DeFi’s Rise to Shame: Its Problems and How to Fix Them by@Wiligut
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DeFi’s Rise to Shame: Its Problems and How to Fix Them

November 18th 2022
10 min
by @Wiligut 7,337 reads
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DeFi is short for Decentralized Finance and refers to a new financial instrument based on distributed ledgers, similar to the ones utilized by cryptocurrencies. DeFi aims to decentralize financial services while providing users with the ability to perform transactions without the need for intermediaries. The DeFi movement quickly gained momentum, making the Ethereum network more popular than ever. However, with the hype dust settling, the honeymoon phase is over and now there is a significant discussion around what is wrong with the sector and how to fix it.

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Roman Wiligut

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With the emergence of Bitcoin, a lot of financial experts predicted big changes due to the utilization of cryptocurrencies. However, it was evident—rather quickly—that Bitcoin has a fairly limited set of applications that could only be useful for sending payments, receiving payments, and lending. This showed that a push for a revolutionary decentralized financial instrument was required in order for crypto’s vision to become a reality. The DeFi movement quickly gained momentum, making the Ethereum network more popular than ever while giving the community a taste of what a decentralized financial world could look like.

However, with the hype dust settling as market situations have toughened, the honeymoon phase is over, and now there is a significant discussion around what is wrong with the sector and how to fix it, so let’s explore DeFi’s issues from top to bottom in order to properly assess whether or not the future has a reserved spot for this technology in our world of finance.

What is DeFi?

Before we dive deep into the sector’s shortcomings, it’s important to properly define what it is and what problem it aims to solve in the first place. DeFi is short for Decentralized Finance and refers to a new financial instrument based on distributed ledgers, similar to the ones utilized by cryptocurrencies.

Its ultimate goal is to decentralize financial services while providing users with the ability to perform transactions without the need for intermediaries This also includes savings for the end user, as the absence of an intermediary means the absence of fees that banks take for performing transactions, which only made the technology more appealing, further contributing to the concept’s popularity.

CeFi vs. DeFi

Starting off, it’s worth noting that the majority of crypto is traded on centralized exchanges. CeFi stands for Centralized Finance and it assumes a centralized institution—in the case of crypto, centralized exchange—responsible for storing and moving crypto, and taking fees for transactions made on the platform. On centralized exchanges, users do not have access to their wallet’s private key, so they depend on the platform for access to their cryptocurrency.

CeFi also requires additional checks and balances to be met before you can gain full access to their services, which means that passing KYC procedures is a must, as these institutions comply with rules and regulations.

On the other hand, Decentralized Finance has been described as the wild west of finance. It is unregulated and has no intermediaries. All transactions are based on smart contracts, allowing the sector to run autonomously without the intervention of a third party. DeFi does not require any user verification, so any person can gain access to financial services, even unbanked users residing in third-world countries. The only thing you need is an internet connection and a relative understanding of the technology.

Centralized finance works in the same way as banks and centralized institutions, while decentralized finance aims to provide transparency, an open-source platform, and a system requiring no special permissions. Their services include crypto exchanging, lending, farming, staking, asset storage, and more.

DeFi: Expectations vs. Reality

When the idea of DeFi was conceived, the market was littered with misconceptions and a poor understanding of how the technology works. Lots of farmers and stakers thought that APYs are free money, where all you had to do is hold for a year and then you’re guaranteed a luxury home and car to accompany it. Welcome to the billionaire's club, right?

Sadly, that wasn’t the case, as many investors dove in head first before acquiring a proper understanding of the technology’s economic structure. This resulted in a large number of users who lost their life savings due to not doing their due diligence when exploring this extremely hyped sector.

If we take the catalyst of DeFi 2.0’s hype, Olympus as an example, we’ll start seeing the bigger picture. In April of 2021, Olympus DAO was created, then in October of that year, multiple forks were created, resulting in a price hike of 5x compared to OHM’s (Olympus’ own token) low in August. This turned many heads and attracted a ton of attention to the sector, especially when looking at their too-good-to-be-true APYs being at almost 8,000%. Compare that to today’s farming percentages residing in the 2 digits or low triple digits and you’ll notice a massive difference.

Couple these promises of gains with users' lack of experience, and you have a misconception that invested capital would recover itself within a couple of months. Sadly, however, that was far from the truth.

DeFi solutions that were at the center of the movement

As we’ve established earlier, DeFi is a category of services that fit under an umbrella term describing decentralized financial tools serving a variety of purposes. Let’s go through these and dissect problems in each solution offered by projects.

What is Staking? Proof of Stake’s flagship offering.

Before we talk about this instrument, it’s important to clearly understand what it is. Staking is an instrument that allows crypto holders to generate passive income with their tokens. Investors can deposit their tokens with validators, which are special nodes responsible for the provision of infrastructure as well as validating new blocks and appending them to the blockchain. This would, in turn, contribute to its further decentralization, making it more secure in the process.

What about profits? What is APY?

Your staking profits are calculated in Annual Percentage Yield (APY) and it takes compound interest into account, including interest earned from the initial deposit plus the interest earned on that interest.

This has become the primary passive income opportunity utilized by the community as it is the simplest and safest way to invest money in a project, although thorough research on the project you’re investing in is still an important prerequisite.

With the emergence of the consensus algorithm Proof of Stake (PoS), comes a great passive earning opportunity for investors. The way it works is simple: buy a PoS-based token, transfer it to your wallet, join a staking pool, and HODL as your rewards are accumulated. The only problem is that some DeFi scams took advantage of the movement and started offering outrageously high APYs and making empty promises, which led to many losing large sums of money as a result.

However, the technology does have quite a few advantages, provided that you’re investing in a legitimate project with a good & planned-out vision:

  1. It’s a great and risk-free way of earning interest on your crypto holdings
  2. You contribute to the further decentralization of a blockchain, thus, strengthening its security
  3. Unlike mining, you don’t need any additional equipment to take part
  4. Compared to mining, it’s a much more environmentally friendly earning method

But how can you get an accurate figure of how much you’ll be receiving?

Understanding profits using APY calculators

APY calculation is a helpful method of understanding how the information displayed in the pool can be translated to terms that you and I can understand. There are plenty of calculators available that can help you get a more-or-less accurate expectation of how much you should expect to receive through staking, of course, assuming that the yield doesn’t change over your staking period.

Here’s the information you need to input in a calculator:

  • The dollar value of your staked tokens
  • The Staking APY
  • The staking period in years

Once you input this data, you should have an idea of how much you should be getting back by staking.

What is Farming? Hint: It has nothing to do with crops or livestock.

This instrument has been a good way for advanced crypto users to invest with DeFi projects. Liquidity farming, also known as yield farming is a reward given for providing your liquidity to the exchange stock. Yield farming is a means of earning interest on your cryptocurrency, similar to how you'd earn interest on any money in your savings account. And similarly to depositing money in a bank, yield farming involves locking up your cryptocurrency for a period of time in exchange for interest or other rewards, such as more cryptocurrency.

Your farming profits are calculated in APR, so what is APR? It stands for Annual Percentage Rate, and it can be dynamic, meaning that it could become higher or lower.

You do need to consider, however, that farming is a riskier instrument than staking, as it does introduce risks of intermittent losses. Though with that additional risk comes a higher reward, if asset rates return to the same level they were at when you put your money into the pool then your losses will be recovered. That is why staking is recommended for crypto newbies instead of farming, as staking offers no such risks and your staking rewards are independent of the token’s value.

Challenges facing stakers and farmers

The problem with these instruments concerns liquidity. Not in terms or its availability, but in the sense that it should be actively used by exchange services and real users. If liquidity sits statically while being farmed, then the model is not sustainable and will not work over several years, instead, it’ll act as a temporary TVL boost. If a service wants to survive over the long run, it’s imperative that liquidity is seeing movement and is actively being utilized by users.

What is a DAO?

These have been a wonderful way to let the community contribute to a DeFi project’s direction, introducing—in theory—a truly democratized environment. Decentralized Autonomous Organizations are organizations represented by rules encoded as a transparent computer program, controlled by the organization members, and not influenced by a central institution. Rules are set in the DAO’s code, which is why this structure does not require any intermediaries, allowing it to run fully autonomously without intervention or interruption.

The idea is great on paper, although practice has exposed flaws in the process.

The challenges facing DAOs

The actions of some DAO participants can directly contradict the interests of the rest, and when they have a high enough share of tokens, they can make convenient proposals that only play in their own interest. This may be the reason why democracy in DeFi—in the common sense of the word—is impossible. One user can create a massive number of wallets, and without incurring any losses, destroy the project or make a profit at the expense of other users.

This is especially relevant when we compare the traditional democratic process to that of DAOs. Usually, 1 person = 1 vote. However, in a DAO, 1 token = 1 vote, so one person could manipulate the voting procedure, assuming that they’re holding onto a large enough quantity of tokens.

This is the main reason, why a democratic environment for DAO participants cannot be achieved. The latest exciting DAO-related solution at the moment is the allocation of professional committees, similar to the model used in Yearn Finance.

These committees hire professionals engaged in improving the protocol, and users can vote for electing or removing members of these committees. They can prepare updates to the protocol, which are then submitted to the DAO, and this system ensures that users will vote for thoughtful decisions while rejecting disadvantageous changes to the protocol, in theory.

How can DeFi be improved?

While there isn’t a shortage of challenges plaguing the DeFi sector, there are starting points that protocols need to consider.

One of which is usability. Banks are effective at what they do, and that is owed to usability. Their apps are easy to navigate and use, and rarely do you need to follow a guide to complete a transaction or make a payment. DeFi, on the other hand, is a different story. Protocols are generally complicated and hard to understand due to being filled to the brim with crypto lexicon and terms that do users almost no justice. You may say that it’s because crypto users are advanced, but if our goal is to improve the state of the industry, then the technology has to appeal to the mainstream, and you cannot do that if the dApp is built for a niche community.

Another problem is the need for better education. The world population has to be educated with regard to crypto and decentralized technologies. There is an influx of misconceptions and incorrect information on the internet. For instance, farming is viewed as just a passive income opportunity, where you put money and grow a project’s TVL when in reality, it’s a tactic to incentivize liquidity in order to meet exchange demands. Educating potential users is imperative to increase trust, as the decentralized industry lacks bailouts that centralized institutions have available, so if it crashes, it has to organically recover, and panic is prevalent in this industry with panic sales being a sure way of destroying years of hard work.

Don’t get me wrong, there are companies already implementing these ideas into their projects, one of them is Broxus - Everscale’s core developer team—whose motto is “crypto is easy”. That is why their offerings are easy to use, intuitive, and built for the mainstream. But in order for the entire industry to grow, this initiative should be taken by the majority of projects and industry players for mass adoption of the technology to become a reality.

There is plenty of innovation left for the decentralized finance sector. If you believe that there is too much competition in the sphere with tons of projects doing the exact same thing, you may want to take a look at all other industries. This is a prevalent issue within the entirety of the tech industry, though this could be a good thing. Competition can be a great incentive for innovation. Those who come up with something new and truly unique will secure a spot in the future of finance. While this specific period isn’t the best for attracting investment, it’s only a matter of time until DeFi becomes a widely-utilized technology in the financial sector.

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