Decentralized finance (Defi) is an industry that is still in its infancy stage. If the sector has hopes to topple the balance and take over powers from the traditional legacy systems, it must rise above several challenges. Nonetheless, there is a new technology that experts in the industry are working on to offer solutions to the existing problems.
By description, Defi is a general term for a broad array of new products and technologies that strive to offer innovative methods for individuals to manage all their finances autonomously. The users can control and manage their finances without the control of a central bank or any government institution.
In general, decentralized applications (DApps) are powered by existing blockchains like EOS, Bitcoin, or Ethereum. They do leverage smart contract technology that lets users have full control over their finances. That applies to savings, payments, investments, lending, insurance, predictions markets, and margin trading. It also covers almost anything the traditional financial system has to offer.
The DeFi tools link users with services that do not comprise of any centralized point of authority. The system is ideally designed to make the whole process safer, more efficient, and fully transparent. These are the qualities that traditional fintech solutions still struggle to implement.
Nonetheless, there are still some challenges that prevent the vision from getting realized.
Who And What Makes Up the DeFi Market?
The DeFi market comprises various actors and subsectors, with some of the participants absent in traditional finance. A majority of the participants are lenders who want to lend out assets and borrowers seeking quick access to the available assets. Also, exchanges can act as a medium for lenders and borrowers to operate.
The DeFi industry also has several other essential solutions and facets. They include the tokenization of real-world assets like art and real estate, peer-to-peer marketplaces, insurance, staking and collateral, prediction markets, and alternative savings with interest-earning mechanisms.
Lending and borrowing are the most popular use cases in DeFi currently. Lenders have a lot of assets and are always seeking ways to earn interest in their holding that mostly transcend usual market appreciation. By introducing liquidity for an asset, the long-term lenders generally get rewards whenever they utilize a particular lending platform.
The strategy comes as a win-win through injecting liquidity into an asset’s market while simultaneously providing passive income to those providing it. On their part, borrowers seek benefits that arise from temporarily controlling lenders’ resources, even if that happens for a price.
Through borrowing an asset, users can probably short the commodity for profit on exchanges that have no margin trading. Additionally, the participating platforms offer quick access to the utility tokens that borrowers do not prefer to hold; but simply want to utilize them for a single particular task like voting on a given network.
Flash loans enable users to borrow a loan, use the money, and then reimburse the money automatically in one transaction. Decentralized exchanges are now also famous for their automated swap capabilities. The only ‘middleman’ involved in the process is a smart contract that never takes a cut or even slows down the entire exchange process.
All funds are retained in a user’s full custody, which minimizes the security challenges that have plagued the centralized exchanges. The security issues have cost centralized exchanges millions of dollars in crypto due to mismanagement and hacks.
Liquidity pools are an emerging channel of DeFi and are mostly linked to decentralized exchanges (DEX). Some DEX platforms like Uniswap and Bancor Network urge their users to create and fund liquidity pools needed to facilitate and support various exchange pairs.
Anyone who has a token and wants to exchange it with another can add some liquidity for the token to enable other traders to swap and trade for it. That open process undermines the process and concept of getting listed on the traditional stock exchange. Both liquidity pools and DEXs have encountered the most significant growth ever since their inception in the last quarter.
Inherent Risks In Decentralized Markets
The most prominent risks arise from issues with user error, smart contracts, lack of adequate insurance on loans, market volatility, and possible failure of the price mechanism. Notably, the DeFi movement is still in its early stages despite its potential benefits. Thus, some of the great benefits of using these platforms also attract relatively high risks.
Smart contract vulnerability is a significant source of problems in the decentralized markets. Although it has programmed intentions, there might be loss of funds if a contract is released into the ecosystem with a flaw existing in its code.
These losses have happened in the past, with some of the significant episodes ever recorded affecting Ethereum. Even though this space has come a long way with peer reviews and audits becoming the norm, there is no assurance that these attacks will not happen again.
The most recent example is the attack against the bZx protocol. In that instance, a hacker managed to exploit subtleties in the way ‘flash loans’ operate stealing thousands of dollars in Ether. While such incidents result in updated solutions for underlying problems, hackers might discover other errors and probably exploit them before the system operates efficiently.
This particular smart contract shortcoming can be linked to another major problem that is currently plaguing the space: user error. Even when the developers allege that their code is compact and airtight, they cannot predict how different users will interact with their applications.
Money in millions of dollars has been lost due to users sending funds to the wrong address, including Dapps’s smart contract blockchain addresses. That is a shortcoming that can be solved using new token standards like ERC-777 that can detect and block the mistaken transactions. However, that increases the transaction costs.
Another notable facet that most users never consider is internal governance of a specific asset and external regulations. Importantly, there is always an opportunity that a particular project may change who runs the platform or how it is operated. At times, it happens with little to no warning.
Additionally, the local governments can enact many new regulations that do anything; from augmenting when a currency can be used or render that currency illegal generally. Other problems like the unpredictable markets that affect some of the decentralized services and lack of insurance mean that there is still a serious risk. Investors could lose a lot of money even if neither they nor the developers made any mistake.
What Issues Suppress DeFi Adoption?
Various issues persist that affect the user experience of these platforms even beyond the risks that come with decentralized finance. Some of the problems include centralization, over-collateralization, low liquidity, and little or no interoperability between blockchains.
Another issue affecting the nascent DeFi industry is that it is not as decentralized as it is supposed to be. It is usual for the new projects to offer a high degree of control on the developers to encourage them to develop the network and promptly respond to issues that may arise and fix them.
While all that makes sense, it may lead to unprecedented situations where a Dapp designed to be distributed is still centralized to some extent. That may prove somehow risky even when the team behind the product is trustworthy; since it opens ways for the misuse of consumer money and funds allocated to various aspects of the project.
Projects often go for a “progressive decentralization” approach to balance these issues. In that context, a project is initially under the control of the central development. However, the team’s governance is designed to be ‘released’ to the community gradually over time. Through that method, the network eventually becomes self-regulated after all the kinks are worked out.
In the instance of lending and borrowing, one of the most significant challenges currently is over-collateralization. Since there are no guarantees with such a highly volatile market; lenders want higher collateral to be put for their loans.
That results in a scenario where most of the lenders fail to agree with the borrower unless they can provide adequate security for the loans. The occurrence undermines the integral function of borrowing. That situation then never fulfills the primary philosophy of DeFi, to bank the unbanked. It also results in significant cuts into profits made on leverage trading, which discourages the adoption of this use case.
The other challenge that makes the current DeFi systems slow and inefficient are generally linked to low liquidity and difficulty in switching between blockchains. Many diverse currencies and tokens are exchanged daily on these platforms. In some cases, the number of available traders is insufficient to move assets around seamlessly.
Combining these shortcomings with limited means of transfer between various commodities typically focused on exchanges slows the rate of DeFi adoption. Also, these issues can slow down the movement of value on the otherwise competent systems. All that works under the assumption that the underlying blockchains are not over-encumbered, which is not a guarantee.
What Next For DeFi?
Many solutions are already getting developed to offer solutions to these challenges. In time, growing volumes, enhanced codes, and new types of interoperability, including pTokens and Atomic Swaps should make decentralized finance highly attractive to the regular citizens and current financial world.
All of the listed risks and challenges are currently being worked on in multiple ways within the community. Some of them may be solved eventually as time goes by. Issues with smart contracts and user errors may become less frequent with a more intellectual implementation of audits; open-source commitments, bug bounties, and a collaborative and inclusive approach to creating new solutions.
As governments start to tighten regulations over these assets; it will offer a more transparent infrastructure for the investors to remain within predictable legal parameters. Maybe most importantly, solutions that enhance and facilitate liquidity are essential. A well-liquidated market supports a fast-growing user base, which, in turn, provides frictionless and enjoyable means for the participants to transfer value across multiple blockchains and their Dapps.
On that basis, many new technologies are being created with only those goals in mind. For instance, to improve the Ethereum network’s capacity, developers can introduce Ethereum version 2 soon. Considerable gains can be made through the speed of transactions and function through the introduction of upgraded infrastructure.
Another promising idea in this field that is being explored is called Atomic Swaps. They can take various forms for implementation and involve transferring value directly from one blockchain to the next. That is achieved using some time-bound smart contracts that are expected to be executed between both chains.
While the Atomic Swaps have seen some interest, the process is majorly technical and has seen limited adoption. Recently, a form of this was introduced by Blockstream’s Liquid sidechain, but for the major part, the technology is still in its experimental stage. Additionally, the surge of decentralized liquidity pools can assist in the introduction of the much-needed flexibility; that will provide more traders with confidence in these forms of assets.
Could Interoperability Be The Missing Link?
It is mainly agreed that one primary catalyst for DeFi adoption is interoperability. By description, interoperability is the ability of every tool, Dapp, and smart contract to interact with each other. Many types of blockchains exist. Each of these blockchains has its DeFi community and ecosystem.
Ensuring that digital assets flow between all blockchains and their Dapps efficiently ‘unchains’ the value for of the whole $250-billion crypto market. That will enhance its utility, liquidity, and usability. One notable project that is creating an interoperability solution is pTokens.
pTokens strives to make DeFi universally accessible by making Dapps usable to crypto users without having to sell or trade their Litecoin, Bitcoin, EOS, and all other blockchain assets that they hold.
pBTC is the first of the pTokens series. It enables anyone holding bitcoin to mint their Ethereum or EOS-compatible tokens. They can use their pBTC to start interacting with all Dapps. These include decentralized lending platforms where they can earn interest on their loaned assets. The pBTC tokens can be converted back to BTC at its current value and at any time.