Decentralized finance (DeFi) refers to financial applications built on blockchain networks that aim to replace traditional financial intermediaries with smart contracts and decentralized protocols. DeFi saw tremendous growth in 2020 and early 2021, with the total value locked in DeFi protocols rising from $670 million in January 2020 to more than $80 billion by May 2021. However, the crypto market crash since mid-2021 has led until the decline of DeFi activity. A new catalyst is needed to spark another surge in decentralized finance.
One of the biggest bottlenecks preventing further adoption of DeFi is scalability. Ethereum currently dominates as the main smart contract blockchain for most DeFi applications. However, it can only process 15-30 transactions per second, leading to network congestion and high gas fees during peak demand periods. The upgrade to Ethereum 2.0 and its proof-of-stake consensus will help scale transaction capacity.
Pools such as Optimistic and zk-Rollups that merge off-chain transactions and submit only on-chain transaction data can improve Ethereum’s throughput. Sharding to spread the network load across 64 new chains will also add scale. Alternatively, DeFi applications can migrate to more scalable smart contract platforms such as Solana, which already has 50,000 TPS. As blockchain scalability improves, it will expand DeFi’s capacity and enable another cycle of growth.
Real-world assets in DeFi
The ability to incorporate real world assets into DeFi protocols instead of just synthetic crypto assets will be the driving factor for mainstream adoption. Platforms like Centrifuge create tokenized representations of real-world assets like invoices, mortgages and real estate on the blockchain. Having real-world collateral opens the door to more practical DeFi use cases in decentralized lending and other verticals than overly collateralized cryptolending.
MakerDAO’s addition of tokenized real-world assets as collateral for its DAI stablecoin is a significant development. The integration of real assets with the transparency, liquidity and programmability of DeFi creates an attractive combination. More inclusion of real-world assets in DeFi can position it for non-crypto-native users and expand the user base.
Most DeFi activity relies on decentralized stablecoins like DAI to avoid volatility. However, even stablecoins have risks of failure, as evidenced by the Terra USD collapse. Algorithmic stable coins need to be developed with better reserve mechanisms and oracles. Asset-backed stablecoins can also scale using diverse collaterals and establish transparency with on-chain certificates.
Improving efficient, scalable and secure stablecoin systems will provide a more reliable base layer for DeFi products. This can instill greater confidence in participants and encourage a new wave of adoption.
Insurance and derivatives
DeFi protocols are exposed to the risks of smart contracts, hacking and market volatility. Developing robust decentralized solutions for insurance and derivatives can limit counterparty risks and insure against technical failures or market downturns. Platforms like Nexus Mutual, CDx, Opyn and InsurAce cover various DeFi risks.
As insurance coverage expands to more DeFi protocols, it may attract risk-averse institutions and retail customers. Innovations such as covered call options, futures contracts, swaps and other on-chain derivatives can also hedge risks and stabilize sectors such as decentralized lending. Developed insurance and derivatives landscapes will promote sustainable, long-term growth of DeFi.
One of the main advantages of DeFi is the open compatibility between decentralized applications and protocols. Money Legos allow mixing and matching old protocols to create new derivative products. However, issues like fragmented liquidity in DEXs limit seamless composability.
As bridges, interoperability solutions, and automated smart contract composition improve, this will increase the pace of financial innovation in DeFi. Cross-chain capabilities can also link assets across different blockchains such as Ethereum, BSC, Solana, etc. to increase composability. Greater buildability extends the pace at which new “Lego” products can be built to drive user adoption.
Usability and Regulatory Compliance in DeFi
Many DeFi apps suffer from a poor user experience, with confusing interfaces cluttered with technical jargon. High gas fees on the Ethereum blockchain also severely limit access for small retail investors and traders. However, solutions are emerging to improve usability and reduce friction.
Switching to a lower-fee Layer 1 blockchain such as Binance Smart Chain, Solana, or Avalanche can significantly reduce transaction costs compared to Ethereum. Level 2 scaling solutions such as Optimistic and zkRollups can also enable low-cost transactions by handling bulk transaction processing off-chain. Additionally, fiat-to-crypto on-ramps such as MoonPay simplify the process for new users to directly purchase cryptocurrencies with a credit card for use in DeFi protocols.
Cost aside, DeFi projects must focus on clean, easy-to-use interfaces comparable to the mobile banking and finance apps that everyday users are used to. Removing technical language and unnecessary features to create a simplified user experience is key. Partnerships with traditional financial firms can bring mainstream design expertise to the DeFi world. Educational resources, explanations and 24/7 customer support can further improve usability for non-crypto native users.
Regulatory uncertainty has always been a barrier to DeFi growth. However, select jurisdictions are beginning to provide clearer guidelines that legitimize DeFi activities without stifling innovation. For example, Wyoming’s blockchain and crypto-friendly policies are attracting DeFi projects like AAVE to establish special purpose depository institutions (SPDIs) in the state to offer decentralized financial services through a regulated entity.
In addition, the recent SEC settlement provided BlockFi with guidance on the parameters for offering credit products without violating securities laws. Increased regulatory clarity gives builders and users more confidence to get involved in DeFi protocols, while opening the door for larger traditional financial institutions to participate. Overall, improving the usability and compliance of DeFi will be key to unlocking the next wave of mainstream adoption.
During the next crypto bull run, solving these issues, such as scalability, real-world assets, a better stablecoin, risk management, usability, and regulation, can lay the groundwork for DeFi to grow exponentially. It may take a combination of these factors to get DeFi back on an aggressive adoption trajectory similar to 2020-2021. The building blocks are falling into place for DeFi to disrupt traditional finance this decade. However, another surge of innovation is needed to gain mainstream traction and for DeFi to deliver on its promise of an open, transparent, user-owned financial system.