What's Holding DeFi Back (and How to Fix It)
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DeFi, also known as decentralized finance, is a fascinating and rapidly growing industry at the cutting edge of modern technology. Spurred by the runaway success of Bitcoin and Ethereum, this new financial paradigm is threatening to completely upend the current global financial system.
Depending on who you ask, you may hear that DeFi’s end goal is to replace an archaic institution of inequality and fraud with a new system based on transparency, democracy and seemingly limitless upward mobility. So what’s the problem?
Well, as a burgeoning movement with elements of tech, finance and politics, there is no shortage of enemies. There’s also a serious drought of informed watchdogs or regulation, which has created a vacuum currently occupied by a parade of rug pulls, exit scams and Ponzi schemes.
Here are three of the biggest bottlenecks to DeFi’s growth, as well as some potential ways the community can resolve them.
It may seem strange to imply that there are issues with an industry that’s worth over $50 billion at the time of writing — but keep in mind that it was worth $80 billion just a week earlier, according to data gathered by DeFi Pulse.
For many people, the extreme volatility of cryptocurrencies is part of the appeal, since it introduces the possibility of exponential short-term returns on their investments. Consider the events of DeFi Summer, which saw projects like Compound and Uniswap pull gargantuan market caps in 2020 as they introduced millions in liquidity to this new financial ecosystem.
But for others, this volatility is terrifying and discourages them from making any long-term investments. Months after DeFi Summer, many of these projects fell steeply in value after the initial wave of hype died down. Even worse, many over-leveraged users of these platforms saw their holdings disappear the next February and May, having billions of dollars worth of coins liquidated as a result of a tempestuous market.
How to fix it
One solution to volatility is stablecoins — cryptocurrencies tied to the value of fiat currencies like the dollar. Using tokens like Tether, Dai and USDC allow for more cautious traders to interact with the DeFi ecosystem without suffering from wild price swings. Additionally, China’s foray into Central Bank Digital Currencies (CBDC) looks like it has the potential to replace bank notes as the new standard for exchanging currency — one that allows regular citizens around the world to interact with DeFi fluidly.
There have also been efforts to create cryptocurrency ETFs in Canada and the United States — and while these aren’t decentralized, they are a way for investors in traditional exchanges to gain exposure to potential profits from DeFi projects while limiting the risk. On the other hand, decentralized ETFs are being explored as well; the Defi Pulse Index looks promising and could be a way to provide a less volatile asset to risk-averse portfolios.
Decentralization is one of DeFi’s strongest selling points. The optimistic point of view is that replacing laws and institutions with smart contracts and blockchains will prevent the corruption, fraud and inequity that has plagued our existing financial systems.
An impartial ecosystem backed by automation sounds wonderful — kind of like the science fiction utopias imagined by Isaac Asimov and Arthur C. Clarke. But the reality is that the darker elements of human nature are still able to interfere with this utopian environment, as you can see from the history of failed cryptocurrency projects like Mt. Gox and BitConnect.
Although Bitcoin’s blockchain technology is designed to be nearly impenetrable, there’s still the possibility of the network being compromised via a 51 percent attack. Additionally, the development of Ethereum and smart contracts has been no stranger to controversy, with many of the most utopian promises from its developers not being met. In that context, it’s hard to be optimistic about the Ethereum Foundation’s ability to address the pervasive scaling issues that are causing ludicrously high gas fees on every transaction.
How to fix it
In a similar vein to shareholder meetings and votes, users who engage in DeFi protocols are often issued governance tokens as rewards for their participation. Although these hold value like any other cryptocurrency, their intended use is to cast votes on decisions these projects will face in the future. This puts accountability in the hands of the people who deserve it most — those who are literally invested in making the best decisions for the project.
Another way to promote accountability in this financial ecosystem is to introduce competition, which is what projects like Cardano are currently doing to Ethereum. These alternate blockchains promise similar benefits to the ones Ethereum is attempting to provide, such as faster transaction speeds, lower fees and greater energy efficiency. Alternatively, projects like Polygon and Polkadot offer a compromise where community projects can enhance DeFi’s infrastructure, placing them on equal footing with Vitalik Buterin and the rest of his team.
Ultimately, perception of DeFi is the biggest issue preventing widespread adoption — it’s arguably the cause of the other two issues I mentioned as well. If you asked someone for his or her opinion of DeFi whose only exposure was breaking news stories, he or she would probably describe it as a mix of tulip speculation, money laundering and a casino.
It’s tough to justify getting involved in a financial ecosystem that can seemingly collapse from a single tweet made by a known market manipulator. And when the technology behind this ecosystem isn’t being discussed for its role in increasing emissions, it’s being used to successfully hold half the country’s energy hostage. Even if this hypothetical observer is financially literate and understands the potential of DeFi, he or she would probably be scared off by the deluge of obvious pump-and-dumps proliferated on the Binance Smart Chain, affectionately referred to as “shitcoins” by the community.
How to fix it
In my opinion, the worst-case scenario is that DeFi users turn to centralized institutions for solutions to these issues. Global governments and financial magnates are hungry to get their hands on this technology, since many of them are starting to realize the threat it presents to existing power structures. I believe that the only way this financial movement can achieve its full potential is to reinvent itself as a separate entity from traditional economics and fiat currency.
Stablecoins, ETFs and CBDCs are compromises that can help newcomers acclimate to DeFi, but there’s an important next step to take. Divorcing the perception of cryptocurrency from fiat currency is essential to its success — if you stop thinking about Bitcoin, Ethereum and altcoins in terms of their dollar value, you can escape the hegemony of the dollar and the ticking time bomb of hyperinflation.
This is all speculation (and definitely not financial advice), but here’s what I can say for certain: Any entrepreneur interested in a financial career should be very interested in this space if he or she wants to have the best plan for the future. I’m far from the only person to recognize these issues, and there are many brilliant people all over the world working to resolve them. The amazing community of coders, traders and watchdogs that have flocked to this rapidly developing industry give me a lot of hope for its future. But if we want to achieve the best possible future for DeFi, education and personal accountability are essential.