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Talk: The impact of CeDeFi’s crash on DeFi

Talk: The impact of CeDeFi’s crash on DeFi

The warning signs that the cryptocurrency market is crashing in the second quarter of 2022 are indeed there, but not everyone is aware of them. When you’re in an over-leveraged market, when you’re long cryptocurrency prices, there’s no way around it for many when you take an unexpected hit. The conflicts in Russia and Ukraine, supply chain shortage issues, inflation and rising interest rates were all partly responsible for the collapse. It was all the result of macroeconomic events that led to a global recession.

Traditional financial markets were severely impacted, and inevitably affected cryptocurrencies as well. Bitcoin has plummeted, falling below $20,000 and has been down for an unprecedented nine weeks. The second top cryptocurrency, Ether, has also fallen and is below the $1,000 support level. The cryptocurrency market has been even worse during this period as the sell-off has caused currencies like ADA, XRP, BNB and emerging cryptocurrencies like SOL, AVAX and DOT to plummet. This brought the total market cap of cryptocurrencies below $1 trillion (source CMC).

The dominoes of cryptocurrencies began to fall after Bitcoin was unable to hold its ground as it continued to fall from $30,000 between March and May. This disruption has created a FUD in the market as the sell-off begins. this is also the result of negative news of a 25 basis point rate hike by the Federal Reserve (starting in March 2022). This is further exacerbated by the rise in inflation, which reaches 8.6% by May 2022. This greatly affects an area of the crypto industry called CeDeFi. Until then, let’s look at the difference between decentralization and centralization.

Decentralization and centralization

The main purpose of cryptocurrencies is to introduce a decentralized currency system. Bitcoin is by far the best example because it is still largely decentralized, with no entity or individual controlling the network. This is in stark contrast to highly centralised financial institutions such as banks.

A centralized type of control is the exact opposite of a decentralized one. In a decentralized system, the money supply is fixed and its value is determined by the free market.

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The rise of DeFi (Decentralized Finance) aims to bring more financial inclusion and independence to users. This led to protocols, which are software developed to provide DeFi services to users. Early DeFi protocols were truly decentralized, meaning they had no organizational entity and were open to all users. They are cumbersome to use and require a certain amount of technical knowledge. This is where CeDeFi comes in.

CeDeFi

CeDeFi’s rise began with digital exchanges like Coinbase and Binance. These companies provide an entry point into the crypto space for new users. They also simplify the process of owning cryptocurrencies by handling the complexities of encryption (such as wallet addresses, private keys, etc.) with professional services. Users sign up for these exchanges through a KYC process similar to other traditional financial services. Users can opt out of KYC, but they won’t be able to fully use the exchange’s products. They provide users with a hosted digital wallet that contains information about their cryptocurrency assets.

They sell and trade various types of cryptocurrencies to users, but they must abide by the rules and regulations of the financial system. That makes them regulated entities, and they’re also centralized. They are centralized because they control the user’s wallet by keeping the private key. That means exchanges can freeze accounts if they are deemed non-compliant or in violation of policies. Users will not be able to buy or sell cryptocurrencies, nor will they be able to withdraw or transfer their funds.

Fintech companies are starting to develop their own protocols to offer DeFi services, opening up the market for profit, pledge and liquidity pools. This allows users to earn interest on yields that are sometimes too good to be true. These agreements offer returns that are much higher than those offered by traditional financial institutions. Block-fi, Celsius, Nexo and Abra all offer this service. They allow users to earn interest by depositing cryptocurrencies like Bitcoin and Ethereum into their systems. These companies use these assets as unsecured collateral that they can lend out. Users profit from loan interest derivatives.

These companies are not DeFi, but CeDeFi or centralized DeFi. Although they provide the tools for DeFi, they are not decentralized per se. These companies are centralized because they control everything on the platform. They hold the customer’s account private key, which gives them full control of the digital wallet. They can freeze all withdrawals and transactions, especially during a crash.

The beginning of a crash

The collapse began with a drop in Bitcoin. Since it is the dominant cryptocurrency, the rest of the market tends to move with it. In this case, it also became depressed because of its correlation with the stock market. And investors are mostly new, seeing cryptocurrencies as risky assets and therefore deciding to sell due to economic uncertainty. The market reached a critical level, which triggered a chain of events that led to CeDeFi’s collapse.

The next crash was Terra’s stablecoin UST (Terra USD). Stablecoins are pegged to the U.S. dollar at a ratio of 1 to 1. The hook is not actually backed by any goods or assets; it is essentially an algorithm. This means staboin support is determined by the purchase of Terra’s native LUNA token. In order to forge UST, LUNA must be destroyed. Between 2021 and 2022, many investors bought LUNA and then destroyed it while getting UST. Destroying LUNA takes it out of circulation, which raises its price. The problem here is that users can earn revenue by depositing UST into the Anchor protocol. At one point, its annual returns were as high as 20%. That could be a red flag for financial analysts.

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UST decoupled from the DOLLAR during periods of extreme market volatility. That’s because panic selling in the markets led to a run. More UST has been proposed than LUNA has been destroyed. This affects the prices of UST and LUNA. As prices began to fall, investors began to worry and things got worse. Terra was unable to maintain the peg, so LUNA’s value fell below $0. UST also collapsed, which affected major shareholders including CeDeFi.

After Terra’s fall, the focus was on investment funds that held UST or LUNA. There was a lot of liquidation across the market as investors rushed to pull their money out. Although Terra has reserves in its LFG (Luna Foundation Guard), this is not enough to restore the link to UST. Despite LUNA’s drop, 58% of traders still thought LUNA would rise, resulting in a $106 million liquidation when UST fell to $0.35. Exchanges like Binance responded by suspending trading in LUNA and UST.

Subsequent

After the Terra disaster, the spotlight turned to CeDeFi. That’s because some of these companies have already invested heavily in Terra’s UST or LUNA, which could cause investors even more concern. The first thing to collapse from UST’s decoupling is Anchor. As the UST price dropped, its total locked-in value dropped from $14 billion to $8.7 billion.

Now, there is a liquidity crisis in the cryptocurrency market. A full-scale liquidation dried up the market. Loan payments are down, and more users are withdrawing money from the system. As withdrawals outnumber capital inflows, Celsius’s warning signs begin to appear. They held a lot of stETH, and as holders started selling, those stETH started losing their ties to Ethereum. This caused Celsius to suspend withdrawals from June 12-13, 2022. Users cannot claim their assets or exchange any cryptocurrencies.

3AC is the next company to come under scrutiny for bankruptcy. 3AC manages $3 billion worth of assets, including projects in the crypto space. Due to the cryptocurrency crash, 3AC was unable to meet margin requirements for low mortgages. They also hold leveraged positions that are in danger of being liquidated. 3AC lost a lot of money during Terra LUNA. They also lost $1 million from a trading account, which also needs to be addressed.

Other CeDeFi firms feeling the pressure include Block-Fi, which has not suspended withdrawals. They actually found a lifeline from the FTX bailout. So far, CeDeFi’s other companies are holding their own, but they are on shaky ground as long as the sell-off continues. There is still a lot of uncertainty in the market and investor sentiment has reached the extreme of fear.

It’s not the protocol’s fault

So, should we blame it all on the developers who developed these protocols?

Not the developers, but the people behind these CeDeFi protocols deserve more blame. The algorithms in their products have a purpose. These algorithms are all designed to allow clients to get the most out of their digital assets. Users who have invested in these deals and expect huge returns are also handing over their assets to the company. The companies decide what to do with the assets. As it happens, these companies may not always make the best decisions on risk management. This is how the CeDeFi lending agreement works.

These assets are not protected in case of bankruptcy or other problems. When money stops flowing, there is a risk that assets will be liquidated. Fintech companies don’t talk much about this, focusing instead on the rewards their agreements bring to their customers. What users don’t know is that their assets are being used as collateral to get those returns from other agreements. These can be decentralized liquidity mining agreements, such as Yearn or Aave, or investment income agreements, such as Anchor on Terra’s network.

Using customers’ digital assets poses risks for them when there is a run on them or a recession. CeDeFi has faced scrutiny for not complying with financial rules proposed by the SEC and other regulators. These deposits are not fully guaranteed, so fintech companies have no obligation to guarantee their safety to customers. Instead, they offer security guarantees through excellent marketing, designed to gain the trust of their clients in exchange for their assets. Some fintech companies are following these rules now to protect clients’ assets, but didn’t enforce them in the past.

Maybe it’s time to speak up about the details of CeDeFi that no one wanted to discuss before.

CeDeFi is not decentralized, these are centralized companies that can control user assets. They scrutinize your transactions, freeze your accounts, suspend withdrawals, and even liquidate your cryptocurrency.

CeDeFi is like a normal lender. They take your crypto assets and lend them to other institutions. You can earn higher than normal interest rates on loan payments because there are fewer intermediaries to deal with in cryptocurrencies. That means fewer middlemen getting a cut and more for users.

When you deposit your cryptocurrency with the CeDeFi agreement, you offer your assets as an unsecured loan to the company. You lend money to companies to use your assets as collateral for financing. Because it is unsecured, there is no guarantee that the assets will be recovered in the event of bankruptcy or other unfortunate events. This is a risk that users must understand.

For CeDeFi to regain the market’s trust, something needs to change. These protocols are broken compared to true DeFi. Maker DAO is a decentralized lending agreement that has endured through this crisis. This is because they do not follow CeDeFi’s practices. Maker DAO issues Stablecoin DAI, which is backed by an overcollateralized commodity to resolve any loan defaults. DeFi protocol follows a market-driven approach and is not controlled by any group or individual.


Post time: Jun-29-2022