DeFi Adoption: How Far Are We from It and What Problems Need Solving?

The financial system is centralized. And even though digital innovation has led to many disruptive advancements, our core financial architecture still remains centralized. 

Decentralized Finance (DeFi) offers an alternative. It uses blockchain to conduct transactions without relying on third parties and custodians. All the third parties’ roles are assumed by smart contracts. They are the base of a DeFi system and are supposed to prohibit intervention and manipulation.

Smart contracts aren’t limited to decentralized systems. They are successfully used on heavily centralized platforms, too. I’d say more: well-managed centralized systems can function way more efficiently than public blockchains. But there is a problem with centralization: it relies on the assumption that all centralized bodies are benevolent. But history shows that this assumption is not always correct. There were numerous cases of corruption and errors within centralized companies. And it is very difficult to check what is happening inside, all their processes are very opaque.

Here is when the main benefit of DeFi comes. You don’t need to trust anybody. Everything is out there, on a blockchain, in public access, just go and check. All data is accessible and verifiable.

DeFi doesn’t have any access restrictions. Whoever has a wallet and access to the web can access DeFi. Banks, on the other hand, limit access to specific types of users by leaving a significant amount of people out of the benefits provided by the centralized financial system. 

The thing is that DeFi has too many issues to contend with.

DeFi is supposed to be decentralized, hence the name. And indeed, it runs on a decentralized ledger. But all DeFi platforms have central governance frameworks that dictate the priorities, development trends, etc. The main participants of these frameworks are the holders of governance tokens, normally, those are the platform developers.

DeFi runs on proof-of-stake blockchains. It means that the power is concentrated in the hands of users who stake more coins. Many blockchains are known for allocating the majority of coins to insiders: early investors, developers, etc. Such blockchains are managed by a specific circle of people and their decentralization is illusory. 

Source: Messari report

1 - the graph displays the size of capital pools in these DeFi investment portfolios.

2 - the graph shows the initial coin allocation to insiders

Why is it bad?

If power over a blockchain is concentrated in the hands of a limited number of people, they can use the blockchain to enrich themselves. 

One of the possible ways to do so is to congest the blockchain with trades between their wallets (wash trades). Blockchain congestions lead to an increase in fees. So, other blockchain users will have to pay higher fees to these guys who caused blockchain congestion artificially.

Another option is to front-run big orders for a higher benefit. It is when somebody, who has access to the blockchain sees an order to swap funds on a decentralized exchange, front-runs and issues a transaction on his own.

In traditional finance, such methods are illegal and punishable by regulators. In cryptocurrency, regulating them is still difficult. 

DeFi is still a young industry, it is still evolving. That’s why it cannot be perfect. There are many vulnerabilities in the system, and these vulnerabilities are exploited by malicious actors. Of over $2 bln worth of crypto stolen, 97% comes from DeFi protocols, and almost 50%% of the hacks were due to the security breach.

With the development of technology, this issue will be reduced even though it won’t be eliminated.

To use DeFi, one shall have at least to know how to use a wallet. This already requires some background knowledge. Secondly, the UI of a DeFi platform is not the simplest. To use it, you need at least to know how the basic dApps work.

In this regard, DeFi needs to go a long way before it becomes accessible to anybody.

DeFi is characterized by its high leverage. It is sourced from lending and trading platforms. Even though loans in DeFi are over-collateralized, the borrowed funds can be used to instantly borrow even bigger amounts on a different platform, and so on. 

This way, investors build an increasingly large exposure for the initial amount of collateral that they have left. 

Leverage allows traders to purchase more assets with the initial amount of funds. But this high leverage exacerbates market procyclicality. If the asset price starts dropping, investors are forced to shed the asset. It, in turn, puts more pressure on the asset and the market. Considering that the market is still immature, it increases the pressure and adds to the price swings. There is no central body to apply some measures to stabilize the system. That’s why DeFi is known for rapid price crashes and high volatility.

These are not the only issues the new financial system faces but once these challenges are eliminated, we will see how DeFi adoption speeds up.