Challenges and Opportunities in Decentralized Finance
What Is the DeFi Ecosystem All About?
Decentralized finance has not yet reached its peak. There’s still room for growth because the industry is quite young, yet it demonstrates tremendous ambitions for the crypto community. Exploding to the levels DeFi is dreaming about — that is, replacing traditional financial systems — requires a lot of effort to ensure an impeccable user experience and provide due security that matches industry requirements. Nevertheless, all of these features are being developed right now. DeFi isn’t stopping at any challenge and is mastering a technology that will overcome all barriers on the way to success.
Decentralized finance, or DeFi, is a term describing a newly emerged industry that represents a range of financial applications based on the blockchain. It offers an alternative to traditional financial systems that has no intermediaries or financial institutions like a central bank executing control over people’s finances.
Applications in decentralized finance, also called DApps, are designed based on already known blockchain solutions, such as Ethereum or Bitcoin. They are all built on smart contracts that enable users to have total control over their assets and provide security and transparency for all transactions because the terms of all agreements are written into the contract code. Smart contracts can be used to manage people’s savings, invest funds, and make payments, as well as for more complex purposes such as margin trading, lending, speculating on a market, and a lot more other use cases within the traditional financial system.
Decentralized finance provides financial services without any intermediaries. That’s is why it’s called decentralized — it doesn’t need any centralized power. It is made for better financial transaction efficiency and speed without centralized control yet fully clear and transparent and, therefore, safe — something dreamlike for traditional financial technologies. Yet, there are still many bumps on the road before DeFi principles can be fully accomplished in reality.
Who Is Creating the DeFi Ecosystem?
The structure of the DeFi market is much more complex than that of traditional financial markets. It is created by numerous participants, including yield chasers who want fast and easy access to assets, lenders wishing to lend their assets, exchanges that serve as a marketplace for borrowers and lenders, and a lot of other participants constituting the DeFi ecosystem, such as P2P platforms, companies tokenizing tradable assets such as possessions or masterpieces, speculative markets, margin instruments, etc.
Lending and borrowing assets are two of the most used options provided by the DeFi market. Users holding enough assets can earn money by lending them to other users for a specified interest rate. This way of earning additional funds is widely used by long-term holders who have the opportunity to provide additional liquidity to their held coins. Multiple lending platforms have been created for this reason to bring together lenders and potential borrowers. These platforms are interested in attracting users and serving like the banks of traditional financial systems. Lending and borrowing are beneficial to all parties because these options provide liquidity to the market and additional earnings to those borrowing and lending assets.
Users borrowing assets look for gains from trading assets that they don’t possess. They borrow the coins they think have short-term potential and trade them at a higher price on an exchange that doesn’t allow for margin profits. On these exchanges, users can easily receive tokens with use cases that they don’t have and don’t wish to purchase but want to have for a short period of time for some specific reason. For example, they made need a specific token to take part in a vote on a network. Users can even borrow assets through flash loans, which are valid only within one blockchain transaction. A user who takes a flash loan must repay the debt before the borrowing transaction ends.
One thing that DeFi exchanges can boast is the opportunity for a programmed swap. The swap is also decentralized, with the exception of one intermediary — a smart contract — but it requires no interest and doesn’t decelerate the exchange. The user still has control of their assets, which guarantees top-level security not provided by regular exchanges that suffer from hackers who steal millions of dollars’ worth of crypto due to poor safety.
Another trend that DeFi is bringing about is the formation of liquidity pools. A liquidity pool is a pool of tokens representing intersections of orders encrypted to a smart contract. They are formed to facilitate trading by enhancing liquidity and are mainly used by decentralized exchanges. On the most popular decentralized platforms, like Uniswap or DEX Engage, users create a separate liquidity pool for each trading pair. Simply put, a pool has two types of tokens and creates so-called market space for this trading pair. A user known as the liquidity provider defines the initial price, supplies an equal value of both currencies in the pool, and receives tokens corresponding to the liquidity they provide.
Liquidity pools have come through an explosive development and made their way to mainstream use within the DeFi space.
What Are the Risks of Decentralized Finance? How Risky Are DeFi Markets?
The main risks related to decentralized markets come from possible problems with smart contract technologies, user experience, cryptocurrency volatility, loan issues, and breakdowns in price formation mechanisms.
Despite all the hype around DeFi, it’s still at the beginning of its development, which means that the advantages of using DeFi technology are accompanied by high risks the industry still poses to its community. The biggest risks emerge because smart contract technology is very vulnerable. A smart contract is a computer algorithm with the terms of a deal encrypted in the code. If the code contains mistakes and is released without corrections, it can lead to many assets being lost forever.
Crypto history has already known such occasions — for example, when the Ethereum network experienced a bug leading to $300 million being irrevocably lost. Of course, each hacker attack is followed by a range of security checks and reviews that shape future bug protection systems, but no one can guarantee that the problem has been solved completely and that no hacker will be able to attack the network again. bZx, a decentralized platform for borrowing and lending assets, was recently attacked with thousands of dollars’ worth of crypto being elegantly borrowed and never returned. This attack was based on the nuances of flash loan operations and the drawbacks the system contained. In general, each big hacker attack where funds are lost is followed by a fork in the system or, at least, an update to prevent the network from similar attacks. But again, there’s no guarantee that the update will cover all the bugs the network contains.
Another risk firmly related to the susceptibility of smart contracts is user error.
User error is an error made by a human network practitioner during an interaction with a computer network. For example, a user may delete a particular file just because they think it’s not important, but the file is crucial for network operations. The same can happen when smart contract users have access to the network and the code. One of the most popular user errors in the crypto space is sending assets to the wrong address. Because blockchain-recorded transactions are finite, there’s no way to get the funds back. Blockchain developers are now studying ways to help users get their funds back, and some solutions have been invented.
The next point to be considered as a source of risks within the DeFi space is state regulations and internal management of DeFi projects. First, state regulative authorities could enact laws prohibiting cryptocurrency or limiting its application in the financial sector, as has happened in India with its crypto ban that killed the cryptocurrency activity in the country for some time. Second, each DeFi project is run by a team that has complete power over the project’s operation. They could change the rules of the game unexpectedly and without prior notice.
Among the other dangers are the unpredictability of market behavior and a lack of guarantees that investors will receive returns on their investments, even if no mistakes were made by the team or user.
Other Issues Stopping DeFi from Gaining Mainstream Adoption
The risks mentioned above aren’t the only problems the DeFi space is facing that stop it from gaining further adoption. A range of additional challenges influences the user experience of most decentralized platforms. They include overcollateralized loans, the existence of a centralized authority, illiquid assets, and interoperability.
Let’s start with centralization. It’s turned out that some DeFi platforms aren’t as decentralized as they claim to be. First, some newly emerged DeFi platforms give a lot of regulating power to the developers with the excuse of enabling them to fix any bugs as soon as possible. Of course, the ability to fix the network straight away is good quality, but it takes away the network’s decentralization because there appears to be a ruling authority. Even if the project is reliable and the team behind it is credible, the fact that a third party has access to the project’s management offers an opportunity to take fraudulent actions against users. To deal with these issues, DeFi projects now turn to the solution of becoming fully decentralized over time. At first, the product’s management and regulation are concentrated in the hands of the developers, but when all drawbacks are dealt with, they pass the power over to the community. Therefore, the network becomes 100% distributed.
Regarding lending and borrowing crypto assets, the main bump in the road is the problem of overcollateralized loans. Trading crypto assets is a highly risky venture, so lenders want to protect their interests and limit their credit risks by requesting higher collateral for their loans. Many lenders refuse to give a loan to borrowers not wishing to back the deal with assets in excess of the loan. The terms look really good to the lender, but to the borrower, they call into question the notion of a loan itself. As a result, the borrower receives much less profit from margin trading. Apart from that, the assets used to back the loan can’t be accessed by the borrower because they are under the complete control of the lender, which lowers asset liquidity.
It’s necessary to mention that liquidity issues do exist in DeFi ecosystems. In general, low asset liquidity is tied up with the issue of the inability to move funds among blockchains. Modern DeFi markets contain thousands of assets being traded daily, and sometimes, moving the assets among platforms or exchanging one asset class for another is complicated. Not all blockchains are open enough to properly share information across different networks.
What Does DeFi’s Future Look Like?
DeFi has problems to solve, but a lot of progress has been made to find ways to address the issues mentioned above. There’s no doubt that with time, mechanisms will be found that will pave the way toward a bright future for decentralized finance with big volumes, faultless codes, and boundless interoperability of blockchain networks, attracting millions of users around the globe.
All the risks and obstacles are being addressed in numerous ways, with some solutions practically perfected and some needing a little more time and effort. As for smart contracts’ vulnerability and the frequent emergence of user errors, they can be minimized through regular checks and verifications, system forks, and updates, as well as more open-to-the-public methods like bounty programs for finding solution mechanisms. As state authorities get down to enacting limitations or taking control of the crypto sphere, they should care about investors and provide them with clear ways to stay within legal grounds.
The most essential solutions that the DeFi space is urgently looking for are the ones assisting in liquidity matters. There’s nothing more attractive across the crypto industry as a highly liquid market. Liquidity will contribute to the growth of the community and investment streams and enable users to move their assets from one blockchain to another without restrictions.
Numerous studies are being carried out to find ways to address these questions. An early example is Ethereum, which aims to enhance its capacity by updating the existing network version to Ethereum 2 in the future. By doing so, the developers can speed up transaction processing and enhance network efficiency.
One next-gen solution is Atomic Swap. It’s a mechanism based on smart contracts that allows users to exchange currencies among one another without a third party, such as a cryptocurrency exchange. Atomic Swaps come in different ways, but all forms are based on blockchain interoperability to move the value of assets from one network to another. Smart contract technology involves a code with the terms of the exchange between chains encrypted. While the opportunity to exchange currencies automatically seems very appealing, it hasn’t experienced explosive popularity across the crypto sphere, mostly because the technology is still in the infancy stage and needs proper testing.
In the meantime, the growing popularity of liquidity pools can boost compatibility, increasing the level of assurance in holding or trading crypto assets.
What About Interoperability?
There’s no doubt that one of the driving forces behind decentralized finance’s journey toward mainstream usage is interoperability — a characteristic of networks, protocols, and applications enabling them to interact with one another as integral parts of a single system. The DeFi ecosystem is saturated with numerous types of blockchains, each representing a separate network, application, and algorithm. If all the assets across these systems could flow from one blockchain to another automatically, cryptocurrencies would instantly acquire bigger liquidity, utility, and adoption.
One of the solutions creating interoperability is Gene Finance, with its governance token GENE tailored to facilitate decision-making processes in cross-chain DeFi smart contracts. The GENE token is designed to enhance liquidity on the cross-chain swap platform GENE Finance, which is built on Ethereum’s decentralized finance ecosystem with a top-notch DeFi product bringing about considerable gain potential.
The GENE token is a component of the GENE Finance infrastructure aimed at both boosting liquidity and staking on the GENE Finance exchange, which will be built on a scalable Metaverse DNA blockchain and able to integrate with other blockchain networks. DNA blockchain serves as a high-performance base for any DeFi product.