Congratulations to DeFi bulls! The space now has $6 billion USD locked into smart contracts at current valuations. Does this mean that the space is growing in any promising manner? Maybe, or maybe not. Here is what these valuations might really mean.
The Source of DeFi Smart Contract Values
As more people engage in DeFi yield farming, they tie up more collateral in smart contracts. They also drive up demand for that collateral. This feeds a weird positive feedback loop: If you see someone making money out of thin air, you are inclined to try it out yourself, or at least inquire.
But you must take these numbers and bullish headlines with a grain of salt. After all, if you are reading this, you are inquiring. This might be one of only a handful of contrarian voices out there. So, here is what we think those $6 billion USD locked in DeFi tell us:
- Cryptocurrency prices continue to go up
- People have money and want to make more money with the money they have (fiat mentality seeping into crypto)
- There is quite a bit of FOMO!
DeFi’s Positive Feedback Loop
DeFi relies solely on positive feedback loops. You need more people coming in to keep it going. DeFi has absolutely no practical real-world use. Think about it:
- If you want to take out a loan and buy something, fiat might be a better choice
- Unless you are part of the 2 billion people around the world who are unbanked, in which case, you would recur to DeFi if you can put up the collateral
This proves the only factor keeping DeFi growing is that positive feedback loop. That is why some cryptocurrency prices continue to go up. It is also why Ethereum transactions are so expensive these days.
Nevertheless, positive feedback loops of this type don’t last when there is no use for the underlying system in the real world.
Making Money with Money Defies Basic Crypto Principles
As the positive feedback loop entices more people, demand for DeFi-related cryptocurrencies increases. So, not only will your collateral be worth more when you get it back – well, at least that is what you might think – but you will get your yields as well.
No bank can offer you this. Most are also offering very low yields for your savings. But the assumption that money should yield interest is flawed. Whether you look at bank rates or DeFi yields, money doesn’t “make” more money.
That is precisely one of the main fundamental differences between Bitcoin and fiat. To make money you have to prove that you have done some work! Fiat mentality seeped into crypto and it is finding a new home in DeFi.
Bitcoin is still more fundamentally sound than other cryptocurrencies – like Ethereum for example. Other cryptocurrencies depend on the same fiat mentality of making money with money instead of work. That makes them fundamentally fragile.
Here comes a New Wave of FOMO!
The positive feedback loop that has people locking more money up in DeFi, will exacerbate the scope of the perils ahead. You should not build on shaky foundations; you should not rely on fundamentally fragile money.
People, however, are prone to making irrational decisions – there is plenty of literature on this topic from Dan Ariely, Richard Thaler and Daniel Kahneman to mention a few. FOMO – fear of missing out – is part of the irrational behavior that pushes people towards investing in schemes that are not fundamentally sound.
The problem is that those who got into DeFi early and have already made some money, can pull their funds out at any point in time. Some of those who are suffering from FOMO will inevitably take the hit when that happens. Nevertheless, their FOMO is driving the market, making earlier investors more money.
Bubbles Pop but Bitcoin is For Ever!
This bubble will eventually pop, just like the ICO bubble before it. On the other hand, if you invest in fundamentally sound money like Bitcoin, you will have a better chance of withstanding the upcoming DeFi debacle.
You should not look at the $6 billion USD locked in DeFi now as an indicator of sound growth. You should see it as a greater fool scheme for which there are even greater fools out there. Just don’t let the market surprise you when it runs out of fools all of a sudden. Be careful with DeFi and all the bullish headlines!