Post-Luna, Can DeFi Weather the Current Storm?

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DeFi has been the darling of the crypto sector for most of the last three years. However, recent events, including the sudden and dramatic implosion of LUNA and UST, have led to much speculation about the future of this nascent sector. Can DeFi weather the current storm to resume its previous meteoric growth?

It’s fair to say that even before the Luna incident began, there were signs that DeFi’s honeymoon era may be nearing the end. From January 2020 to December 2021, the total value locked in DeFi increased by 200 times, from $1 billion to $200 billion. However, at the turn of this year, as the crypto bull market began to turn bearish, value locked in DeFi began to fall.

Over the last year or so, the space has been dogged by a series of huge hacks. In August 2021, an attacker managed to steal over $600 million, which was fortunately later returned. However, in January, it was left to a philanthropic stakeholder to replenish over $300 million stolen when the Wormhole bridge between Solana and Ethereum was hacked. In April, fraudsters made off with $625 million from a hack of the Ronin blockchain, which supports the popular Axie Infinity game.

In May, Luna began its death spiral, wiping $60 billion from the cryptocurrency markets in a matter of days. The incident wasn’t a hack, but long before it began, some detractors had been pointing out that it was set up to fail. The much-vaunted 20% “yield” being paid by Anchor Protocol on UST deposits was effectively an unsustainable arrangement that relied on new users continually pumping in funds while a small handful of long-term holders were savvy enough to redeem their holdings early in the game.

A full post-mortem of the incident is beyond the scope of this article. Suffice to say that Luna’s collapse has shaken the crypto community and the DeFi sector to its core. It’s also worth noting that at the time of writing, the markets are currently reeling from yet another shock – the news that lending platform Celsius has halted withdrawals.

The Decentralization Dilemma

Of course, Celsius has never claimed to be decentralized, so it’s arguable whether it deserves mention in the context of DeFi. However, it raises an important point that’s become clearer as the DeFi sector has evolved. DeFi has become a blanket term for describing blockchain-based financial applications and protocols that are intended to operate automatically based on smart contracts.

However, it’s not unreasonable to say that under the hood, most DeFi applications are about as decentralized as Celsius. Indeed, in the case of Terra’s collapse, most people place the blame squarely at the door of its founder, Do Kwon, implying that Terra’s operations were highly centralized under the control of a single person.

Even those protocols operating under governance tokens arguably have a strong centralized component, given Ethereum isn’t equipped to process much more than straightforward asset transfers. Elements such as web and data hosting are typically centralized, and under the control of founding teams.

The fact that much of DeFi remains at least partially centralized also effectively kills the idea that DeFi protocols are censorship-resistant and beyond the reach of regulators. Following the Terra incident, the German financial regulator called for EU-wide efforts to regulate DeFi, while speculation is rife that US lawmakers will use the opportunity to clamp down on DeFi operators.

What Next for DeFi?

It’s evident that DeFi is currently locked in a perfect storm of events. One commentator has even called it crypto’s “Lehman moment,” referencing the sub-prime mortgage collapse that precipitated the start of the 2008 financial crisis.

Whether or not that’s justified, it seems fair to assume that the Luna crash will come to be viewed as a watershed moment for DeFi. The regulatory question has been looming over crypto for many years now, so it’s only reasonable to expect that regulation will be extended to DeFi at some point.

We can also anticipate that regulators will seek enforcement action against the individuals they deem responsible for launching and running these protocols, regardless of how decentralized they may proclaim to be. If it comes down to it, even paying for the web hosting necessary for a front-end interface could be deemed sufficiently “responsible” for a DeFi operation in the eyes of a prosecutor.

However, DeFi may be down, but it’s definitely not out. 2021 was a record year for venture investments in crypto projects, with over $30 billion in funding pouring into the sector. Investors remained bullish into 2022 even as overall market sentiment was turning bearish. Those investments will be put into building products and communities, much of which have yet to come to fruition.

Then there’s the institutional interest in crypto and blockchain, which hasn’t yet peaked. Sam Bankman-Fried has been a huge proponent of bringing elements of risk management in financial transactions on-chain. The US Commodities and Futures Trading Commission has now opened up a consultation on his proposal for FTX to deploy automated liquidations on positions that don’t meet the minimum margin requirement.

If approved, it could pave the way for transforming the entire US financial system by eliminating a huge part of the broker’s role. Incorporating blockchain into the financial system will inevitably lead to the broader adoption of DeFi-type applications that facilitate trade and commerce.

Chilly Times Ahead?

It’s worth noting, though, that crypto is now undeniably in bearish territory. If previous market cycles are any indicator, the downturn could likely continue for another year or even more. Therefore, the short-term outlook for any related sector could be similarly bearish. More so than other segments like NFTs, DeFi is inextricably linked to activity in the crypto space. It depends on users holding crypto and generally being bullish enough to speculate through trading and the credit markets.

So while the long-term prognosis gives good reason for DeFi degens to remain positive, the short and mid-term is likely to involve sharing the pain with the rest of the crypto markets. For now, it’s time for the faithful to sit it out and wait for the sunnier days to return.

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