Coinversation : Will DeFi be able to lead the Future after a Crypto Bear Market?

While the crypto market is falling apart over the past few months, I am still confident of the financial Future DeFi promises us. Bull market or Bear, DeFi, or decentralized finance, has several use cases beyond just that of Crypto currency. DeFi will help change the financial market and the future of finance, bring in a lot more transparency, inclusion, and better hopefully better regulations. This is because the core of DeFi is to?be permissionless, hierarchy-less, transparent and open-sourced, all while offering great security. And this edition we shall look into what is behind this crypto winter and what impact will it have on DeFi’s future?

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Reasons behind the current Crypto Winter

Before we proceed any further lets have a trailer of what exactly happened in the Crypto currency universe that has had investors spooked, causing the market cap of the top crypto currencies to come crashing down. And what were some top reasons behind the crypto bear market

Terra LUNA and Algorithmic Stablecoins Unpeg

Terra-LUNA was supposed to be a Proof of stake blockchain, focused on mass transaction processing while creating a useful stablecoin crypto ecosystem.?And Terra network charged a much, much lower fees when compared to not just traditional payment processors like Mastercard, Visa or Amex but other crypto networks too. And in order to avoid the wild price fluctuation Terra was programmed in a way to mimic what the Feds and other central banks too.

That is, when the value of the currency falls, pull back on the currency in supply, so that it matches the demand, there by bringing the value back up. And if the value of the currency appreciates too much, increase the supply in the market.

But to do that, it needed another cryptocurrency, which was its sister coin LUNA which is the native currency on its blockchain.

Now in theory, every time the value of Terra got unpegged, which simply means was worth less than a dollar, then the ecosystem would “destroy” Terra tokens, thereby limiting the supply of it in the system, and bringing up its price. But why would anyone agree to destroying their tokens ? because they are being incentivized with LUNA coins and can potentially sell it at 1 Terra later on, or trade it for other cryptocurrencies. And if the value of Terra goes above $1 then they will “print” more Terra tokens, and distribute it to the LUNA coin holders. In both sides of the transaction, theoretically the LUNA holders would make a profit. And that was probably the whole issue with the system, because either ways LUNA holders make profit figuratively out of thin air, which only the Central banks have authority to do so in the real world!

To know more about the de-pegging, and get some insights into the technicality of it all, you may be interested in revisiting my earlier article on the Terra-LUNA Unhinge

But the question still remains, why was Bitcoin impacted by it? Because weeks prior to the crash, LUNA foundation bought themselves close to 350 Bitcoins as reserve currency. The rapid drawdown and subsequent market cap of LUNA crashing spooked investors as it could have potentially led to a massive Bitcoin sell off.

Next stablecoin depeg happened earlier this month to DEI. But the reason why there wasn’t wide spread panic when this happened was two fold

1.????DEI was only trading on Decentralised Crypto Exchanges (more on that in my upcoming newsletter)

2.????The DEI foundation did not have significant amounts of other cryptocurrencies in its reserve unlike Luna Foundation Guard

Celsius and Three Arrows Fiasco

Celsius network is a regulated, SEC compliant, lending platform that enables users to receive interest on deposited cryptocurrencies or take out crypto collateralized loans. While they offered quick and fee less transactions the main allure were the high yields, some times as high as 18% on cryptocurrencies like Ethereum,Bitcoin and even the stablecoin USDC (I promise to write on why USDC despite the stablecoin crashing around it still continues to attract users to it). They are even confident enough to go ahead and launch their Euro Stablecoin!

But early signs of trouble began in Apr’22 when Celsius network admitted that their coins CEL were indeed susceptible to being stolen, or hacked into, which posed a significant regulatory risk. Then there were a slew of comments from regulators demanding Celsius prove that some of their offerings weren’t circumventing the regulatory asks of Securities. And finally on Jun 12th Celsius announced they were freezing withdrawals, transfers and Swaps for their customers. While speculations are rife on what caused the pause, solvency issues and preventing a “run on the bank” were the top reasons.

Then there was the crypto venture firm, Three Arrow Capital 3AC, which on 16th failed to meet its marign call and is considering selling its assets as a bailout. What was the size of their Assets under Management? $10 Billion! And all of this surfaced thanks to a rather cryptic tweet by their founder

But while 3AC had borrowed several digital currencies, and had exposure to some syhtetic assets which weren’t doing well in the market, the real reason it is important news for the crypto verse is because the ethos that is central to DeFi. TRUST

Or the erosion of it.

Debacle of Public Crypto Companies

All of this leads us to how publicly traded crypto firms have been doing in the market, and how have they responded to the crisis.

Unfortunately, most of them did not do a very mature job of responding.

We saw massive layoff, cut backs in investments, freezing of withdrawals and other such activities, all of which hurt the stakeholders in the ecosystem.

So public sentiment too started turning against crypto in general. And this was measured by the new low-lows that crypto witnessed the last week.

Metrics to measure whether this is a downcycle or a Bubble burst

So that was a crypto bubble that burst right ? Yes and no. In order to rationally decipher that answer that we will have to look at some key metrics, and decide for ourselves.

Long Term Holders selling at a Loss

This is a term that is directly borrowed from the stock market. Long term in the stock market is over 52 weeks, so we shall go by that, even though there are way to many traders in crypto who buy and sell in under a few seconds.

Drop in Trading Volumes

This is also an indirect way to measure the volatility of a particular cryptocurrency. If it is witnessing a sudden dip in its trading volumes for at least 5 sessions, rest assured what will follow is the price coming crashing down.

5 days moving average Price from 52 weeks high

Using this we can then gauge whether or not the current price trends will ever recover back to the highs it saw in the past. Or are its days of glory behind it. Because after 5 days of the price constantly hitting new lows, it becomes increasingly difficult for even the whales to support the cryptocurrency. Resulting in a death spiral. Like the one we saw in the case of LUNA

New Wallets trading

This can be a good indicator to see if new investors are joining the crypto fray or not, and if so because of which particular cryptocurrency. Another related metric would be see if there were any dormant wallets that started trading. Were they selling versus buying. And if so which coins.

Nassim Taleb’s take

So Taleb, a vocal crypto critique, put up an interesting argument over why Bitcoin is not much of an asset class in his opinion. But his choice of period to check other asset class is interesting. Because after GFC, 2009 was when a lot of quality stocks and assets were available at a bargain.

Another bias in the argument is that this is presumably for assets in the US. Whereas critics can show several other countries where all assets have underperformed bitcoin by a huge margin.

Nonetheless makes for an interesting analysis.

What is DeFi and what problem does it solve?

Now that we have examined the spectacular crash of some cryptocurrencies lets take a look at DeFi, something that cryptocurrencies promise to deliver

What is DeFi?

DeFi is an broad term used for a variety of Financial services using cryptocurrency and blockchain aimed at disrupting financial intermediaries. Its aim is to facilitate peer to peer financial transactions, in a secured, transparent and hierarchy less. If that sounds a lot like what blockchain, well that is because DeFi does rely on Blockchain for its implementation. (To know more about Blockchain click here)

Basically anything your bank or traditional financial institutions can do- earn interest, borrow, lend, buy insurance, trade derivatives, trade assets, and more, you can do using DeFi. Only faster, and cheaper because now you don’t have to pay middlemen their cut of facilitating the transactions. This has the potential to create more open, free, and fair financial markets that are accessible to anyone with an internet connection.

But how was the existing system, Traditional Finance or TradFi, a problem that DeFi had to solve ?

For starters, was the issue of transparency. What happens in the background to your Loan Application is something only known to esoteric underwriters who were at work. With Distributed Ledger technology, DeFi aims to bring about that level of transparency in the system.

Next was the cut the middlemen would take. Did you know, even after so many IPOs tanking and taking with them retail investors hard earned money, how much losses did the Investment Bankers have to incur? None. If anything they all made more profits than they did the year before! And went home with a fat bonus cheque, same as what happened in COVID, when a lot of my Kammunity members had to accept a haircut in their salaries.

And thanks to these 2 points, it also made the financial system more accessible to others, thereby bringing more people under the financial inclusion umbrella.

DeFi Use cases that will help in the future

Inflation

The first use case where DeFi can help is in beating inflation

Why ? Because government controlled money as per Ilja Laurs, guarantees us 2% inflation every year, thanks to their manipulation of demand supply of currency in the economy. But with DeFi where the money supply does not change with the change in the government you know the flow of currency in the system till perpetuity, hence making it a hedge against inflation.

DApps

Decentralized applications, gives users the ability to not only cut out the platform middlemen, but greater control over their personal data which platforms would collect in order to personalise offerings to their users.

Imagine using Uber, but not having to pay a hefty fee to the platform every time they connected you to a driver ?

Or, being a creator on a social media platform, but not being held to the terms and conditions of the platform for the revenue share and creator payouts?

Governance as a service

This is again a concept I simply cannot harp on enough.

I had previously spoken about Principal – Agent problem. And the best solution available to combat it is, Decentralised Finance.

But not just that. If you see the governance model at a particular organisation working well, and you believe that will fit your requirements, there isn’t a need for you to reinvent the wheel. Being open sourced means you can simply import the good parts of it for your organisation and replicate it there! Reducing the lead time to implement change as well.

DeFi and Regulations

The past few months have seen way too many upheavels in the Decentralised world that has left several people destitute, and with no recourse available. We had cryptocurrencies being wiped out of their value, Lending platforms refusing people to withdraw their funds, and DAOs voting out seed investors. While all of this has hurt the over all market, it has also eroded a lot of trust in the system.

And to combat that Governments across the world have adopted 2 broad ways. One, is like what India and China are doing, to put restrictions in place that hinder people from entering the DeFi space. But the downside is you are restricting the opportunity of your citizens to participate in a system where they have as much of a say in what happens, as the other guys.

The other approach is like the Crypto Bill which was tabled by U.S. Senators Cynthia Lummis (R-Wyo.) and Kirsten Gillibrand (D-N.Y.). The bill aims to provide clarity to both industry and regulators, while also maintaining the flexibility to account for the ongoing evolution of the digital assets market. The bill may also call for a self regulated body, a sandbox for other DeFi projects to be developed, and so on.

Or there is a third way to deal with it. The way El Salvador is. ?Buying huge reserves of Bitcoin at its all time high, and forging ahead buying more bitcoin on the dips? While most of their citizens are yet to understand what bitcoin is and how they can effectively use as a hedge against inflation. Although yes, when it comes to making it easier for foreigners in the country, it certainly has a great use case. But where the scheme fails is in ensuring that merchants accepting bitcoin won’t see their values eroding away.?

And that brings us to the close of this edition of Kam Questions. Do join in the Coinversation, and let me know where you think DeFi is heading towards? Or do you believe that this is a bubble that will soon burst? if so I'd love to hear your views.

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