From neglecting security to bad tokenomics, DeFi has played a hand in its own decline

Published at: Oct. 12, 2022

Decentralized finance (DeFi) led cryptocurrency’s rapid growth in early 2021, but the crypto market has since plummeted in value. Global markets have played a role, but so has recklessness among developers when it comes to both cybersecurity and (often self-serving) inflationary token models.

Too much DeFi has been based on tokens minted from nothing or tokens that finance other tokens at high interest rates, with no part of the entire activity having any real underlying economic activity to back the yields offered.

Secondly, security issues, hacks and exploits of DeFi contracts and bridges have been widespread, and most notable DeFi platforms have suffered some form of exploit.

Lastly, the lack of a uniform standard for defining DeFi contracts has limited DeFi to native smart contract platforms and tools, which also limits potential for growth, universal clients and, ultimately, adoption.

Despite these failures, DeFi is likely here to stay. But it will need to see changes and improvements to have true utility.

Too many unsustainable yields and too much ‘minting’

The DeFi summer of 2021 gave rise to several projects that promised yields that were not undergirded by any real economic activity. Some of the yields were at rates as high as 200%, and many were paid for by minting more of the same arbitrarily created tokens.

This arrangement essentially created a system that required an ever-increasing number of new users to create demand. The promised yields could only be sustained as long as new users were forthcoming. Eventually, several DeFi operations offering tokens with high yields suffered catastrophic failures (Terra, Voyager, Celsius and 3AC, to list a few). The future of DeFi will likely not lie in tokens that promise yields that are not sustained by true economic activity outside of minting tokens.

Cybersecurity has not been a priority

Another feature of the DeFi summer was the large number of projects that suffered from external and internal hacks of their reserves or users. Examples include the Ronin network, Polygon, Blizzard, Wormhole, Meter Bridge and, most recently, Binance Smart Chain (BSC). Some of the hacks illustrated weak security practices, to put it mildly.

Some projects lost a good portion of their reserves, and it took days or weeks before anyone noticed or disclosed a breach. And there were examples of protocols that were coded to move value without checking account balances. There were also examples of protocols undermined by developers that the operators apparently hired without fully validating their identities. These unfortunate incidents could prove to be learning experiences for the community.

Resorting to fundamental security practices such as independent system monitoring and alerts would be beneficial, in addition to more rigorous and careful vetting and development. DeFi projects that will prove successful in the future will be those that approach security in a more fundamental and principled way while learning from the issues and events of DeFi’s early days.

Redefine DeFi to finance real economic activity

One of the touted and expected benefits of blockchain technology is its potential to bring more of the unbanked and underbanked into the financial system. This represents a huge potential for the growth and upliftment of communities.

However, it has been a missed opportunity thus far. Much of DeFi has simply focused on financial products for those already in the crypto community by building those products around the borrowing, lending and shuffling of crypto tokens. DeFi’s maturation would be bolstered by addressing the aspirations of the underbanked in the real world.

Taking advantage of the ability to tokenize real-world items using similar standards as ERC-721 for nonfungible tokens (NFTs), “buy now, pay later” (BNPL) DeFi products are beginning to emerge. Some of these products are based on lending to finance tokenized real-world items such as smartphones as a work tool, and recently even mortgage financing.

The DeFi products are secured by those real-world items, able to accommodate a decentralized set of agents and customers, and are based on the actual yields achievable for such financial transactions. More products designed to underwrite real-world financial aspirations and address underbanked communities are likely to continue to emerge.

Develop a standard for representing DeFi contracts

Standards can be a significant catalyst for growth. The ERC-20 standard, for instance, helped the development of fungible tokens by making them easier to interpret across different applications and platforms. For instance, an ERC-20 token can be defined on Ethereum, BSC or Avalanche, and a user can manage them with clients developed by teams independent of those projects.

Examples of such clients include MetaMask, Brave or, indeed, any client implementing the ERC-20 standard. There are many developments that this has enabled, including the bridging of tokens across platforms. Similarly, the ERC-721 standard has been a catalyst for the growth of nonfungible tokens, allowing users to utilize different platforms and clients for managing NFTs.

A standard for representing decentralized financing for end users will likely have similar effects. For one thing, it will allow various development teams and projects to represent DeFi products in a consistent manner, which would reduce a lot of ad hoc interpretations and coding of DeFi contracts and aspirations. It will allow users to manage their DeFi products on different clients and browsers that support the standard. This would include automatic payment for DeFi loans or lines of credit, as well as potentially providing portability for DeFi products across platforms.

Define a standard for DeFi contracts

A DeFi standard would necessarily need to be encompassing enough to be able to define various types of DeFi products. This would include secured and unsecured DeFi loans, lines of credit, BNPL contracts, DeFi mortgages, and even crypto yield products currently prevalent in the crypto community.

This standard is defined such that it could be utilized for any DeFi contract, and would be based on a generalized form of DeFi consisting of a lender or asset provider, a borrower, and a potential repayment structure. For instance, a BNPL contract would be similar to a secured loan, having a principal amount, collateral, duration and terms, but where the interest rate would typically be 0%. Overall, the standard would define such broad and general ways to successfully define DeFi contracts. The standard would improve on existing DeFi and traditional finance contracts by allowing such contracts to be more portable, potentially transferable, and more easily tradable as collaterals by having a consistent form utilized by all users of the standard.

The future of DeFi

Assets need to have utility. They also need to provide rewards for those who deploy them. When these constructs work correctly in identifying and pairing those with funding with those in need of funding (who are also able to deploy resources efficiently and repay resource providers), they have been an important driver of growth and development in human societies.

These constructs drive enterprise and small businesses; fund commerce, mortgages and provisions of shelter; and touch every part of any economy. Societies that have developed more successful ways of identifying borrowers with lower default rates, utilizing credit scoring and other algorithmic means, including even AI, have tended to be more successful at lifting more members out of poverty than those that have not.

Decentralized finance has the promise and ability to reach millions not served by the traditional banking and finance system. This potential has a greater chance of being realized if DeFi shakes off its initial incarnations that focused more on products with bogus yields that were not underlined by any real value creation by borrowers and relied more on simply printing unbacked tokens.

Developing and utilizing standards in the creation of DeFi contracts would be a catalyst for leading the growth of DeFi when applied to responsible and well-grounded contracts and products.

Ken Alabi has a doctorate in engineering from Stony Brook University, a master’s in computer-aided engineering from University of Strathclyde, and is an IT professional, programmer and published researcher with several peer-reviewed publications in various fields of technology. The author has also published articles related to blockchains, decentralization of business processes similar to blockchain technology, and the interoperability of blockchains.

This article is for general information purposes and is not intended to be and should not be taken as legal or investment advice. The views, thoughts, and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.