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Key Issues of the DeFi Ecosystem


What is a decentralized financial ecosystem?

The very idea of decentralized finance is still in its infancy. Yes, this is a young and promising industry that someday (if possible) will be able to replace the outdated financial systems existing at the moment. But for this it must at least overcome several major obstacles. Such as creating a seamless user experience and meeting industry security standards.

DeFi is an umbrella term for a range of technologies and products that offer people innovative offline financial management capabilities. And, most importantly, without the control of a central bank or other regulator.

Decentralized Applications - DApps are usually built on top of existing blockchains such as Bitcoin, EOS or Ethereum. Most often, they use smart contract technology, which gives the user full control over their financial assets. Moreover, this applies not only to storage, investments and regular payments, but also to other areas of human activity - loans, insurance, margin trading, forecast markets and much more.

And all such DeFi tools connect to systems that don't have any centralized control. But nevertheless, everything works efficiently, safely and in a completely transparent mode. Which, so far, has not been achieved with traditional financial systems. However, there are some obstacles that prevent the widespread implementation of this idea in life.

Who Shapes the DeFi Market?

The DeFi market consists of many different actors and subsectors, some of which do not exist in traditional financial systems at all. In addition to the standard participants - lenders, borrowers and intermediary exchanges, there are others offering their solutions or opportunities. These include peer-to-peer decentralized markets, asset tokenization systems, prediction markets, rates and collateral, alternative ways of storing assets, often associated with obtaining a percentage of profit for this, various insurance methods, and much more.

Lending and borrowing are some of the most common use cases for DeFi today. Lenders tend to be high-volume participants looking for additional ways to make money beyond the usual market valuation. They provide liquidity to certain assets, and very often receive a reward for this. In essence, it is a win-win and win-win option. One side gets the liquidity that is so necessary for the world of cryptocurrencies, the other gets passive income with practically no risk.

Borrowers are looking for the benefit that comes from gaining control over some of the lenders' resources, albeit for a fee. As a result of this method of obtaining an asset, users, for example, can continue to interact with exchanges that do not support margin trading. Another option is to get a certain number of service tokens, which can be used to solve a specific problem, for example, to vote on the network, and then return so as not to store them. There are even so-called "urgent loans". This is a financial instrument that makes it possible to get a resource on credit, use it for its intended purpose, and then return it. And all this in one transaction.

Decentralized exchanges are also becoming more popular due to their automatic exchange capabilities. The only "intermediary" in this case is a smart contract, which does not increase the interaction time and does not require a salary. And because the funds are completely under the owner's control, the risk of security problems is reduced. Here, a situation typical for centralized exchanges is impossible - when, due to hacking or mismanagement of the system, attackers gain access to all cryptocurrency wallets associated with it.

Liquidity pathways are also an important aspect of shaping the DeFi ecosystem. Very often they are tightly linked to decentralized exchanges. For example, platforms such as Bancor Network and Uniswap encourage users to create pools of liquidity that make it easier to deal with different currency pairs. If, for example, you have a token and want to exchange it, then you can additionally add liquidity to it to make it more attractive in the eyes of other traders. This process is the opposite of the listing concept used on traditional stock exchanges.

And yes, these liquidity pools have grown markedly due to the general rise in interest in decentralized finance.

What are the risks inherent in decentralized financial markets?

These are mainly: problems of smart contracts, user errors, high volatility, lack of credit insurance and potential failures of the pricing mechanism.

Despite the significant potential benefits, DeFi is still in its early stages. This means that the use of projects related to this idea is associated with relatively high risks. One of the main ones is the vulnerability of smart contracts. Despite the fact that they are positioned as reliable and hack-resistant ways of working with finances, mistakes can be made in them even at the moment of creation, which then, when such a contract enters the ecosystem, can lead to a significant loss of funds.

And this has already happened many times. Including with such a large blockchain as Ethereum. And although this area is now subject to special audits and peer review, there is no guarantee that mistakes will not happen again. An example is the recent hack of the bZx protocol. The hacker exploited a vulnerability in the work with flash credits, due to which he received ether in the amount of several thousand dollars. Yes, such "security holes" are successfully closed, but it will take some time, and the more - the more funds the attackers will be able to withdraw.

In addition to vulnerabilities from smart contracts, user errors also play an important role. Even if the developer has created the most robust code, he cannot know how users will interact with it. For example, millions of dollars were simply lost due to users irreversibly sending their cryptocurrency assets to the wrong blockchain addresses. However, this problem is partially offset by the introduction of new standards for tokens, for example - ERC-777, which allow you to "roll back" incorrect transfers, but at the expense of increased transaction costs.

Another important aspect that users sometimes forget about is internal asset management and the ability to connect external regulation. There is always a chance that a project will change management principles without warning, which can seriously affect both the speed of work and access to resources. Not to mention the fact that local authorities can simply declare this or that cryptocurrency illegal, which will seriously complicate its use and withdrawal.

Another serious pitfall is the unpredictability of the market fluctuations that underlie decentralized finance. That is, the high volatility of cryptocurrencies in general. And since insurance in this industry is either absent or very poorly developed, there is a risk of losing large sums of money simply because it happened so.

What are some of the issues preventing widespread adoption of DeFi?

In addition to the above risks, there are other issues that affect the quality of the user experience when interacting with decentralized finance. These include oversupply, relative centralization, low liquidity, and poor interoperability between different blockchains.

  • Centralization. The fact is that many DeFi projects are not as decentralized as they are advertised. This is especially true for new projects where developers retain partial control. Officially - to respond faster to changes and more efficiently fix problems. But sometimes this situation persists even at the stage of widespread distribution. Which is quite risky, even if the development team has a good reputation and is trustworthy. The solution to this problem is ā€œprogressive decentralizationā€. This is when at first the developers can really control a lot, but as the project develops and grows, their ability decreases to the point of turning the project into a self-regulatory system.
  • Oversupply. One of the main problems in lending and borrowing. Since the market does not offer guarantees of stability, lenders want their assets to have higher collateral. That is, they will refuse to work with borrowers who do not prove their ability to work effectively with funds. And this undermines the very idea of lending, making it the prerogative of only the ā€œeliteā€. And it directly contradicts one of the points of the DeFi philosophy, according to which the system should serve as a "bank" for those with whom traditional banks do not want to work. In addition, it reduces the profit when working with leverage, which makes this trading option less attractive for traders.
  • Low liquidity and difficulty in switching between blockchains. Among the huge variety of cryptocurrencies and tokens, it is sometimes extremely difficult to find traders who will not only be ready to exchange one for another, but will also have sufficient funds for this. And if you add to this the complexity of transferring some tokens to others, you get an extremely slow system in which you have to wait a long time for your turn to conclude a deal.

Further development

Solutions to the above problems and difficulties are already being developed. And if you consider that technologies are improving, the code is improving and new forms of interaction appear, such as atomic swaps and pTokens, then it is obvious that DeFi is gradually becoming more and more attractive both for the financial world in general and for ordinary users in particular.

The community is actively discussing ways to solve current problems, so in some situations, you just need to wait a bit - and the users will fix everything themselves. The complexities of smart contracts can be eliminated with more granular audits and rewards for finding bugs in open source. As for the users, only an increase in general computer literacy and responsibility will help. And since DeFi is increasingly becoming interested in major players, we can soon expect the introduction of insurance and additional legal restrictions.

In any case, all these solutions make the decentralized finance market more liquid, convenient and pleasant for ordinary users. And for further work in this direction, developers regularly introduce new technologies. For example, to increase the throughput of the Ethereum blockchain, an early transition to a new system is planned - Ethereum 2.0. The developers believe that this will increase not only the speed of individual transactions, but also the overall throughput.

Another promising idea is atomic swaps. They can have different forms of implementation, but the essence remains the same - fast and direct transfer of funds from one blockchain to another. This is achieved using time-bound smart contracts that are the same for two different chains. In general, the idea is clear, but it is fraught with serious technical difficulties. An effective attempt to implement it is Blockstream's Liquid sidechain. But this technology is still at the experimental stage.

Is interoperability the key?

It is widely believed that one of the main catalysts for DeFi adoption is interoperability. That is - the ability to interact with various tools, smart contracts and applications. There are many blockchains that have their own DeFi ecosystems and a very active community. And if we create an opportunity for assets to more or less freely flow between such ecosystems, then the total value of the decentralized cryptocurrency market will be approximately $ 250 billion. And the larger it is, the better the situation with liquidity, utility and convenience for the end user will be.