Despite a small September wobble, the decentralized finance (DeFi) boom shows no signs of slowing any time soon. While these applications have provided a boon to the entire crypto market, Ethereum in particular has reaped big rewards for both ‘hodlers’ and those playing the market.
Sadly what goes up, usually comes down, and a DeFi correction or crash is inevitable. The question is, what kind of impact would it have on Ethereum? Is it worth considering at this time?
Smart contracts are the foundation upon which DeFi projects are constructed. Rather than relying upon individuals or institutions to judge whether a transaction is viable, DeFi platforms use code.
There are a few platforms that can run smart contracts but by far the largest is Ethereum’s ERC20 standard. Put simply, these are tokens that meet the requirements to operate on the Ethereum blockchain. They are coded in Ethereum’s solidity language, which can be used to build Decentralized Apps or dApps.
Let’s take the example of crypto lending platforms like Compound. They replace the institution that arbitrates loans with a smart contract that governs the terms of a loan. A lender stakes their cryptocurrency in order to provide liquidity and a borrower agrees to pay back the loan plus interest in a set period of time.
Normally these terms would be policed by a physical contract. With DeFi, they are policed by a smart contract — essentially lines of code operating under the "code is law" principle. If the requirements specified in the coding are not met, then the contract cannot be fulfilled, removing the need for a third-party arbiter.
The kicker here is that any smart contract requires gas. A small amount of gas is expanded whenever a contract is actioned in order to reduce the risk of an attack against the Ethereum blockchain. In order to purchase gas, Ether (ETH) is required.
The actual cost of gas is based on the number of applications currently active on the network. Despite this, the price of ETH did not increase significantly during the early stages of the DeFi boom. The reason for this is that while the price for gas increased, it was miners who would reap the rewards.
Currently, Ethereum relies on Proof of Work which means that miners profit from these inflated prices as they are the ones rewarded with more ETH. For example, miners recently made over $16 million in one day. However, the Ethereum 2.0 update could change this dynamic.
The much-anticipated shift towards a Proof of Stake system means that holders of ETH will soon be able to directly stake their tokens to secure smart contracts. Thus a healthy DeFi sector will have a much larger impact on the overall price of Ethereum as tokens become necessary to secure a growing number of DeFi apps installed on the Ethereum blockchain.
Another major change is the rise of crypto lending platforms. These provide another way for crypto traders to make money without being forced to liquidate their crypto assets. The high-interest rates of many crypto lenders have led to a practice called rate farming.
When users engage in rate farming they are essentially moving their cryptocurrency around different crypto lending platforms chasing the highest interest rates. All the cryptocurrency locked into these contracts, around $11 billion, decreases supply on the market. The high-interest rates, in turn, increase demand.
This has had a positive impact on the crypto ecosystem overall in the short-medium term. But problems could be on the horizon.
While the DeFi crash in September was exaggerated, it did take a toll. The DeFi sector was essentially cut in half. However, the DeFi craze, and subsequent correction, were not a bubble in the 2017 sense. And the DeFi space has experienced a strong recovery over the course of October.
Updated monthly returns since May for $BTC, $ETH, and sample of $DeFi tokens.— Ceteris Paribus (@ceterispar1bus) September 30, 2020
September pretty much cut the DeFi sector in half after August saw the median DeFi token double. Median token is now back to Aug 1 valuation (although obviously variation across the board). pic.twitter.com/n4JyB6kbML
The biggest change from 2017 is that the crypto sector as a whole has matured. In the wake of the initial correction in September, a number of decentralized tools have been released that are designed to help traders and investors navigate the DeFi sector.
One example is DeFi Pulse’s new safety rating system. The team is working with the digital asset modeling platform Gauntlet to create a system for rating different platforms based on a number of factors including: user behavior, collateral volatility, protocol parameters, and smart contract risk. Based on these factors it will give a specific project a risk profile between 1 and 100 which should help investors and traders better understand specific DeFi projects.
This kind of project is a positive sign for the market. A major challenge for Ethereum in the future will be to limit the volatility caused by poor quality or fraudulent projects that are based on its ERC20 protocol. In order to control this volatility there needs to be either some kind of outside regulation, which is far from ideal, or a decentralized solution that can police the DeFi and dApp space.
The crypto industry's recognition of this is key. If crypto companies can build the tools to regulate the space, then it will theoretically be possible to mold the direction that this regulation takes and prevent it from suffocating the crypto sector’s creativity.
If these solutions can be successfully built then it is unlikely that the Ether boom will ever turn into a full-scale crash, and hopefully, we will see sustainable growth in the medium-long term.
Featured image via Pixabay.