What am I missing? It seems the way DeFi is currently set up it could potentially take down the entire crypto market. The whole ecosystem is over-leveraged, dependent on constant liquidity and rising token values. If that liquidity dries up, or the collat

I'm not trying to be a doomer or just spread FUD, but I've been doing a lot of research on DeFi recently and don't really see any other way to interpret this. I know I'm not the first to notice how fucked the current situation seems. As far as I can tell, the DeFi ecosystem has built itself into a giant house of cards, propped up by hopes & dreams at this point.

Getting a picture of the entirety of DeFi is kind of complicated (I definitely don't understand it all), but for the sake of this post, DeFi i'm referring to is the series of applications developed to enable various "decentralized" financial functions on the blockchain.

The 2 most popular functions being Crytpo Lending/Borrowing and Decentralized exchanges (DEXs)

Crypto holders are incentivized to participate in DeFi as a means of "Yield Farming". Basically, parking crypto assets into a liquidity pool so it can earn interest and fees, paid out in the form of an app-specific token. Sometimes the annual interest returns are huge.

Cypto borrowers get a great deal through these apps too. Put up some coins as collateral, and in return you get instant access to liquidity. No credit checks, no applications... all automated.

There is a lot of opaqueness in the DeFi market and like I said, I don't fully understand it all. What I understand for sure is:

1. DeFi depends on a consistent stream of incoming liquidity
2. DeFi also depends on the volume of transactions on the network (to collect fees)
3. The price stability of tokens on DeFi apps rely on arbitrage traders (a lot of this in the form of bots)
4. People who get into DeFi projects early see much higher returns. As returns drop, they move their liquidity elsewhere.

All fine in a controlled environment. But here's where I see it going all wrong.
As the crypto market heated up in 2020, money began flooding into DeFi applications. Since DeFi allows traders to leverage their assets to make bigger transactions...this in turn helped prop up the entire crypto market with a surge of new liquidity. After all, all of those tokens previously sitting idle in people's wallets were now being put to work.

The amount of value just locked into DeFi is now astronomical, currently somewhere over $66 Billion (down from a peak of almost $100 billion).

But as the DeFi world started to heat up, more and more dApps came into the fold promising increasing interest and rewards. Interest rates in these pools are almost always higher when the coin or token supply is low and demand is high....as more people rush to participate, the yield returns typically drop.

So we saw Yield Farmers getting increasingly sophisticated. To maximize rewards, many lenders started to run their tokens between different pools chasing the highest returns.

Yield farmers also began to then re-invest the tokens received from one liquidity pool, into separate liquidity pools on other dApps for THAT token. Creating complicated daisy chains of returns.

To stretch things even thinner...many of them then started to use their yields as collateral to BORROW more assets, then invest those in liquidity pools, to further increase their returns.

The economics behind this are pretty mind-numbing. Its akin to the mortgage backed securities situation in 2008. Basically....tons of collateralized "junk" assets are being traded, all based off a pool of inherently risky & volatile crypto assets. Remember, the market for these tokens only exists on DeFi.

Honestly its hard to wrap my head around. But I do know all of it depends on new liquidity and volume coming into the systems, and the value of the underlying tokens remains stable or growing.

So the big glaring question is....what the heck happens when the liquidity dries up or the value of the tokens drop off a cliff?

We've already seen multiple times how a dApp can have a meltdown.

• In Mar 2020, we saw the MakerDAO liquidity crisis . Basically, ETH price dropped...people rushed to stablecoin DAI, and the app also triggered automatic liquidations (which malfunctioned). This caused a huge shortage of DAI on the system, and people to lose out big time. https://www.coindesk.com/makerdao-adds-usdc-as-defi-collateral-following-black-thursday-chaos
• Later in Sept. 2020 we saw the SushiSwap rug pull. Long story short...a billion dollars flooded into SushiSwap DEX...then the developer pulls out all of his liquidity suddenly. The underlying token value plummeted...but so did the price of Ethereum (by 30%+), and subsequently bitcoin.
• Then last month we saw the IRON/TITAN "bank run".... investors tried to redeem their stablecoins and sell the asset, leading to a massive selloff that tanked the token price to $0 https://www.coindesk.com/iron-finance-says-it-suffered-cryptos-first-large-scale-bank-run-in-token-crash-postmortem

So we already know potential consequences that can happen.
1) bank runs on DeFi tokens are possible.
2) A sharp drop in the value of any of the assets in a liquidity pool can lead to mass liquidations,
3) When the value of DeFi tokens plummet suddenly, it takes the "mainstream" crypto market down with it
4) All of this also has the potential to unpeg stablecoins

As far as I can tell, all it would take is for the underlying crypto asset price of Ethereum or Bitcoin to crash low enough to trigger mass liquidations. Suddenly, you're left with a huge flight of liquidity, and tons of "empty" token pairs.

As traders rush to get their tokens exchanged for "safer" assets, the liquidity pools are drained, and gas prices skyrocket. These combined effects could in-turn shut down the entire arbitrage and liquidation markets...all resulting in complete price instability.

The mad-scramble for stablecoins would dry up all the supply in the midst of huge demand, likely unpegging the coins value.

It would cause a catastrophic ripple effect throughout the entire market. Even after the initial panic…once all of that leveraged lending goes away, and thousands of coins are unlocked/ sold onto the open market, it will be apocalyptic for crypto prices.

Whether individual projects are "good" and some are "bad", doesn't really matter in this case. They've pretty much all been linked together in some way. If the biggest domino falls at the top, the rest come with it.

Tbh, its kind of horrifying.

TL;DR: The current DeFi ecosystem seems like the 2008 mortgage crisis, Bernie Madoff ponzi scheme, and Amway all rolled into one...and its going to collapse when the price of Bitcoin / Ethereum drop too low. Only this time, there's not going to be a bailout. Am I reading into this wrong?