Here are the four main lessons about crypto finance we will retain.
- Test DeFi protocols under all market conditions
Terra blockchain tried an innovative approach to stablecoins, based on a hypothesis that minting incentives could balance the stablecoin/native crypto (UST/LUNA) pool, which would ensure the peg. With hindsight, we can see that this hypothesis was not tested against the possibility of a huge inflow of either crypto that would unbalance the pool. And that’s exactly what happened.
DeFi is generally more reliable than centralized finance because it follows its algorithm instead of human judgement. The only exception is the creation of the algorithm itself, which normally should be proven viable even in extreme market conditions. Clearly, Terra’s resistance has not been duly assessed, and its spectacular implosion is a logical outcome.
What’s impressive is that most established DeFi protocols did not experience any issue when the markets crashed. A good example is DAI – a decentralized stablecoin issued by MakerDAO. It has had its own set of problems since its launch in 2017, but it has worked through, adjusting the stability fee here, reducing the supply there… As of now, DAI has survived two crypto market crashes and it is still pegged to the dollar.
- Beware of asset concentration
Terra’s demise was triggered by a DeFi lending-borrowing platform Anchor, which used to hold a whopping 70% of all UST circulating supply.
When users started to withdraw their UST from Anchor, Terra’s mint-and-burn system could not cope with such inflow, which led to UST losing its peg and sending Terra’s ecosystem spiraling down. Such massive concentration of an asset within a single yield protocol was a ticking bomb, and it ended up by exploding.
When something looks too good to be true, it generally is.
The reason so many people have minted UST and put them into Anchor was its promise of a 20% APR. This means that the protocol was somewhat artificially inflating the UST demand, creating ideal conditions for trouble. When the APR started to decrease, users began withdrawing their UST, sending them back to Terra and ending up by unbalancing the pool. Anchor’s token plummeted.
As to other DeFi yield protocols with more modest yields, they continued working without any hiccup. Despite cascading liquidations and investors frantically moving funds, none of the leading DeFi protocols like Aave, Compound or Uniswap has suffered any disturbance. On the contrary, they seem to have been doing a good business: in the end of June Uniswap daily fees have exceeded those of the whole Ethereum blockchain, with other DeFi protocols showing the same tendency.
- CeFi platforms must be always over-collateralized
With over $12 billion of asset under management, Celsius was one of the biggest representatives of the CeFi – centralized crypto finance operating in a traditional way (keeping clients’ assets under the firm’s control) but with DeFi and other crypto companies.
It has stopped withdrawals lats month, joined since by BlockFi, Babel Finance, Coinflex, Vauld, and Voyager Digital.
Specific reasons for these companies’ distress vary (unsecured loans to friendly hedge funds, maintaining individual accounts that went into negative equity, risky financial operations…), but they can all be accused of not maintaining enough quality collateral to ensure the necessary liquidity.
However, not all CeFi frms have been caught into the greedy trap. It looks like Celsius’ main competitor Nexo is doing fine and even planning expansion. After having proposed to buy Celsius’ depreciated assets, Nexo is now reportedly in talks with Singapore-based Vauld to explore an all-equity acquisition of the firm.
How did Nexo avoid the meltdown? It is likely that its over-collateralization has helped: the company repeatedly communicated about its real-time third-party audit that ensures it always has more assets than liabilities.
Probably one of the key lessons of 2018 was that crypto was not magic, and behind every ICO there’s a more or less capable company, or a scammer. Since then, both the users and the regulators got wiser, and the ICOs have deflated from a boom to just another type of fundraising, and are existing peacefully ever since.
By 2022 crypto finance has developed well beyond, and this market crash helped reveal more of its mistakes, for all of us to learn from.
Written by D.Center