Analysts Point to 3 Key Flaws That Caused DeFi to Crash

The cryptocurrency market has had a rough year, with the collapse of multiple projects and funds setting off a contagion effect that affects nearly everyone in the space.

The dust has yet to settle, but the continued disclosure of details has allowed investors to piece together a picture that highlights the systemic risks posed by decentralized finance and poor risk management.

The following experts discuss the reasons behind the DeFi collapse and share their views on how the crypto industry can recover.

unable to generate sustainable income

One of the most frequently cited reasons why DeFi protocols struggle is that they fail to generate sustainable revenue and add meaningful value to the platform’s ecosystem.

The basic design principles of DeFi:

- If the protocol cannot function without reward tokens, it is a Ponzi scheme

Reward tokens should not be a requirement for the protocol to function. That means the agreement is not a revenue-generating business.

— Joseph Delong* (@josephdelong) May 23, 2022

To attract users, they offer unsustainably high yields without sufficient inflows to offset payments and provide underlying value for the platform’s native token.

This essentially means that there is no real value backing the token, and the token is used to pay for the high yields offered to users.

When users start to realize that their assets are not really getting the promised yield, they will withdraw liquidity and sell reward tokens. This in turn led to a drop in the token price, as well as a drop in the Total Value Locked (TVL), which further fueled panic among protocol users who likewise would withdraw their liquidity and lock up the value of any rewards received.

Tokenomics or Ponzinomics?

The second flaw highlighted by many experts is that many DeFi protocols have poorly designed token economics, often with extremely high inflation rates, which are used to attract liquidity.

High rewards are nice, but if the value of the tokens that are rewarded doesn't really exist, then users are basically taking huge risks by giving up control of their funds for little or no reward.

Much of this has to do with DeFi’s revenue-generating issues and its inability to build sustainable treasuries. High inflation increases token supply, and if token value cannot be maintained, liquidity leaves the ecosystem.

Users who use excessive leverage

Excessive leverage is another pervasive problem in DeFi, a flaw that became all too apparent as Celsius, 3AC, and other platforms investing in DeFi began to unravel last month.

Users who staked these inflationary tokens to over-leverage their positions were liquidated as the market sell-off drove prices down.

This led to a death spiral for the protocol. @Wonderland_fi is such a protocol, users use TIME to borrow MIM, and then get liquidated

— Magik Invest ✨ (@magikinvestxyz) June 28, 2022

These liquidations only exacerbated the downtrend many tokens were already experiencing, sparking a death spiral that spread to CeFi and DeFi platforms as well as a handful of centralized cryptocurrency exchanges.

In this sense, the blame lies with users who use excessive leverage without having a solid investment plan to deal with market declines. While it can be challenging to think about these things at the height of a bull market, it should always be something traders should be thinking about, as the cryptocurrency ecosystem is known for its volatility.