What Caused The Recent DeFi Crash?

Causes of the DeFi drop in 2022

Since 2020, decentralized finance has become one of the cryptocurrency industry’s fastest-growing and most important sectors.

Between January 1 and December 31, 2020, the total value locked (TVL) in DeFi protocols surged from only $601 million to $18.62 billion. In addition to this thirtyfold increase, the decentralized market continued to grow in 2021, achieving an over 1,200% ROI at $235.54 billion TVL by the end of the year.

And, despite bearish trends that took over the market since last November’s peak, DeFi has been doing quite well for most of 2022. However, on April 4, the sector’s TVL started to fall and took a massive hit earlier in May.

As a result, the DeFi market’s size shrank from $231.57 billion to $106.64 billion by May 29, representing a nearly 52% loss in less than two months.

But what are the main reasons behind the sector’s underperformance this year, and what challenges do protocols have to solve for the DeFi market to recover?

The Terra Crash

As one of the most significant black swan events throughout the history of the crypto market, it’s safe to say that the recent Terra crash was a primary driver behind the DeFi sector’s underperformance in 2022.

On May 9, UST, the primary algorithmic stablecoin powering Terra’s blockchain ecosystem, lost its peg to the USD and started to freefall. After dropping to $0.765 on May 10, a day later, the cryptocurrency’s price continued its bearish movements towards $0.30.

Despite early hopes, UST not only failed to restore its peg to the US Dollar but kept declining in price. And after the project relaunched its blockchain as Terra 2.0 without algorithmic stablecoins on May 28, the coin stood at $0.025 as of May 29.

As an algorithmic stablecoin, UST’s value is maintained without using fiat or crypto collateral. Instead, Terra’s algorithm was responsible for achieving price stability for the asset through a complex mechanism that involved arbitrage and the project’s original native LUNC token, which was renamed from LUNA to Terra Classic
(LUNC) after the launch of the new blockchain. Read this article on AAX Academy to learn more about this process.

Due to the algorithm failing to achieve price stability after UST lost its peg on May 9, LUNC’s supply grew at such an extreme rate that it led to hyperinflation, driving down the coin’s price from $60.35 on May 9 to $0.00008 by May 29.

Since UST was the asset that powered Terra’s stablecoin ecosystem, its depeg event, along with LUNC’s collapse, rendered many protocols and applications built on top of the protocol useless.

For the DeFi market, this definitely means bad news, as Terra was Ethereum’s largest competitor within the decentralized finance sector, with a 14.5% TVL before the black swan event. However, after UST’s depeg, Terra’s $28.02 billion TVL fell to $65.92 million by May 29.

Growing DeFi Hacks and Fraud

Cybercrime targeting the DeFi market has been on the rise lately.

In fact, according to a recent Chainalysis report, the sector hit a new record in Q1 2022 in this field, with decentralized finance protocols accounting for 97% of the $1.3 billion stolen from crypto services. For comparison, DeFi investors lost $2.3 billion between January and December 2021.

Besides that, scammers continuously target decentralized finance investors with fraudulent schemes, such as rug pulls, pump and dumps, phishing, and exit scams.

Combine these with the unregulated nature of the sector, new investors (with a primary focus on institutions that are active in the traditional finance market) remain hesitant to join the DeFi space – no matter how ludicrous the opportunity is for them.

Bearish Market Trends

While DeFi activities like yield farming, staking, and lending can come in handy for investors to generate a passive income even during a crypto winter, bearish trends in the broader digital asset and traditional finance markets could have harmed the decentralized finance sector.

With multiple signs pointing to a looming recession, Bitcoin and several other top cryptocurrencies, as well as leading stock market indices, have all suffered double-digit losses in 2022.

Of course, as DeFi protocols offer much better rates than most TradFi services even after significant interest rate hikes, combining this benefit with the limited volatility of stablecoins could facilitate a substantial influx of new investors throughout a financial crisis.

However, Terra’s black swan event discouraged many from investing in stablecoins. Moreover, the increased complexity of services and the rising rates of cybercrime targeting the sector’s users hinder the adoption of decentralized finance protocols by non-crypto users.

DeFi Has Great Challenges to Solve

We can conclude that UST’s depeg and the wipeout of nearly $30 billion of Terra’s TVL were the main culprits behind the recent DeFi drop.

Furthermore, UST was by far the most successful algorithmic stable asset on the crypto market, achieving price stability for over two years. For that reason, investors’ faith in stablecoins dropped significantly since the Terra crash, and it will take some time until the DeFi sector can recover in this field.

At the same time, bearish crypto market trends and the rise of criminal activity against users could also have had a negative impact on the DeFi sector.

But do all these signal the downfall of decentralized finance? Definitely not. Like the crypto market did so in the aftermath of 2017’s ICO craze or even after the China Bitcoin ban, the DeFi sector experiences significant short-term losses but will recover in the long run.

However, decentralized finance protocols must address crucial challenges – such as the lack of proper platform security and investor safeguards, increased systematic risks, and the limited sustainability of business models – to regain their lost TVLs and maintain organic growth in the coming years.

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