFi is still very much in its infancy, there are many questions about its future that remain unanswered.
What are the advantages to DeFi?
The principal advantages of DeFi are accessibility, reduction in friction, and potentially higher returns and lower fees.
DeFi shares many of the same advantages that we’ve come to expect from cryptocurrencies. One of the biggest is that anyone can access it, so long as they have an internet connection. It doesn’t matter where you live, who you are, or what socioeconomic position you’re in. You don’t have to prove how much you earn, and you don’t even need a fixed address. DeFi is open to everyone.
Another big advantage is that DeFi is, by definition, decentralized. It’s powered entirely by the blockchain and allows users to do away with the third parties that are typically involved when dealing with traditional banks. Borrowers can communicate, negotiate and deal directly with their lenders, rather than a random person at a large organization. It’s also entirely open source, so anyone can build DeFi products, which typically means a wider range of lenders to choose from, and greater flexibility.
While it’s not clear how much longer this will last, one of the additional advantages of DeFi is the potential to realize gains without taxation — in several countries at least.
What are the disadvantages to DeFi?
The principle disadvantages are that it doesn’t have the protections of regulatory agencies and so the possibility of scams and manipulation are greater. It is also subject to the volatility of cryptocurrencies.
In essence, the things that make DeFi so appealing also tend to be the things that make using it somewhat risky. Its open nature makes it an appealing target for hackers, scammers, and other attackers. In recent years, there has been a rise in DeFi “flash loan attacks,” in which borrowers seek finance from multiple different lenders and use it to manipulate markets for their own benefit. A flash loan occurs when users borrow and settle DeFi loans within a very short period of time. Unlike other loans, which require some form of collateral, flash loans are “secured” by setting a tight time limit in which repayment must be made. If the loan is not repaid within that limit, the transaction is voided automatically. Flash loan attacks happen when traders exploit the system by using various tricks to quickly buy and sell cryptocurrencies to make a profit.
For instance, a trader might borrow $50,000 and spend it all on one cryptocurrency on one exchange, where the price is $10 per token. They then sell the tokens on another exchange, where the price is $12 per token. Once the $50,000 loan is repaid, the trader is left with $10,000 in profit.
There has also been a rise in DeFi “rug pulls,” in which scammers create a new cryptocurrency token, wait for people to invest other, more valuable tokens into it, then disappear with those investments. This leaves only worthless tokens behind, and holders are unable to recover their investments.
What’s more, because DeFi isn’t protected by the same laws and regulations that govern traditional banks, there is no one to step in and support those who have lost out when these scams do occur. It’s up to users themselves to understand the risks and protect their assets.
Another thing to be aware of is that DeFi is very closely tied to cryptocurrencies, typically Ethereum, which are volatile by themselves. So, it is possible to borrow $1,000 worth of Ethereum, for instance, that ends up being worth significantly more or significantly less just a short time later.
The collapse of Terra and Luna
To better understand the risks involved with DeFi, you only have to look at the recent collapse of the Terra blockchain and its UST and Luna cryptocurrency tokens. On May 9, after more than 18 months of steadily holding its value against the U.S. dollar, stablecoin UST became unpegged. It subsequently suffered a significant nosedive in value that has had a substantial impact on the entire market.
The problem is that, unlike many stablecoins, UST isn’t backed by dollar reserves, which would have helped it remain more securely pegged to the fiat currency. Instead, UST is backed by Luna, its partner token, which sees $1 of Luna removed from circulation every time a new UST token is minted — and vice-versa. UST was also tightly linked to the Anchor lending protocol.
Anchor gave UST holders the ability to deposit their tokens for massive yields of up to 20% a year, which was obviously an attractive prospect for investors, who inevitably took advantage of the opportunity in droves. Before the crash, Anchor held an astonishing 75% of the entire supply of UST tokens, or $14 billion worth of the total $18 billion (before the price fell).
But those unbelievable yield rates couldn’t last forever, and although Anchor hadn’t decreased them too significantly, investors started pulling their UST tokens anyway. In early May, deposits dropped from $14 billion to just $3 billion, and since Anchor was one of the few real use cases for UST, most of those tokens ended up on the open market. This led to major selling pressure in the Terra ecosystem.
Both Luna and UST began to see sharp drops in price, and for the first time ever, the market cap of Luna overtook that of UST, so $1 worth of Luna was no longer worth $1 of UST. Luna Foundation Guard (LFG), the nonprofit behind both tokens, decided to sell off its stockpile of Bitcoin tokens worth billions of dollars and buy UST in an effort to raise its price again, but it had little success.
The crash saw the price of UST drop from around $1 to as little as $0.10, while Luna fell 99%. Almost $60 billion in value was wiped from their combined market caps, which caused a knock on effect across the entire cryptocurrency industry — including for Bitcoin and Ethereum — as many investors started to panic.
To put the crash in perspective, we only have to look at Binance’s investment in Luna. In 2018, the company put $3 million into Luna and received 15 billion tokens in return. In April, when the price of Luna hit its peak, the value of those tokens reached a whopping $1.6 billion. Just a month later on May 18, the same tokens were worth less than $2,400.
What’s the latest?
As things stand, the value of UST has begun to climb again, but it is currently sitting at around $0.30 per token, which is less than a third of its value before the crash. LFG is yet to give up, and it is currently weighing various plans that it hopes will lead to UST’s recovery in the future. But it’s likely going to be a very long road, and there’s currently no telling whether a full revival is possible.
The whole fiasco is an eye-opening reminder of how volatile some aspects of the cryptocurrency industry can be. But it certainly doesn’t signal the end of cryptocurrency or DeFi.
DeFi has a long way to go
As you’ve probably established after reading about the risks, DeFi is still developing, and there are lots of areas in which it needs to improve with more robust systems and technologies. It’s also likely that it will face some kind of regulation at some point, with the Securities and Exchange Commission (SEC) in the U.S. already urging DeFi participants to comply with the law or face the consequences.
However, for an increasing number of cryptocurrency investors, DeFi has become a much more appealing and more accessible alternative to traditional banks. It almost certainly isn’t going away any time soon, so there’s a good chance its many kinks will be ironed out, and that DeFi will become a safer, more stable (but still very much open) system in the future.
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