Growing interest in DeFi is stressing Ethereum’s network

Zoran Spirkovski

Ethereum is facing a new set of challenges for the first time in the history of the cryptocurrency platform. Even though it experienced extreme price gains in the past alongside Bitcoin’s rally in 2017, Ethereum is leading the pack for the first time.

At the onset of this summer, in June, DeFi started to gather the attention of crypto investors around the world. Slowly, but surely the hype started to engulf the general community. DeFi apps are not new, but with the launch of Compound (COMP) a new wave of interest flooded the crypto markets.

The amount of assets locked in smart contract lending applications rapidly grew from $1 billion USD at the start of June to $4.7 billion USD at the time of writing.

The result? Ethereum is uptrending

It took a little more than a month for this interest to start shaping the value proposition of Ethereum. People are now thinking about the future and what can be done with these new liquidity providers. They are talking about real world companies being able to tap into cash flow through collateralized debt positions.

Even if we are far from this reality, many are starting to believe that we are currently on the precipice of the next crypto revolution that will make legacy Fintech obsolete.

The overarching benefit is easily seen in the massive price gains that Ethereum has gathered since mid-July. In a matter of weeks, Ethereum’s demand and price blew up nearly 60% as more investors started paying attention to the market.

One of the major growth factors behind these gains are lending platforms.

Compound, yEarn, Aave, and Maker contain the majority of currently locked assets, i.e. $3 billion USD out of $4.7 billion. The creation of governance tokens for users of these platforms is one of the primary driving factors, however stability and reliability is shown to be extremely relevant for investors as evidenced by the #1 position held by Maker.

Maker has a governance token, but it is unhinged from dApp activity. You cannot create any MKR tokens. Compound and yEarn specifically, pay liquidity providers in governance tokens for staking their crypto in the dApp, for which investors eventually hope to be able to use to tip the scale in their favor.

Ethereum is getting more expensive

I wish that complex strategies such as yield farming, i.e. the process of pursuing the highest annual percentage rates (yields) was the real cause behind the overwhelmingly massive ETH fees. However, reality shows a much bleaker image.

The real reason for these excessive gas prices are MLM scams, such as Forsage, Lion’s Share, and MMM. Collectively they spend 3163 ETH or about $1.2 million USD every month on gas fees, propping up the market and causing normal smart contract calls to cost upwards of $50 USD per execution.

Authentic dApps also use a lot of gas, with Tether USD at 3k ETH, Uniswap v2 at 1k ETH and most dexes collectively for another 1k ETH per month. Nonetheless, without these scams being so popular with people, retail investors would be able to get into this market and be proactive.

Right now, retail investors are forced to either skip on lending platforms altogether, or extremely carefully select a position and stick to it. Otherwise, they would lose anywhere between $20-100 USD every time they want to take their money to another platform.

There are alternatives to ETH-based lending platforms, such as NEXO, which uses cryptocurrency but is far more centralized.

Let’s be clear, regular ETH transactions are still cheap, regardless of high gas prices. The reason for this is because they only use 21000 gas in order to complete the transaction. In other words, they are simple operations. Smart contracts such as Compound are much more complicated and as a result require a higher gas limit for completion.

Depending on the actions the user takes on the platform, gas requirements range from 100k to 800k per smart contract call.

Expensive doesn’t matter

Regardless of the high gas costs associated with entering and exiting a DeFi position, big bag holders are still flocking to these apps and providing their holdings as liquidity for borrowers.

They do this because for the first time in crypto history they realize that they can make regular returns on their assets whenever they are not actively trading. Holding a position in crypto no longer constitutes an opportunity cost.

Naturally, traders will be traders as they hope to benefit from the speculative price movements on the market. The only difference now is that they are able to leverage the liquidity provided by holders for a minimal fee in order to make their trades more efficient.

Without traders, this model would not work, as they are currently the only users on the receiving end of lending platforms. Until the revolution happens and the bakery down the street can tokenize their business and use it as collateral for a loan that will be used to grow the business, traders will remain the only people that can benefit from borrowing crypto.

On a superficial level, lending platforms give them the opportunity to enter managed leverage positions by repeating the process of borrowing and lending, or keep a long position while they use the rest of their finances to trade.

Solutions and Risks

High gas prices on Ethereum are a real concern for the platform’s developers. With ETH 2.0 on the horizon, new scalability solutions are quickly becoming a reality. With the recent testnet launch, a variety of different challenges were revealed. The Medalla experiment launched improperly, initially creating a consensus of only 57% of the entire stake.

Various reasons caused these issues, such as connection bugs and the zero value of testnet Ethereum, but eventually the network stabilized. Although not perfect, at this stage it doesn’t have to be.

What is important is the fact that these solutions are being tested, and that is reducing the risk of a catastrophic failure in the future.

Nonetheless, there are risks with DeFi that investors blinded by easy gains and greed do not fully comprehend. There are many new players that do not remember the DAO hack, or haven’t experienced a loss because of a coding issue.

Many of these lending platforms are speculative and risky. Indeed, many developers such as Andre Cronje invest heavily into security audits and perfecting their smart contracts. This does not cancel the possibility for a hacking event or code failure in the future, unfortunately.

Many of the current lenders and borrowers in ETH-based lending platforms are institutions and whales hoping to increase their profit margins, while borrowing third-party crypto to continue their trading activities.

In general, complex financial positions are able to generate (and lose) more value for the investors, and these participants are doing their best to take full advantage of this nascent marketplace.

As long as we avoid the creation of CDO’s based on CDO’s, which was the leading cause of the financial market crash in 2008, the crypto ecosystem can avoid repeating history.

Conclusion

Compared to the rest of the crypto market, DeFi represents only a small fraction of the entire picture. Compared to Bitcoin, Ethereum, and many of the other leading cryptocurrencies, assets locked in DeFi as a whole would rank on the 6th or 7th place in the list.

This is by no means a small feat, but considering the risks and relative “youth” of these platforms, there is no expectation for DeFi to outperform any particular cryptocurrency.

All current investors risk losing everything they have invested in these lending platforms. If by a stroke of luck or genuinely well crafted code, they manage to avoid a platform breaking disaster, DeFi will eventually become a completely decentralized bank for future generations.

Lending and borrowing, trading, exchanging, eventually even consumer payments may end up being managed in an autonomous, decentralized way.

In a stark contrast to what Messari researcher Ryan Watkins has to say about the topic, as he hopes to diminish the value of this space, DeFi is here to stay, and by its nature, here to grow.