by Nikhilesh
User adoption of DeFi has failed to gain the critical mass despite localized periods of influx in liquidity, my blog is an attempt to highlight the key challenges to explain the adoption lethargy and further build on an innovative solution to address these challenges. Or so I think 🙂 Read on…
What is DeFi?
Decentralized Finance, or DeFi as we know it, is an innovative and inevitable approach to solving for centralization of power and decision making in our financial system. This is achieved by something known as DeFi protocols, which are nothing but a set of instructions to blockchain nodes for user interactions and transfer of value. These protocols act as a self-governing financial service provider that do no need to know anything about you except your account number (in this case a 0x wallet address). User can interact with these protocols using their cryptocurrency assets to lend, borrow, stake, trade financial derivatives etc. just like one would in a traditional financial (Trad-Fi) market.
Given protocols can be deployed by anyone and everyone, we see very many flavors of them. Also since there is no centralized ownership of protocols it is nearly impossible to impose regulation upon them.
Challenges in DeFi adoption
Over last couple of years, DeFi has seen growth in Total Value Locked (TVL) of around ~$200 billion at its peak in 2021 and as of Nov 2022, this number is hovering around ~$45 billion.
So why has this new approach not gained mass adoption yet?
Parking aside technical challenges and complexity in accessing these protocols for average joe, the 2 key reasons to see no material interest from institutional and “smart money” in this space are listed below.
Decentralization is a double-edged sword
1. Security, Assurance and Accountability
DeFi allows you as an end user to access capital markets which otherwise would require sophisticated bi-lateral agreements with major players vetted by expensive lawyers and massive capital in collateralization. Ofc, this is an over-simplified view, but it highlights the power of decentralization.
Since blockchain transactions do not require any definitive proof of personal identity, background or credit checks, proof and source of income declaration, it raises a major concern in terms of security of your funds committed into the ecosystem.
As I mentioned earlier, DeFi protocols are self-governing and self-preserving. They do have a democracy-based governance for most part however there is no “teams of humans” providing any checks and balances or assurances to your investments or their safety. Should a bad actor manage to get his/her hands on your funds, or worst yet — on the entire protocol funds, there is no definitive way to identify such a bad actor and hold them accountable.
Therefore, whilst blockchain transactions are transparent and do not need to know your name, age, sex, income, color of your skin, country of birth, social security number — this also means you don’t know this information about others on the network!
We’ve seen the bad actors at play in DeFi with some major incidents like Genesis DAO Hack that resulted in ETH being what it is today. Surely Vitalik thought long and hard before hard forking the mainnet! Till date it is estimated that DeFi exploits have summed up to roughly $2 Billion — see report.
2. Regulatory Framework and Oversight for Financial Stability
Trad-Fi has gone through decades of struggle to bring stability to financial markets. Banks are required to put aside capital to cover for losses that may rise from very many types of risks but primarily for safe-guarding investors and counterparties from insolvency. The mathematical models that generate these capital numbers have also gone through years of refinement to ensure capital is optimized and businesses are not unduly penalized.
Evolution of DeFi protocol till date have been through extremely talented individuals but these protocols lack fundamental safety mechanism as far as “exploits” are concerned. We’ve seen “liquidity dump” attacks in which massive amount of liquidity is dumped into the protocol, such that the token value that the protocol is underpinning loses the battle of supply and demand and therefore token loses its market capitalization. Another popular attack type is that of “timing the transaction”, in which a user is able to pay higher fees to get their transaction processed ahead of a market order and therefore acquire the asset for a slightly cheaper price. This would be equivalent of order manipulation on exchanges in FIX protocols (those of you who know it — if not watch HFT documentary here or read about this super quant guy Hiam Bodek)
As far as trading or shall we say transferring value or asset/debt is concerned in Trad-Fi world, we’ve well thought through agreements and frameworks in place such as ISDA MA/ CSA, GMRA, GMSLA and similarly for risk assessment and measurement like VaR and Stress Testing reports. Simply brushing all of this wealth of knowledge aside saying “that’s old school” will not be best use of our collective intellectual capital.
Meaningfully translating what we know of TradFi into DeFi without importing the dominance of centralization will unlock the true potential of DeFi!
The answer to regulating DeFi market is in the name itself, we need to decentralize regulatory framework and its enforcement.
What we need is a layer or collection of layers that acts as a “DeFi Highway” on which DeFi ecosystem can be built upon! The Highway will act as the substrate to define regulatory framework and enforce it — without killing Decentralization in its spirit!
4key developments need to happen at infrastructure level to ensure we’ve ability to build regulatory framework and enforce it without centralizing it.
DeFi stack needs to go beyond providing ability to deploy smart contracts and float ERC tokens, it needs to be able to act as a delegate for definition of regulatory framework and act as a regulatory watchdog on behalf of not just the regulator but also the ecosystem users.
The 4 key developments needed to achieve above are highlighted in the exhibit below
- KYC/ Credit Checks — Tokenization of user identity to be verified by network where verification rules are based on what is currently implemented will ensure rational and legitimate actors are allowed on the DeFi Highway. This will also help weed out sanctioned individuals, state actors and enterprises as well as those with past record of criminal activities. Ofc, we can leverage ZK-Snarks and other Zero-Knowledge proof methods to minimize personal data transfer. Here is a good summaryas a starter for ten published byIgnas | DeFi Research
- Financial Stability and Capital Requirements — building standard interfaces which dictate the necessary requirements for launching DeFi protocol on the DeFi Highway will ensure all deployed protocol meet certain standards in terms of capital requirements, segregation of accounts, protection of investor funds but also technology and contract audits, fail-safe mechanisms and other such necessary requirements that will be a combination of Trad-Fi lessons learnt and all that is needed from a smart contract perspective to ensure minimization of risks related to technology exploits (attacks on smart contracts themselves).
- Transaction Monitoring — monitoring transactions with now known identity will help regulators, protocol developers and protocol / DAO itself as well as users to protect themselves and the community should a bad actor be spotted in the mix. AML/ Compliance solutions from today’s world can be leveraged to build protocol upgrades to network, post which each node can act as an event monitor against any user/ protocol.
- Regulatory Reporting — lastly, with above implemented, it will be feasible to ensure protocols are able to provide regulatory reports to watchdogs and ecosystem users in agreed risk assessment templates that are easy to understand and highlight likelihood of risk materialization. Such reporting tools can also be used by regulators to assess health of the markets and intervein if necessary, via mechanism yet to be thought through (I know, CBDC and their reserves could be a solution, eh?)
Conclusions
- First things first, there’s a lot to be learnt from mistakes made and lessons learnt from Trad-Fi. It wouldn’t be wise if humanity to repeat them in evolution of DeFi.
- Secondly, a level-headed approach is needed to bring stakeholders around a table. This would mean an active and constructive dialogue, keeping skepticism aside, between global regulators, leaders of blockchain development community and major financial markets participants.
Given the infancy of DeFi markets, we can initiate global forums with appropriate stakeholders around the table like blockchain developer communities such as Ethereum, Polygon, Avalanche, Polkadot as well as those from private chain network, Global Regulators and Trad-Fi market participants (Make sure you invite the QUANTS!! they know the best!)
The goal of the forums should be to kick of workgroups and conclude meaningful solutions to achieving something like above, so we can move forward and develop protocols that are robust and innovative — helping push human race forward!!! (Tall order — I know! 🙂)
Disclaimer — the boring but necessary bit.
All my opinions, thoughts, views, analytical results and their inferences (if any), research outcomes or any such information presented above is my personal view and do not reflect that of my current or past employers. The purpose of my blog is purely for educational/ informational purpose only and in hope of initiating discussion amongst like-minded people.
The content in my stories is intended to be used and must be used for informational purposes only. I will not be responsible for any liability or loss incurred by any person who acts on the information, ideas or strategies discussed in my stories on Medium.com. Readers are encouraged to seek independent advice for any financial decisions they may wish to make.
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