DeFi has given the opportunity to build a new generation of financial services – but there’s six major points where it can do better.
Decentralised finance isn’t as perfect as you think.
Surviving catastrophe upon catastrophe within the past few months, DeFi has proven itself to be a sturdy building block for the future of digital assets. But, the DeFi industry has drastically shifted, as market changes created conditions where top participants have been whittled out.
As a result, many people are losing faith in DeFi, regardless of how resilient it is. Not to mention its ongoing battle with centralised finance (CeFi) and centralised financial institutions, there are many challenges that DeFi has to address before becoming a key player in the next phase of the crypto market. But how can that happen?
To put it simply, the market that made DeFi what it currently is doesn’t exist anymore, and major structural changes need to happen.
There’s still many individuals who strongly believe in DeFi’s philosophies – decentralisation, censorship resistance, and financial freedom and inclusion, but now, there’s increasing pressure added.
While the most recent DeFi rush showed huge interest in the creation of projects and protocols (even from big companies in the crypto space), the composition of the crypto market has drastically changed, leaving some protocols to be at their lowest total value locked (TVL), and even some ecosystems be deserted.
Amongst those DeFi protocols surviving are also pressured by the collapse of several CeFi institutions that gave rise to new laws, restricting how DeFi protocols run business.
DeFi now has to move with the times to realise its full potential yet again in a new era of crypto. But in order for that to happen, six things have to change for DeFi to reclaim its place in being the building blocks of crypto financial services.
1 – Creating new financial primitives
The DeFi space is dominated by two financial primitives: market making, and lending. Primitives are algorithmic layers in a blockchain that are used to build protocols, and are integral for creating a financial market.
However, living with just market making and lending wouldn’t result in an efficient financial market. DeFi desperately needs to introduce more primitives that can improve and grow itself, and to sustain use and popularity, just like lending protocols and automatic market makers (AMMs).
One possible new addition to the set of DeFi primitives could be derivatives. Derivatives can introduce elements such as capital efficiency and risk management to DeFi, as it’s a financial instrument that derives its value from an underlying asset. While many DeFi derivatives projects such as Ribbon and GMX are being developed, they’re still in their infancy. More meaningful adoption and new technologies need to be developed to address the needs of the growing and changing market.
2 – Credit
The past year’s crypto collapses can be often attributed to credit – rather, the lack of it. Many of 2021’s market leaders in lending have gone out of business, or are unable to operate due to the lack of funds – and most of these leaders lack transparency in credit flows.
New mechanisms for showing credit transparently have to be built, and is quickly becoming an attractive space to build in the crypto market.
One possible way to improve credit systems in DeFi may be to build and devise new forms of undercollateralized or semi-collateralized lending. While these lending mechanisms already exist, they aren’t quite DeFi, and users can run the usual risks that lie with lending.
Alternatively, making lending systems that lend to parties with predictable on-chain activity (staking providers, miners) can be an interesting area to explore.
3 – Efficiency with assets
The first generation of DeFi primitives have done a great job at giving everyone equal access to programmable financial services – but aren’t quite efficient enough with assets.
While automated market makers (AMM) have majorly innovated the space, giving transparency to financial markets, they unfortunately aren’t efficient enough as CeFi’s order books.
What can maybe propel DeFi to further popularity may be hybrid decentralised exchanges (DEX) which combines the structure of CeFi order books and AMM mechanics. Including undercollateralized and semi-collateralized lending may also give birth to even better innovations.
Related: Can DeFi Save us from a liquidity crisis?
4 – Risk management
After the past few months, DeFi projects, protocols, and those hoping to use them have to be aware of risk management.
Risk in DeFi however looks very different to that which occurs in traditional markets, and innovation in this area is required to safely conduct business in the space. Risk management in DeFi first revolved around avoiding technical smart contract exploits – but it’s only a small fraction of what investors may encounter in the sector.
Effective new risk management technologies are needed to have institutional adoption of DeFi. Solutions for managing situations of economic risk including depegging, pool compositions, slippage, and whales need to be addressed before major capital institutions can confidently adopt DeFi at a larger scale.
5 – Use cases and the real world
It can be argued that DeFi has seen very little off-chain applications, and is mainly closed off within itself. While innovation in the space has shot up exponentially from the want and need to develop more crypto technologies, it excludes another use case that can make DeFi sustainable as a financial market – within the real world.
As such, the sector needs to follow suit and create systems that can bridge the gap between itself and traditional finance (TradFi) applications, so that it can bring utility to itself. One protocol that has been experimenting with such utilities is MakerDAO, where they have extended loans to financial institutions.
6 – Regulation
The conversation on regulation within the crypto community is polarising – and also inevitably seeps into the DeFi space. There have been plenty of aggressive regulatory pushes from global governments on crypto, and they have changed how crypto has been operating over the past few years. But if implemented thoughtfully and with discretion, the sector has a chance of going more mainstream, and to be adopted by institutions.
Many regulated financial institutions are torn between the potentials of DeFi has to give and the presumed “wild west” image of regulatory uncertainty that it has. Perhaps one way to make financial institutions feel a bit more safe may be to create protocols for regulatory controls. Although know-your-customer (KYC) can be quite tedious, thoughtful and unobtrusive regulatory measures should be devised in order to bring DeFi forth as a major player in the future of financial services.
