Decentralized Finance (DeFi) is without a doubt the biggest news to come out of the crypto space this year. Bitcoin is grabbing the attention of Wall Street at last over its surprising price resilience and recovery during the pandemic, posting YTD returns of 65% and running circles around the S&P 500 at just 8% YDT and even gold at 31% YTD, but the real gains are happening in DeFi.
The rise of an alternative financial system that can lend services to the world’s unbanked brings real-world assets onto the blockchain. Further, it allows for the transfer of billions of dollars in value in seconds at a next-to-nothing fee while providing high returns and passive income. This is simply too compelling to ignore.
Yet, as with almost all areas in this nascent space, DeFi’s growth is a marathon and not a sprint, at least, it should be. We are seeing one exciting innovation after another come out of this industry and billions of dollars of value being locked into its protocols. But, while there are many promising projects to invest in, if you truly believe in the promise of DeFi, short-term parabolic growth is inevitably going to attract the speculators looking for quick gains.
When DeFi tokens are soaring by more than 1000% in less than a week, it’s hard not to want a slice of the action. Yet, unlike the ICO boom in 2017, it is not only speculators driving this momentum. Yield farmers are further fueling the fire feverishly searching for the best APYs in the space to make superlative gains while they can.
While all this action is certainly contributing to the growth of the DeFi economy (yield farming has led to more than $9.1 billion in locked value today), it is starting to place too much pressure on the projects in the system. DeFi mania is forcing decentralized finance to run before it can walk and, if the pressure gets too great, could place a strain on its future development.
What Is Yield Farming and Why Is It Potentially Harmful?
With so many innovations happening in a short space of time, it can be hard to keep up with the latest practices and terminology coming out of DeFi. But, take a look at the main one that is driving its wild growth right now: yield farming. In a nutshell, yield farming is where projects create tokens to reward liquidity providers on their platforms. It is not important whether it is a lending or borrowing app, or a DEX; the premise is the same: to
receive these rewards (yields), holders must lock their tokens into the project.
These tokens must remain locked for the liquidity providers to receive rewards and cannot be sold or traded. It is not surprising then, that with the staggering growth many DeFi projects are seeing (yEarn’s YFI token grew by an astonishing 15,000% in less than one week) that the USD value of all the tokens locked into DeFi projects is skyrocketing higher every day.
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Locking tokens for yields also has the double effect of restricting supply and pushing its price higher, leading to beaming smiles on the face of many a speculator. And it is not only DeFi tokens that are being locked into protocols but plenty of Ether as well. While there is abundant anticipation for the upcoming switch to ETH 2.0 and Proof of Stake, it is also no coincidence that ETH price is flying as more of it is locked into DeFi.
As DeFi has galloped ahead, ETH has posted a YTD of well above 260% even reaching $471 at its peak in recent days. Why is this a problem? Because just like pot stocks, the ICO craze, or Bitcoin’s FOMO-fueled run in 2017. We have all seen what happens when the price outstrips the real underlying value of the asset.
DeFi Still Has Many Challenges to Overcome
At my company, we have not been watching the growth of the DeFi space from the sidelines. We have been actively contributing not only by offering the most comprehensive range of high-quality DeFi tokens for our users but also by building alongside the major protocols.
We are truly invested in the DeFi economy and believe in its promise and longevity over time. But, we must remind all investors that this technology still has a long way to go. Anticipation over ETH 2.0 is building, yet it isn’t entirely certain when (or indeed if) the PoS switch will come. We are seeing more DeFi protocols independent from ETH springing up, though the vast majority are still overwhelmingly dependent on the Ethereum blockchain, including major players like Maker and Compound.
The fact remains that even with innovations and pushes to improve the security of the sector, such as open price feeds and decentralized oracles, DeFi’s fundamentals are not improving as fast as the price of its tokens. This could be a problem as investors hellbent on increasing their risk are leveraging to obtain maximum yields. This snowball of frenzied hype and expectation could cause DeFi to undergo enormous strain and even lead to a shakeout that sees a lot of people getting burned.
If there is a problem with the tech, such as network congestion or a breakdown in oracles, a price correction may come and the hungry over-leveraged yield farmers will be unable to liquidate their assets. This could cause a landslide that shakes the confidence in this area and undermines DeFi’s long-term trajectory.
While it will be the weak hands shaken out of the market, it will still be a shame if it happens. We should support the growth of DeFi by actively building and working to make it more robust, rather than seeking quick gains and creating unreasonable expectations.
Jay Hao is the CEO of OKEx