DeFi Is Helping to Fuel the Crypto Market Boom—and Its Recent Volatility

There are two key differences from mainstream banks: All services are for digital currencies instead of government-issued ones such as the dollar and the euro, and there is no intermediary or centralized system through which transactions are processed.

Users typically access DeFi platforms through software known as dapps, or decentralized apps, most of which run on the Ethereum network. They connect their digital wallet to the app and select a service from a drop-down menu. Functions handled at a traditional bank by a loan officer or teller are automated.

“It’s essentially banking for the blockchain space,” said

Antoni Trenchev,

co-founder and managing partner of Nexo Capital Inc., one of the largest firms in the DeFi industry.

DeFi, however, has been a double-edged sword for the crypto market lately, helping to fuel a surge in volatility. Many traders have turned to derivatives and arbitrage strategies on DeFi apps for a chance to amplify their returns in a white-hot market. They can place outsize bets with only a small amount of money upfront, effectively taking on leverage, the practice of borrowing to amplify returns.

Assets deposited as collateral on DeFi platforms, a measure known as total locked value, have grown to more than $100 billion, of which about $64 billion is on Ethereum, according to the website DeFi Pulse. A year ago, there were only about $1 billion of DeFi assets on Ethereum.

The implosion of leveraged bets has been a key factor in accelerating a monthlong selloff in bitcoin and other cryptocurrencies. As prices tumbled, many bullish bets were automatically liquidated, adding more downward pressure on prices and leading to a vicious cycle of further liquidations.

A similar boom in leverage is occurring in the U.S. stock market, where investors had borrowed a record $847 billion against their portfolios as of April, according to the Financial Industry Regulatory Authority. Although levels of what is called margin debt typically rise alongside index levels, records can precede bouts of volatility as they did in 2000 and 2008.

The surge might be more ominous for the crypto market. While margin debt represents only 2% of the $49 trillion U.S. stock market, total locked value comprises about 6% of the $1.6 trillion cryptocurrency market.

Although many DeFi platforms have collateral limits, some allow users to employ huge leverage. BitMEX, one of the earliest and most popular crypto derivatives exchanges, allows as much as 100 times leverage on some futures contracts, for example.

It isn’t clear what percentage of assets are being lent and lent again across various DeFi platforms and other exchanges, a dynamic called rehypothecation. “Everything in crypto is rehypothecation,” said Alex Mashinsky, founder of DeFi firm Celsius Network. “Everything. Including the collateral.”

For users, the appeal of DeFi is simple. There are almost no requirements to participate, except for having some form of crypto as collateral. Interest rates are attractive compared with traditional investment products. And because transactions are automated, settlement is virtually instantaneous, removing some of the traditional counterparty risk.

Interest in DeFi has contributed to this year’s surge in the price of ether, the Ethereum network’s in-house currency and the second-largest cryptocurrency by market value behind bitcoin. Ether hit a record $4,383 in May, up from less than $200 a year ago. It has since fallen to about $2,750, part of a broader selloff in digital currencies.

DeFi accounted for about 40% of the ether moved on the Ethereum network in the 12 months through April, according to research firm Chainalysis, up from 7% in the prior 12 months. Many NFTs, or nonfungible tokens, also run on Ethereum. NFTs are bitcoin-like tokens connected to a digital work of art or other real-world item and sold as a unique digital item.

DeFi services using Ethereum competitors are growing too. Binance Smart Chain has about $26 billion in assets across about 60 apps, according to the website Defistation. Meanwhile, the largest startups offering DeFi services, Celsius and Nexo, have $21 billion and $15 billion in assets, respectively.

DeFi is still an immature and highly risky market. In some cases, those running the apps are anonymous, making it harder for users to determine which platforms are reliable.The services aren’t regulated or insured, so if a platform fails there is no recourse.

Another risk is security. With money pouring into the space, DeFi platforms are increasingly attractive to hackers. If the code behind a service isn’t sound, it can be exploited and money funneled out.

Hackers stole about $120 million from DeFi protocols in 2020 in 15 separate attacks, less than half of which was later recovered, according to research and media firm Block Research. This year there have been at least 23 attacks to date that have netted the hackers about $411 million, according to data compiled by Rekt.news, a website set up to track thefts.

In April, a hacker stole about $60 million of digital currency from a platform called EasyFi by targeting a single vulnerability: the founder’s computer. The hacker stole the access code and drained about 30% of its total funds. Another service, called Value Defi, has been hacked three times since November—twice in May alone—for losses totaling about $28 million.

Write to Paul Vigna at paul.vigna@wsj.com