Why DeFi Is Going to Fail: Solution and Consequences

defi market article cover with logo of uniswap chainlink

We hear about Decentralized Finance (DeFi) and its tokens here and there. Everybody says that DeFi is a new level of cryptocurrencies: the DeFi platforms are opened, transparent, and self-custodial. They give us an opportunity to become rich very fast and not be in charge of the consequences. What possibly can go wrong? 

Some experts think that the prosperous era of DeFi is about to go. Others expect it to grow and prosper. In this article, we’ll try to find out why the DeFi sector is probably going to fail and what are the consequences for the investors. 

Is DeFi a Bubble?

We all remember the boom of ICO in 2017. DeFi now repeats the same trends: investors put up money with a desire to become rich without any responsibilities. People became kind of crazy about DeFi projects mainly because of two things: their transparency and benefits for borrowers. 

What are DeFi platforms used for? First of all, they offer to provide or receive loans (like Compound or Aave), exchange currencies (like Uniswap), or just for payments. The unique thing about such platforms is that they are not connected to any bank, third-parties, or government. 

Initially, there is no liquidity in DeFi projects. However, the developers found a way to solve this problem: they created some motivational models that helped them transfer the money flow from centralized to decentralized platforms. One of the forms is yield farming

The investors play the role of those who are increasing the liquidity of the platform. Since they cannot trade or sell these tokens, they are just investing them to get the quick profit offered by the yield farming process. It reduces the supply of available tokens for trading, so actually, yield farming feeds the bubble. By the time of writing, the DeFi Pulse Index lost 13% for the last month. 

defi pulse index with the chart for one month (23 October 2020)
DeFi Pulse Index (10/23/2020)

The problem is that decentralized platforms don’t have any rules. Most of them are archaic organizations that are managed by the community. There is no regulation in such forms as KYC or AML, so it’s kind of hard to detect and capture any criminal activity. By the way, liquidity pools increase the risk of money laundering. 

Frankly speaking, centralized lending platforms are the only entities that seem to have the future. Such platforms offer greater functionality and speed. Yes, it might contradict the main idea of cryptocurrencies, such as decentralization and anonymity. But let’s be clear, the money needs third-party to be controlled and regulated. 

DeFi is operating in a highly volatile and unpredictable market. There is another statistic about DeFi projects: only 30% of these assets work within such platforms. There are two reasons why DeFi doesn’t unfold in full force. The first is the fact that transaction fees are ridiculously high. We’ve already discussed it in the article about Ethereum’s gas. All the activity in DeFi frames makes the Ethereum blockchain too overloaded. 

The second reason is the lack of insurance. Users are absolutely not insured against any cases of theft or just exit scam. By the way, there are already some cases of scam in DeFi. One of them we’ll discuss in the next few paragraphs.

Some DeFi Projects Turn Out to Be a Scam

An unknown user recently lost $140,000 in Uniswap decentralized exchange tokens after being placed in the UniCats project pool. This man stumbled upon a fancy lucrative farming scheme called UniCats. He thought that it could replicate the success of yEarn Finance (YFI) and decided to contribute some UNI.

He received a message from MetaMask: “let this dapp spend your UNI.” The investor, believing that this is standard practice for all similar DeFi protocols, agreed.

The creators of Unicat provided a backdoor in the smart contract. The attackers conducted two transactions for 26,000 (~$94,000) and 10,000 UNI (~$38,000). Obviously, our investor was not the only victim.

Unicat managers have devised a scheme. To cover their tracks, they create a new smart contract for each new victim and transfer the pool ownership to it. Each new contract assigns a portion of the funds, exchanges them for Uniswap, and transfers onwards to addresses owned by Unicat. The stolen ETH was then transferred to the Tornado Cash mixer.

What SEC Thinks of DeFi?

The decentralized finance sector will challenge the regulatory framework and force many difficult questions to be asked about what it really is and how it should be regulated. Speaking at the LA Blockchain Summit, Hester Peirce, U.S. Securities and Exchange Commissioner, said that despite the potential for disruptive change and promises of self-regulation, government oversight of DeFi protocols will be difficult. She has previously talked about the need to be less liberal in the regulation of the decentralized finance sector.

According to Pierce, there are numerous questions about the impact of the governance tokens of decentralized platforms on corporate governance. The Commissioner plans to consider the changes in the industry and make an updated version of his proposal for a regulatory vacation. For example, the part devoted to the protection of token buyers could get a more extended interpretation. Pierce is also looking at disclosures and technical issues to limit the token sales rate by startup founders.

DeFi Coins’ Fate – Bottom Line

For the last three months, the volume of DeFi investments has increased by more than $9 billion. Even the Ethereum leader, Vitalik Buterin, criticized the new trend in the DeFi. For about a month now, the DeFi sector lost part of its trend after the overall DeFi market decrease. Just look at the numbers below:

table contains the list of the most popular defi coins such as yfi, chainlink, compound, sushiswap, bancor, etc. and its price decline from the beginning

On October 7th, the decentralized projects’ market capitalization fell by more than 20%. At the end of October, the vast majority of DeFi coins lost in their price twice. Remember that the cryptocurrency market is very volatile, so the actual trend is very unclear.