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Here’s Why DeFi’s Total Value Will Regain Traction After the Recent Plunge

cryptoknowmics.com 20 May 2022 00:45, UTC
Reading time: ~5 m

Since its inception, DeFi seemed to have a Midas touch. Growth was explosive, and innovations were constantly popping up. The competition wasn't on if projects would come up but on the ones that would break the $100 million mark first. However, a recent bearish market has put a halt to the good times. At $111.88 billion by the time of writing, the total value locked has dropped by 53% from a high of $236.64 billion at the start of 2022. Yet DeFi is expected to get back on its feet. Read on to find out why.

Understanding the Cause of the Plunge 

To best understand why DeFi is bound to get back to the good times, it is worth knowing why things fell apart in the first place. There are two key reasons;

  • US Fed Actions

The main cause of the current plunge has been the US Federal Reserve Bank (Fed) policy actions. The bank has announced far-reaching steps to combat a rapidly rising domestic inflation, with adverse effects on most investment properties. During the height of the Covid-19 induced economic downturn, the Fed slashed lending rates and pumped massive amounts of helicopter money into the economy. Abundant liquidity drove most asset prices, such as crypto and stocks, into a massive bull run since 2020.  However, the resultant huge money supply expansion caused inflation to rise to a 40yr high. To combat the rapid inflation rise hurt consumer expenditures since salaries don't rise in tandem with inflation, prompting Fed action. By raising interest rates by the highest rate in 2 decades and announcing actions to reduce the money supply, investor confidence was dampened. It's the fundamental cause of the DeFi price plunge.

  • The collapse of Terra Blockchain 

Once an investor magnet, the collapse of Terra's UST and its LUNA sister currency have caused a considerable stir. Even more stunning was the fact that UST is a stable coin, which should, in theory, avoid any of the other cryptos' price volatility. Despite several attempts to salvage the coin, UST went burst. Along with it was 99.9% of its investors' assets. The threat of a potential spread of Terra's woes to other cryptos sent huge panic sales in the blockchain world. "UST’s collapse undercuts confidence in all liquidity protocols,” said Aaron Brown, a Bloomberg opinion writer, and avid crypto investor.

Why a Rebound will Happen

The Bearish Market isn't Constrained to DeFi Alone

One of the surest guarantees that DeFi will regain its stride is the widespread nature of the plunge. Nasdaq has dropped by 29%, A&P by 20%, and Dow by 15 from the start of the year. Bitcoin's market cap is down by 37% during the same period. While the numbers are not encouraging in any way, they mirror a general worldwide market bearish sentiment. A rebound in all assets is therefore expected, DeFi being one type of such asset.

Macroeconomic Policy Action will not be Permanent

The largest cause of the gloom has been the interest rate hikes by the US Fed as well as other major central banks. The target is to reduce the rate of inflation by reducing interest rates and mopping up too much money in circulation. While further rate hikes may be forthcoming, increments will eventually halt once inflation is tamed. Interest rates may even be reduced across the board to stimulate economies. Such action will stop the gloom in DeFi and spell a recovery, as is expected with other investment assets.

Terra's Ordeal was Unique, Hasn't Spread, and Could Stage a Recovery

Terra's collapse was very surreal and devastating to investors. It is, however, wise to observe the uniqueness of Terra's woes. First, 75% of all UST tokens in circulation were held in the Anchor Protocol. That was unique among major coins, with its effect being increased susceptibility to problems with Anchor. Second, the unsustainable 20% yield on UST created a market bubble. It was backed by Terraform Labs and some deep-pocketed spenders who ran out of financial cover as expected. Lastly, UST was quite different from other stablecoins. Rather than have a reserve asset deposit of equal value to back it like other stablecoins, its value was algorithmically determined.  The combination of these characteristics isn't present in other major Defi projects making a resurgence in investments very likely. In addition, the project's founder is working on staging a recovery. “Know that I am resolved to work with every one of you to weather this crisis, and we will build our way out of this," tweeted Do Kwon. 

The Current DeFi Use Cases are Still a Scratch on the Surface

DeFi use cases are yet to be fully explored. Among potentially huge innovation areas that should drive a DeFi rebound are Web 3.0, Play-to-earn games, the use of NFTs to counter counterfeits, and PFP NFTs. With all those mentioned above still being drafted or in the early stages of implementation, DeFi use will only grow in the future. It makes the recent plunge a temporary blip on the road.

Take Away

The current plunge in DeFi should not be dismissed in any way. It represents a high loss in investors' assets and a lack of confidence in the space by those cashing out. There are, however, hardly any other investment assets worldwide not experiencing tough times. The plunge is caused mainly by government macroeconomic policies to address the dire consequences of Covid-19 stimulus packages. The troubles of Terra also go a long way in influencing DeFi's plunge. Given the nature of the causative agents, a rebound in DeFi is very likely. All is not lost.

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