In the Part One of this series, we introduced Decentralized Finance (DeFi) and why it is the solution to the many drawbacks of our current traditional financial system. We also broke down the differences between DeFi and FinTech. In this episode, we’ll look at the potential limitations of DeFi and some of the most exciting DeFi projects available today.
Image Source: doggbitcoin.com
Limitations and Risk Factors of DeFi
No doubt about it, DeFi provides a number of benefits over legacy financial systems, but as with anything, it’s important to also consider its risks and limitations so you fully understand what it’s all about. These include:
Mass adoption concerns
This is one of the biggest challenges plaguing the DeFi space today. Despite the fact that we are connected through the Internet, public awareness about DeFi and its many advantages is still quite low. There’s simply not enough people who know about DeFi, which in turn has affected its use rate. Crypto and blockchain technology may have gained popularity over the years, but they are still nowhere near the adoption and use rate of the Internet and other more popular innovative technologies out there today.
Blockchain capacity limitations
Public blockchains may be capable of processing the financial transactions of every one of us out there, but they mostly lack the bandwidth to operate efficiently. To give you some context, giant payment processing platform, Visa is able to process thousands of transactions per second, whereas Bitcoin can only process less than 10 transactions per second. This huge divide is one of the factors hindering the number one cryptocurrency from being a big success like everyone expects. Second-generation blockchain solutions, such as Ethereum and Cardano are faring better than Bitcoin, but still don’t quite measure up to existing legacy financial system networks. The good news is that blockchain researchers are currently hard at work to make the technology more scalable.
Potential for getting hacked
DeFi basically depends on smart contracts to operate and run decentralized applications (dApps). Now, these smart contracts are typically open-source, meaning anyone can review them. However, these smart contract codes are written by a human and therefore, there is always the risk that there is a vulnerability somewhere or that those reviewing the code may have missed something.
Image source: Zoltan Balazs, Linkedin
Take the case of DeFi project, the DAO hack for example — they had managed to raise a whopping $120 million in cryptocurrency for their crowdfunding campaign. However, in June 2016, hackers were able to exploit a loophole in the smart contract code to steal about 3.6 million ETH, amounting to $70 million at the time.
Data feed centralization
Blockchains do not have access to off-chain data so they have to rely on Oracle programs to interact with external data, like price feeds and changes in prevailing conditions that can trigger smart contracts based on the terms of said contract. Remember that smart contracts are self executing and will automatically act once a clause or term is triggered. So let’s say you have an insurance smart contract designed to make payment in the event of a flight delay. Once the blockchain receives this information from an oracle program, then it will release the payment immediately. But what happens if the oracle program provides the wrong information? This could be catastrophic for all parties involved in the contract.
Volatility in cryptocurrencies
This is yet another concern as the violent swings of the cryptocurrency market can ultimately affect the value of funds in a DeFi setting. As a remedy, many DeFi projects are turning to stablecoins since these tokens are essentially pegged to the value of fiat currencies and are therefore less prone to volatility. However, there’s still a lot of work to be done in this regard as regulatory compliance continues to be a major hurdle. For example, not too long ago, Facebook rolled out an ambitious plan to launch its own stablecoin known as Libra. This plan was met by stiff opposition from U.S. policymakers citing that Libra could effectively undermine the U.S. dollar.
In spite of these limitations, the benefits of DeFi continue to dwarf the many inefficiencies and downsides of today’s traditional financial system. The best part is that major players in the DeFi space are acutely aware of these risk factors and are constantly working on figuring out how to protect against them.
Exciting DeFi Projects Worth Considering
With time, decentralized finance will become mainstream as more and more people come to realize what they stand to benefit from making the switch. With that in mind, here are some of the most exciting DeFi projects worth considering today:
A quick snapshot of DeFi project hosted on Ethereum’s blockchain | Image Source: blockgeeks.com
As with traditional insurances, DeFi Insurance projects aim to provide a compensation guarantee for specified damage, loss, illness, or death in return for premium payments. Projects include:
- Etherisc — This decentralized insurance protocol is designed to build risk transfer solutions in a collective manner.
- Nexus Mutual — This project essentially secures against risk and potential bugs in smart contract codes.
- VouchForMe — This blockchain based web tool enables users to ask family and friends to vouch for them for their financial transactions.
DeFi payments dApps and protocols focus on enabling an open finance ecosystem that can cater to just about everyone, from institutions to underbanked and unbanked individuals. Projects include:
- Lightning Network — This decentralized network utilizes smart contract functionality to enable instant payments in BTC.
- Matic — This blockchain scalability platform is designed to provide secure and instant transactions through PoS side chains.
- Whisp — This project focuses on payroll solutions using crypto payments. Users can pay their workers in crypto and automate the record-keeping process as well.
Crypto margin trading in the DeFi space refers to the practice of trading financial assets using borrowed funds from a broker. The asset being traded forms the collateral for the loan. Projects under this category include;
- dYdX — This trading platform is designed with open-source protocols to enable decentralized margin trading of crypto assets.
- Liquid Long — This tool lets you convert your ETH into a leveraged ETH position against the U.S. dollar in a single transaction for a minimal fee.
- Margin DDEX — This advanced decentralized margin exchange lets users create leveraged margin positions as well as earn interest by way of decentralized lending pools.
dApps and protocols under this category essentially offer an alternative to the traditional banking system. However, instead of fiat currencies, you’ll be depositing crypto assets. These deposits are then used to bolster open-lending from which you can then earn interest. These projects include:
- Dharma — Currently one of the most popular players in the DeFi space, Dharma offers alternative savings and aims to simplify open-lending experience.
- Voluto — This alternative high-interest savings account is available to users and comes with no lock-up period. It lets them enjoy 0.45 % interest on their digital cash.
- Outlet— This is another high yield savings account alternative with an interest rate of up to 6% on savings and zero upfront costs.
Asset Management and Security
This aspect of finance essentially deals with safeguarding and managing an individual or institution’s financial assets. In DeFi, the protocols come in the form of wallets and specially designed apps managing cryptocurrencies and other digital assets. Projects include:
- AlphaWallet — This mobile crypto wallet interacts with smart contracts and dApps to ensure smooth transactions across the board.
- Ambo — This platform lets users easily buy, exchange, manage and store their Ether and ERC tokens.
These are just some of the categories and projects that are currently being utilized in DeFi. Other key DeFi project categories worth noting include:
- Decentralized exchanges
- Infrastructure & Dev Tooling
- KYC & Identity
- Lending & Borrowing
- Prediction markets
- Asset Tokenization
How can DeFi expand across the board?
Snapshot of total DeFi value locked in Ethereum as of 2019 | Image Source: sci.smithandcrown.com
Unlocking new partnerships among DeFi projects and establishing viable contacts with key stakeholders and decision-makers will go a long way in helping this technology reach the masses. Still, DeFi is still in its early days and who knows how the tomorrow’s traditional financial system will be, especially with governments pumping out trillions of dollars on economic stimulus packages due to the COVID-19 pandemic. After all, pumping massive amounts of money into an inactive economy could result in fiat currencies losing their value over time. DeFi could be a promising solution.
DeFi may still have a long way to go, but it is undeniable that it is a groundbreaking and revolutionary trend with the potential to completely redefine many facets of our current financial products and services system. Like cryptocurrencies, DeFi is all about financial liberty, giving economic power back to the people in an efficient and transparent manner.
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