Key DeFi Ecosystem Problems, Explained
What is the decentralized finance ecosystem?
Decentralized finance is still in its infancy. If this young and ambitious industry ever hopes to supplant current legacy systems, it must overcome some hurdles, such as achieving a seamless user experience and secure industry standards. However, new technology is being worked on right now that aims to bridge most of the major pitfalls still standing in the way.
Decentralized finance, or DeFi for short, is a blanket term for a whole array of new technologies and products that look to offer innovative ways for people to manage their finances autonomously — without the control of a central bank or institution.
Generally speaking, decentralized applications, often called DApps, are built on top of existing blockchains, such as Bitcoin, EOS or Ethereum. They typically leverage smart contract technology that allows users to have complete control over their own finances. This applies to not only an individual’s savings, investments and payments, but can extend into use cases such as lending, insurance, margin trading, predictions markets and virtually anything the legacy financial system has to offer — and more.
DeFi tools connect users with services that don’t involve any centralized point of authority. This system is designed to make the entire process more efficient, safer and completely transparent — qualities that traditional fintech solutions still struggle to implement. That being said, there are still some roadblocks preventing this vision from becoming fully realized.
Who makes up the DeFi market?
The DeFi market is made up of many different actors and subsectors, some of which simply don’t exist in traditional finance. While a large majority of participants include lenders looking to loan out assets, borrowers looking for quick access to those assets and exchanges that can act as a medium for lenders and borrowers, there are a number of other important facets and solutions. These include peer-to-peer marketplaces, the tokenization of real-world assets such as real estate and art, prediction markets, staking and collateral, alternative savings with interest earning mechanisms and even insurance.
One of the most popular use cases in DeFi today is lending and borrowing. Lenders are generally players who hold a significant amount of assets and are looking for ways to earn interest on their holdings that transcend normal market appreciation. By providing liquidity for an asset, long-term lenders are often rewarded when they use a specific lending platform. This comes as a win-win by adding liquidity to an asset’s market while giving passive income to those providing it.
Borrowers are seeking benefits that come with temporarily taking control of lenders’ resources, even if for a price. For one, by borrowing an asset, users can potentially short that commodity for profit on exchanges that do not support margin trading. Furthermore, these platforms can offer quick access to utility tokens that the borrower may not wish to hold, but simply wants to use for one specific task, such as participation in voting on a network. There are even “flash loans” available — a financial tool that enables users to request a loan, use the money borrowed and reimburse the loan atomically in a single transaction.
Decentralized exchanges have also gained popularity for their automated swap capabilities. The only “middleman” is a smart contract, which does not take a cut or slow down the exchange process. Funds remain in a user’s full custody, minimizing the security issues that have caused centralized exchanges to lose tens of millions of dollars in cryptocurrency due to hacks or mismanagement.
Liquidity pools are another emerging avenue of DeFi, and are often tied to decentralized exchanges. Some decentralized exchange, or DEX, platforms like Bancor Network and Uniswap encourage users to create and fund the liquidity pools needed to facilitate different exchange pairs. If you have a token and would like to exchange it with another, you can add liquidity for that token so others can swap and trade for it. This open process undermines the concept and process of getting listed on the traditional stock exchange.
Both DEXs and liquidity pools have experienced the largest growth ever since their inception in the past quarter.
What are some of the inherent risks in decentralized markets?
Some of the most prominent risks present in the fledgling DeFi field come from issues with smart contracts, user error, market volatility, lack of insurance on loans and potential failure of the price mechanism.
Despite its possible advantages, the DeFi movement is still in its infancy. This means that some of the great upsides of using these platforms also come with relatively high risks. One major source of problems is smart contract vulnerability. Despite its programmed intentions, if a contract is released into the ecosystem with a flaw in its code, it can lead to loss of funds.
This has happened in the past, with perhaps some of the most notable episodes affecting Ethereum. Though the field has come a long way with audits and peer review becoming the norm, there is no guarantee that it won’t happen again. A recent example is the attack against the bZx protocol, where a hacker was able to take advantage of subtleties in how “flash loans” operate in order to steal thousands of dollars worth of Ether. While events like these do usually lead to updated solutions for the underlying problems, there are likely to be more discovered and exploited errors before these systems operate flawlessly.
This smart contract vulnerability can be closely tied to another common problem currently afflicting the space: user error. Even if developers think their code is airtight, they cannot anticipate the ways in which users will interact with their applications. Millions of dollars have been lost due to users sending their funds to the wrong address, such as a DApp’s smart contract blockchain address. This is a problem that can often be rectified with new token standards such as ERC-777, which can detect and block these mistaken transactions, although raising the transaction costs.
Another facet that many users don’t consider is both internal governance of an asset as well as its external regulations. Essentially, there is always a chance that a given project can change who runs the platform or how it is operated, sometimes with little to no warning. Furthermore, local governments can enact new regulations that do anything from augment when a specific currency can be used or render the currency illegal altogether.
Other pitfalls, such as the unpredictable markets that underlie some of these decentralized services, combined with a lack of insurance, means there is currently still a very real risk of an investor losing large sums of money even if neither they nor the developers made a single mistake.
What other problems are holding DeFi adoption back?
Even beyond the risks involved, certain issues persist that often affect the user experience of these platforms. These include overcollateralization, centralization, low liquidity and very little interoperability between blockchains.
Another common issue with the DeFi industry is that sometimes “decentralized finance” isn’t as decentralized as it should be. It is not uncommon for new projects to give a high degree of control to the developers, so that they can develop the network and respond and fix issues as fast as possible. While this makes sense, it can lead to a situation where a DApp that is meant to be distributed is still in fact centralized in some way. This can be risky even if the team behind the product is trustworthy, as it opens the door for misuse of consumer funds. In order to balance out these issues, projects often choose a “progressive decentralization” approach, in which a product is originally under the control of the main development team but whose governance is designed to be “released” to the community over time, eventually becoming a truly self-regulated network once the kinks are worked out.
In the case of lending and borrowing, one of the biggest problems today is overcollateralization. As there are no guarantees with such a volatile market, lenders want significantly higher collateral to be put up for their loans. This leads to a situation where many lenders won’t actually work with a borrower unless they can effectively front a significant amount of assets, which undermines the essential function of borrowing. The situation then does not fulfill one of the main philosophies of DeFi, which is to bank the unbanked. It also causes notable cuts into profits made on leverage trading, discouraging that use case as well.
The other problems that make current DeFi systems slow or clunky are generally tied to low liquidity and difficulty switching between blockchains. With so many diverse currencies and tokens being exchanged, sometimes the number of traders available is simply insufficient to make moving assets around seamless. Combine this with very limited means to transfer between different commodities, which are usually focused around exchanges, and otherwise competent systems can be bogged down by sluggish movement of value. Of course, this all assumes that the underlying blockchains themselves are not currently overencumbered, which is by no means a guarantee.
Where will DeFi go from here?
A wide variety of solutions are already being developed to address these issues, and in time, growing volumes, better code and new forms of interoperability like Atomic Swaps and pTokens should make DeFi increasingly attractive to the current financial world and regular citizens alike.
All of the listed risks and problems are being worked on in a variety of ways within the community, and some may simply be solved with time. Problems with smart contracts as well as user errors may become less frequent with a more thoughtful use of audits, bug bounties, open-source commitments and a collaborative and supportive approach to building new solutions. As governments begin to cement regulations over these assets, it should provide a clearer framework for investors to stay within predictable legal parameters.
Perhaps most important, solutions that improve and facilitate liquidity are vital; a liquid market will support a fast-growing user base, providing frictionless and enjoyable ways for players to transfer value across different blockchains and their DApps.
To that end, multiple new technologies are being developed with just those goals in mind. For example, in order to improve the capacity of the Ethereum network, the developers are planning to introduce Ethereum version 2 in the near future. By introducing this upgraded infrastructure, significant gains can be made not only in the speed of transactions, but also capacity.
Another promising idea being explored is known as Atomic Swaps. These can take a variety of forms for implementation, but basically involve transferring value directly from one blockchain to another. This is achieved using time-bound smart contracts that must be executed between both chains. While this concept has seen some interest, the process is highly technical and has seen limited adoption. Most recently a form of this was implemented by Blockstream’s Liquid sidechain, but for the most part, the technology is still in the experimental stage.
Furthermore, the rise of decentralized liquidity pools can help bring in the much-needed flexibility that will give more traders confidence in these assets.
Is the missing link interoperability?
It’s commonly agreed that one of the major catalysts for DeFi adoption is interoperability — the ability for every tool, smart contract and DApp to interact with one other. There are a multitude of blockchains, each with its own DeFi ecosystem and community. Enabling digital assets to flow between all blockchains and their DApps effectively “unchains” the value of the entire $250 billion cryptocurrency market, enhancing its liquidity, utility and usability.
One such project building an interoperability solution is pTokens, which aims to make DeFi universally accessible. pTokens makes DApps usable to crypto users without having to sell or trade their Bitcoin, Litecoin, EOS or any other blockchain asset they hold.
pBTC is the first of the pTokens series, enabling anyone holding Bitcoin to mint their own Ethereum or EOS-compatible tokens. They can use their pBTC to start interacting with every DApp, including decentralized lending platforms where they can earn interest on their loaned assets. pBTC can be converted back to BTC at its current value and at any time.
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