Friday Focus: DeFi Dilemma 

The last few months have seen a brutal realignment and reassessment of the DeFi landscape. Starting with the Terra/Luna meltdown in May, the systematic deleveraging of interdependent DeFi lending platforms, and continuing through the recent series of hacks of bridge protocols, the DeFi proposition is rightly being called into question. So is DeFi dead?

As the dust is settling, a fundamental investing lesson has been re-learned:  If something seems too good to be true, it probably is. Early DeFi protocols offered sky high interest rates of 30% or higher, which of course were unsustainable. These platforms were not transparent, were complicated to use, and most investors didn’t understand how they were generating the yield. To attract new lenders to the platform, interest rates were often subsidized. When the subsidies were withdrawn, lenders would leave or threaten to leave for other platforms. This competitive posture caused many DiFi platforms to keep promotional rates too high for too long, distorting the expectations of lenders and leaving the system vulnerable to systemic risk like the Terra de-pegging.

DeFi at this juncture reminds us of the Internet before Netscape browser popularized its widespread use in 1994. From a technological perspective, there are developments underway that can enhance the usability and security of DeFi. These include decentralized identities, used to verify the identity of the user, and associate credentials such as college degrees, professional certifications and awards; modular blockchains, which break critical blockchain functions in to smaller pieces for greater efficiency and security; digital yield curves and derivatives such as swaps to allow long term hedging of asset prices; Decentralized Science (DiSci), which provides innovative funding and collaboration mechanisms for scientific research and development; and Zero-Knowledge Proofs, which facilitate trusted transactions between parties without revealing sensitive confidential information.

Why this matters: 

Just as the traditional finance system learns from its mistakes, like the Global Financial Crisis of 2008, DeFi can course-correct following the events of 2022. Financial and intellectual capital continues to flow into DeFi, which should enable continued growth and innovation. To reach its ultimate potential, DeFi projects need to focus on security, transparency, usability, education, and be subject to sensible regulation to protect investors. 

Sources: 

‍Coindesk: Advisors Should Look Before Clients Leap Into DeFi, 8/4/22
Cointelegraph: DiFi isn’t dead, it just needs to fix these 3 critical problems, 5/31/22
Arca blog, Jeff Dorman, 5 ideas that might change everything, 8/8/22.

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