The Crisis of DeFi: What’s the Solution?

Since the UST de-pegging incident, the cryptocurrency market has entered a downward spiral. Institutional bankruptcies, exchanges halting withdrawals, lending protocols facing liquidations and bank runs—all these events highlight a liquidity crisis that has laid bare DeFi's vulnerabilities in stark detail.

In 2020, the advent of "DeFi Summer" sparked unprecedented enthusiasm. Liquidity mining drove the total value locked (TVL) in DeFi protocols from less than $100,000 to a peak of $300 billion. The promise of extraordinarily high annualized yields created a wealth effect, attracting swarms of users. This frenzy was further fueled by leveraged players, propelling DeFi to its zenith. However, as the cryptocurrency market encountered unsystematic risks, DeFi suffered a swift and dramatic downturn.

As shown in Figure 1, as of July 7, 2022, DeFi’s TVL had dropped 64% from its all-time high. The market capitalization of "blue-chip" DeFi projects also plummeted. For example, Uniswap’s market cap fell by 82%, Compound’s by 94.4%, with most DeFi projects returning to their pre-bull market valuations.The bubble has burst.

Reasons Behind the DeFi Crisis

1. Treating Lego Stacking as Innovation

In the early days, projects like MakerDAO, Uniswap, Compound, and Aave established a solid foundation for DeFi. These protocols were permissionless, transparent, logically simple, and robust even in turbulent markets.

DeFi's composability was once hailed as a key strength. When one project sparked market interest with an innovation, numerous others quickly followed suit, combining or iterating on that idea to launch their own "hit" products. For instance:

Liquidity Mining: Initially proposed by Hummingbot and later popularized by Compound, liquidity mining quickly became a standard for many projects to launch their tokens. A prime example is SushiSwap, which forked from Uniswap, introduced liquidity mining, and offered governance tokens (SUSHI) to liquidity providers. This strategy allowed SushiSwap to capture 83% of Uniswap's liquidity in a short period, spawning a wave of similarly named food-themed decentralized exchanges (DEXs).

Layered Pools and Leverage: Innovations like "nested pools," leveraged mining, and bonding introduced increasingly complex reward structures to attract funds, creating a Ponzi-like effect that left investors vulnerable when projects collapsed.

Over the past two years, most so-called innovations in DeFi were superficial. Instead of true innovation, they stacked features, often with opaque and overly complex mechanisms, eroding DeFi’s transparency and leaving investors unable to assess risks.

True innovation should focus on technology stacks, economic models, practical applications, and security infrastructure while retaining permissionless, transparent, and user-friendly attributes. Examples include Uniswap V3's NFT-based liquidity positions and Curve's veTokenomics, which allows CRV holders to lock tokens for tiered rewards.

However, innovation alone isn’t always beneficial. For example, Terra’s UST stablecoin once offered 20% returns, attracting institutional and traditional investors alike. Yet its flawed mechanism violated market principles, leading to catastrophic failure that sparked a series of crises.

2. Unsustainable Tokenomics

Distribution Mechanisms

In DeFi’s early days, tokens were mainly distributed via liquidity mining and public sales. While these incentives attracted users and liquidity, they primarily drew short-term speculators who “farm-and-dump,” creating significant sell pressure in secondary markets. This reduced the effectiveness of token incentives over time, especially as newer projects offered higher yields.

To address this, Curve introduced veTokenomics, incentivizing long-term investors while discouraging short-term speculation. veCRV holders can influence CRV reward distributions across liquidity pools, sparking the so-called "Curve Wars," where protocols bribe veCRV holders to secure liquidity. This system inspired layered projects like Convex and Redacted Cartel.

However, veTokenomics weakened governance. Many veCRV holders focused solely on maximizing rewards rather than voting for the long-term health of projects, often leading to misallocated funds. Furthermore, token lock-ins exposed holders to greater risks during market downturns.

Lack of Value Capture

Most DeFi tokens fail to effectively link project value to token value. Early governance tokens, often distributed via airdrops or liquidity mining, serve only governance purposes. However, governance participation is usually low, and decision-making power often rests with institutions or project teams, leaving users disinterested or voiceless.

This token design also complicates valuation. Unlike traditional finance, where valuations are based on profits or cash flows, governance tokens lack such mechanisms. For example, Aave sought to tie platform revenue to its token by using fees to buy and burn AAVE, creating deflationary pressure. While this approach links token value to platform success, it is still vulnerable in bearish markets.

DeFi tokens should adopt models that establish long-term value, moving beyond governance and liquidity mining. For example, Tokemak allows TOKE holders to influence liquidity direction, an attempt to enhance token utility. However, the effectiveness of such models remains to be seen.

3. Weak DAOs and Governance

Uneven Token Distribution

In many projects, teams and venture capitalists hold the majority of tokens, monopolizing decision-making power. This centralization often undermines community governance. For instance, Solend's rushed proposal to take over a whale’s account faced backlash for bypassing adequate community consultation.

Weak Community Engagement

After their initial hype, many projects see reduced community interaction, with even social media activity dwindling. Token holders often focus solely on price movements, ignoring project development. While some projects allocate tokens for governance incentives, these often result in low-quality or ineffective proposals.

Balancing Developer Control and Community Autonomy

Project teams, being intimately familiar with development trajectories, must balance their authority with community participation. Decentralizing governance too early risks incoherent decision-making, while delayed decentralization can stifle community engagement. Community-driven governance should evolve as projects mature and attract value-aligned participants.

4. Overuse of Leverage

In 2022, global liquidity tightening and risk asset devaluation triggered widespread deleveraging. DeFi was no exception, with $124 billion in Ethereum value deleveraged within six weeks, according to Glassnode. Events like Luna’s collapse and stETH’s temporary de-pegging highlighted the systemic risks posed by excessive leverage.

Many DeFi products offered leveraged mining or structured tokens, promising high returns without educating users on associated risks. Such products often lacked proper risk assessments and were developed without financial engineering expertise. In extreme market conditions, collateral assets—being highly volatile—faced liquidation risks, further exacerbating market instability.

How Can DeFi Emerge Stronger?

Simplify and Focus: DeFi products should prioritize usability and transparency over complex structures. Practical innovations like permissionless asset management tools or unsecured credit-based loans are promising directions.

Educate Users: Lower entry barriers by providing educational resources on DeFi basics and risks. Initiatives like "My First NFT" exemplify effective user education through step-by-step guides.

Redesign Tokenomics: Tokens should promote long-term engagement and utility beyond governance or staking.

Conduct Robust Testing: New products must undergo market simulations, stress testing, and iterative improvements to withstand extreme conditions.

Strengthen DAOs: Foster active community participation with fair token distribution and meaningful incentives, while ensuring governance aligns with project goals.

Conclusion

The DeFi crisis was predictable and aligns with natural market cycles. While painful, the ongoing deleveraging offers an opportunity for healthier rebuilding. By embracing simplicity, innovation, and strong governance, DeFi can achieve sustainable growth and unlock its true potential.