Business

DeFi is the way forward, but it needs to evolve

ProDentim


Recent events in the crypto markets have reaffirmed the value proposition of decentralized finance (DeFi) as one of the essential elements of the future of digital assets. However, the DeFi space has also been impacted by changes in the market, as many of the major DeFi participants have effectively disappeared. This combination of events creates very strong friction for the future of DeFi. In some ways, challenges with centralized financial institutions (CeFi) are expected to drive adoption of DeFi protocols. On the other hand, the fundamental market conditions that triggered the recent DeFi summer are no longer present. While we can all agree that DeFi should be a key part of the next phase of the crypto market, the details are far from trivial and, most likely, will require significant changes in the industry.

Jesus Rodriguez is the CEO of IntoTheBlock. This article is part of Crypto 2023.

The Paradox of DeFi Adoption

Philosophically, DeFi is the only movement that embraces the true philosophy of decentralization, censorship resistance, and financial inclusion. The recent DeFi rush has been marked by both a huge level of protocol innovation, but also a disproportionate wave of artificial incentives that have fomented unsustainable returns and drawn participation from some of the biggest companies in the world. crypto space. Recent compositional shifts in the crypto market have resulted in the total value locked (TVL) in some protocols being at multi-year lows and activity in some DeFi ecosystems virtually non-existent. Yet DeFi protocols have largely remained incredibly resilient while some of the largest centralized crypto institutions have completely crumbled.

The crypto market is relatively small, and CeFi and DeFi are intertwined in an almost paradoxical way. While DeFi infrastructure has been able to withstand recent market shocks, the collapse of CeFi institutions has put a lot of pressure on DeFi protocols.

Simply put, DeFi has flourished in a market that no longer exists. To fully realize its potential in the new crypto reality, DeFi must evolve. But this evolution can translate into massive opportunities. For DeFi to find its place as the financial services foundation of the crypto space, there are five key areas where it needs to improve.

Read more: 10 predictions for the future of crypto in 2023 | Opinion

Capital efficiency

The first generation of DeFi primitives that dominated the market embody the principles of democratizing access to programmable financial services, but they do so at the expense of capital efficiency. Automated Market Makers (AMMs) are an incredible innovation for fostering transparency in financial markets, but they lack the efficiency of centralized order books. Oversecured loans have fueled amazing innovations like flash loans – but that’s the classic definition of capital inefficiency.

Building a new wave of DeFi protocols with a solid foundation of capital efficiency is paramount to streamlining DeFi adoption. Ideas such as hybrid decentralized exchanges (DEXs) that combine order books and AMM mechanisms or semi/sub-collateralized lending protocols are likely to unlock some of the value in this area.

Credit

Crypto credit markets have been under pressure for a few months. Many market leaders in discretionary lending have gone out of business or remain unable to operate. As a result, building new credit mechanisms in a transparent manner has become one of the most attractive opportunities in the crypto market. The way to improve credit in DeFi is to create new forms of sub-collateralized or semi-collateralized loans. Although there have been a few attempts in this space, they can hardly be considered DeFi and have suffered from the native risks of lending to market makers. Alternatives that lend to parties with predictable on-chain activity such as staking providers, miners, or DeFi protocols could be worth exploring in this area.

New financial primitives

The majority of activity in DeFi today is dominated by two main protocol primitives: market making and lending. While these elements are certainly important, they are hardly sufficient to build an efficient financial market. DeFi desperately needs new financial primitives that reach the level of traction experienced by AMMs and lending protocols.

Derivatives seem to be the obvious place to expand the set of financial primitives in DeFi as they play a role in capital efficiency and risk management. The DeFi derivatives space has been steadily growing and protocols such as Ribbon or GMX have certainly showcased the potential of the space. However, most DeFi-derived protocols have yet to see significant adoption and more innovation is certainly needed in the space.

See also: There’s Less Money in Crypto, and That’s a Good Thing | Opinion

Risk management and insurance

Events of the past few months have put risk management at the top of the list of requirements for institutions to participate in DeFi. Risk takes a very different form in DeFi than in traditional markets and therefore requires a new form of risk management technologies. Initial risk management efforts in DeFi have focused on technical smart contract exploits which, while significant, represent only a portion of the risks investors face by participating in DeFi.

Managing economic risk represents one of the biggest opportunities to catalyze institutional adoption of DeFi. Solutions that manage economic risk conditions such as pool composition, de-anchoring scenarios, slippage, whale impact and many more are needed to establish the level of rigor that major financial market institutions have need to adopt DeFi at scale. One of the most interesting expressions of risk management will be insurance products. Economic insurance in DeFi remains a largely unresolved issue and limits the options for creating sophisticated institutional structured products on DeFi rails.

TradFi bridges and real-world utility

Over the past two years, DeFi has remained a crypto-to-crypto market with very limited exposure to off-chain applications. While crypto-centric dynamics have been key to accelerating innovation in the space, it limits the sustainability of DeFi as a financial market. For example, sustainable returns in financial markets come not just from market asymmetries, but also from the creation of utility in real-world businesses. DeFi needs to recreate a similar dynamic.

Building bridges to traditional financial applications (TradFi) can bring a new wave of utility to DeFi that translates into new avenues of financial activity. Protocols like MakerDAO have experimented with ideas in this area by granting loans to financial institutions.

Thoughtful regulations

When it comes to DeFi, very few topics are as polarizing as discussions surrounding regulation. Whichever side of the regulatory argument you sympathize with, it’s hard to argue that recent shifts in the makeup of the crypto market have catalyzed a more aggressive regulatory agenda that will hit DeFi at some point.

Regulation can certainly hurt the innovation taking place in DeFi but, when implemented thoughtfully, it presents an attractive opportunity for the institutional adoption of the space. Many regulated financial institutions are struggling to balance the financial benefits and opportunities of DeFi with the regulatory uncertainty surrounding the space. Protocols that implement forms of regulatory controls can certainly fill this void. Most of the initial efforts to force know-your-customer (KYC) routines on DeFi protocols have seen limited adoption, but there are exciting opportunities to leverage on-chain data for regulatory assessments of protocols. Brute force regulation could be very detrimental to DeFi, but thoughtful regulatory checks could open the door to new waves of institutional adoption.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

nasdaq

alpilean
Back to top button