The Future of Decentralized Finance (DeFi)

The recent collapse observed in the crypto markets has had a devastating effect on one of the most innovative and promising sectors in the cryptosphere, namely DeFi. Not surprising, after the series of bankruptcies that have occurred in the industry, starting with Earthsaw it off Three arrows capital, Travel digitally and recently, Celsiussaw the total value locked in DeFi an unprecedented decline, from $85 billion in January to $35 billion in early July, according to data from DeFi Pulse.

Source: Adobe

While specialists predicted an exceptional year 2022 for DeFi, with continued growth and a proliferation of new users, recent events have made them reconsider how DeFi should evolve over the next few years.

DeFi: total value locked over a period of one year, Source: DeFi Pulse

A review of risk management mechanisms

The balance between risk and return is the basis for investment strategies in the traditional financial sector. Traditional markets rely on strong intermediaries and regulatory frameworks to prevent asymmetric risk relationships.

As pointed out by three officials from Coin base in a blog post titled “Institutional Insights: Our approach to crypto finance”, the absence of risk control mechanisms is the source of the difficulties for most crypto companies who have been carried away by the frenzy of the rising markets and have forgotten the basics of risk management. “The problems here were predictable and indeed credit specific, not the specific nature of the crypto industry,” said Brett Tejpaul, Matt Boyd and Caroline Tarnok. Most of these companies were overleveraged with short-term liabilities that were ill-suited to longer-duration illiquid assets.

Weaknesses in these business models will undoubtedly lead to the phasing out of the aggressive incentive programs that allowed traders to enjoy ridiculously high returns without the need to resort to sophisticated financial strategies.

Centralization, again at the heart of the debates

Analysts and the most influential people in the sector seem to agree that recent events have highlighted a level of centralization that is far too high in DeFi. Timo Lehesco-founder of the protocol DeFi Swarmbelieves that part of the problem with DeFi is that decentralization occurs on a sliding scale, with platforms consisting of a mix of decentralized and centralized elements. Ryan Sheacryptoeconomist at the trading platform Trax explained that if a Defi protocol wants to be decentralized, it must work on a “peer-to-peer” basis and all transactions must be done using smart contracts:

“Examples of such platforms include AAVE, Maker and Compound. Unlike CeFi [finance centralisée]users do not need to trust the lending company, but the integrity of the code that executes the smart contracts.”

Regulation, inevitable

Terra’s fall has dramatically increased pressure for regulation, with the US, UK and EU all pledging to move quickly to bring stablecoins into a regulatory framework.

In traditional finance, depository institutions have a set of rules for how they can use customer capital and are continuously monitored. Timo Lehes believes that a similar mechanism will be necessary for DeFi to function on a consistent decentralized basis:

“Regulation adds layers of transparency to existing products and innovation. Going forward, investors should be advised to only engage in products where processes and smart contracts are fully verifiable, where there is a remedy against malpractice, and where there is full transparency about how warranties are Used.”

On the other hand, many observers also point to the importance of self-preservation, where one of the main advantages of cryptocurrencies is to allow individuals to achieve economic sovereignty. As Timo Lehes said at :

“The easiest way to prevent institutions from being creative with clients’ funds is to retain custody of them. The architecture of DeFi allows you to maintain full control of your assets – add layer regulation and you have a winning combination”.

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