Decentralized finance, in a nutshell, promises transparency and offers beneficial terms for borrowers. DeFi platforms are supposed to build an alternative financial system for offering/receiving loans, exchanging currencies, making payments, etc. There are no banks, brokers or trusted third parties, governments are not involved, and finally, notorious middlemen are eliminated. There is just secure, transparent software.
DeFi allows borrowers to take hassle-free loans: You don’t have to worry about bank account creation, lengthy application reviews or paperwork. For crypto holders, DeFi offers an opportunity to lend their assets to other users, thus earning a profit of about 20%. Decentralized exchanges often act as custodians of funds, thus eliminating that annoying middleman again. This is how DeFi should work and probably will work someday. And what follows is the actual current situation.
What’s wrong with DeFi in its current state
Decentralization is a very lucrative word. The philosophy behind it is rather romantic, or in more honest terms, utopian: a world without vertical order and rules imposed by archaic governments, organizations and banks. Everything is managed by a community of enthusiasts who religiously worship transparency. Nothing is bad with this one.
The problem is that such thinking can result in anarchy, which many consider a desirable backdrop to the “new world” — but not when it comes to personal finance and savings. Here, we still crave at least some order and rules of play.
And that’s when the tricky part of DeFi emerges: the disregard of regulations and Know Your Customer/Anti-Money Laundering procedures. This leads to a high risk of money laundering via liquidity pools. And make no mistake, the United States Securities and Exchange Commission will notice such activities pretty soon. There are too many DeFi projects that scream “bubble,” but for general users, it’s really hard to crack down on such frauds. So, serious sums of money could be lost.
Why I believed in DeFi, and what I’ve learned
We don’t believe in DeFi in its current state. In the beginning, when we were a peer-to-peer platform, things looked different. But we quickly understood that prospects are blurred for the current version of DeFi. Only centralized lending platforms have a promising future, and they have proved their credibility already. They offer greater functionality and speed, they’re easy to understand and use, and rates are fixed for borrowers, while lenders can earn fixed interest on their deposits.
DeFi operates in a highly volatile, unpredictable market. It’s not user-friendly, despite all those claims we keep hearing. Smart contracts, self-managed crypto wallets — how familiar are general users with these terms? And I don’t even have to mention the number of bugs and glitches on decentralized platforms.
What’s happening now is a perfect example of good old hype — the publicity machine with “maximum power” mode on. There is lots of noise and unfounded praise, but if you scratch the surface a bit, you’ll see that only up to 30% of assets are working within DeFi. Non-DeFi, or centralized finance, projects have up to 80% of assets working. That’s some difference, right?
To be more precise, though, transaction fees are ridiculous, and they alone almost nullify all existing DeFi benefits. The cost of executing an operation in DeFi could be as high as $100. It doesn’t make any sense to utilize unless you’re playing with crazy big money.
Why is it happening? Well, because that’s exactly how a boom or hype works! DeFi exploded recently, resulting in Ethereum network overload. Hence, transaction costs have gone through the roof, and suddenly, what claimed to be available for everyone is actually not!
The main risks for those who interact with DeFi platforms now
The main risk is a smart contract vulnerability. One “glitch” can lead to the blocking of all assets, or even to the loss of funds. There are lots of examples, from The DAO to the recent hacking of DeFi platforms. In the latter case, oracles, which supervise prices, were responsible for cheating and fund withdrawals from smart contracts.
Another risk is an inevitable human error. Developers can claim their codes are invincible, but they can’t oversee how each user interacts with applications and platforms. We’ve all heard stories of funds being lost due to a mistake in an address.
The market is still very unpredictable, and there is almost no insurance available for investors. So, the risk of losing significant funds is very high.
And of course, there is another buzzword, “yield farming,” which actually stands behind the sudden explosion of DeFi. In simple terms, yield farming means the creation of tokens to reward users who provide liquidity to a project. The trick here is that users have to invest their tokens into the project, and therefore, they’re unable to trade or sell those tokens. More and more tokens are involved in DeFi because high yields are offered and people want quick profits, but this inevitably leads to reducing the supply available for trading. Yield farming feeds the bubble.
As I mentioned earlier, at the moment, it looks like the hype created by initial coin offerings in 2019. Lots of people were tempted by ready-to-grab “opportunities” and lost their money in the end. With DeFi, though, the risk is bigger: You can lose all savings, not just some free bucks.
Who, or what, is behind the DeFi hype?
Herd instinct is behind it, nothing more. It’s very strong in the crypto community, I should say. A mass hysteria happens every time a tweet from some “evangelist” is posted. So, there are no surprises here. Also, DeFi tokens have a low capitalization rate compared with Ether (ETH) and Bitcoin (BTC), and it’s very easy to increase prices on them.
Recently, Ethereum co-founder Vitalik Buterin commented on DeFi tokenomics:
“Seriously, the sheer volume of coins that needs to be printed nonstop to pay liquidity providers in these 50-100%/year yield farming regimes makes major national central banks look like they’re all run by Ron Paul.”
But once the hype is over, look out for the downfall of DeFi tokens — it’ll be rather dramatic. Craving quick, high profits, people will lose money, sadly. Greed is a dangerous “driver.”
Alex Faliushin is the founder and CEO of CoinLoan. He is an entrepreneur with eight years of experience in fintech. He specializes in international payments solutions, organizing acceptance and processing payments in high-risk industries. In the first half of 2019, before the crypto-lending market was formed, Alex started CoinLoan, a platform for loans secured by digital assets.
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