DeFi Shows Cracks as User Growth Slows in Crypto Hotspot

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Red flags are starting to appear in what’s often been the most lucrative and volatile sector of the crypto universe this year.

While the broad 60% or so declines in decentralized finance, or DeFi, tokens are generally in line with the recent plunge in digital stalwarts such as Bitcoin and Ether, a closer look suggests something else is at work. Many of the tokens, which power applications that allow users to lend, borrow and trade crypto without intermediaries, are being hurt by the unwinding of the multiple layers of leverage that underpin the transactions.

The number of new DeFi user accounts opened daily has dropped to the lowest levels since the embryonic sector started hitting its stride in September, according to Nic Carter, founding partner at Castle Island Venture, who used data from Richard Chen of venture fund 1confirmation to measure the decline. For the past four days, only a few thousands new accounts were opened daily, down from from nearly 40,000 in mid-May, the data shows.

This may spell trouble, since it’s the injection of new users into the system that helped DeFi investors achieve triple-digit overnight returns on tokens of apps such as Compound and SushiSwap. Many DeFi apps essentially let users lend out their coins to new users and to earn returns on the loan. If there aren’t fresh users clamoring for the coins, the yields fall.

“DeFi is going to be challenged because it relies on this injection of new liquidity, and ultimately a lot of DeFi yields are a function of new buyers supporting token prices,” Carter said. “I don’t think DeFi is going away, it just might be a less attractive place to park capital in the next few months.”

DeFi Shows Cracks as User Growth Slows in Crypto Hotspot

The amount of funds locked in Defi applications is already more than 40% lower than in mid-May, according to data tracker DeFi Pulse. The drop to $51 billion from $87 billion effectively shows money leaving the sector.

Investors have been flocking to the sector because of the often instantaneous triple-digit returns seen in the past year, outstripping even the almost fourfold gains in Bitcoin.

“These experiments are very interesting and very promising, but that’s still all they are,” said Gil Luria, director of research at D.A. Davidson. “Just like any category of startups, I would expect most of the new financial services delivered through crypto technology to fail.”

Many DeFi apps that exist today have a slew of inherent problems. Scores of projects lack the financial and regulatory controls and compliance processes likely required of them, making them vulnerable to a regulatory crackdown, Luria said. Some of these projects have also experienced hacks, and lost millions of funds, such as Yearn.Finance.

Billionaire crypto investor Michael Novogratz tweeted Wednesday that the sector could be facing tougher regulatory scrutiny.

Often the developer of an app and a few investors own the lion’s share of the coin supply. Popular decentralized exchange Uniswap, for instance, allocated about 40% of its Uni token supply to its team, investors and advisors.

What’s more, the DeFi coins have been subject to front-running using software called bots, akin to that described in Michael Lewis’s “Flash Boys.” Many DeFi apps run on the Ethereum blockchain, whose users can chose to pay more -- a so-called gas fee -- to have their transaction processed faster. That opens the door to front running, where someone can see that a transaction is sitting in a queue, and pay more to have their own transaction processed beforehand and make money on a difference in a coin’s price.

Decentralized exchanges that are a major part of Defi have suffered from front running, which is “a realistic threat to Ethereum today,” according to one paper.

“I could essentially be the middleman with no risk,” Klaus Kursawe, a consensus researcher at Vega, which is trying to fix such problems, said in an interview. The front-running risk could deter users from accessing decentralized exchanges, he said.

Even with the technology, regulatory and other problems, many investors still see DeFi holding a lot of promise.

“I’d say the frenzy in DeFi is fading, but the long-term prospects remain strong,” said Aaron Brown, a crypto investor who writes for Bloomberg Opinion. “This is not a bubble that popped leaving nothing behind, it’s a market that got a little ahead of itself and is now retrenching a bit.”

©2021 Bloomberg L.P.

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