What are the biggest challenges of Defi mainstream adoption?

The decentralized finance market, or DeFi, keeps growing, adding around 4% a day to its market capitalization, which has already attained an impressive volume of around $156 billion. However, the stellar growth of the sector is accompanied by a slew of accusations ranging from fraud and copycat, makeshift protocol code, to outright violation of international financial regulation for the sake of attracting liquidity from unsuspecting users.

Many of the innumerable DeFi platforms that are emerging on a daily basis have little or no regard for true safety of user funds, as they rely on shamble coding and poorly formulated underlying mathematical functions, which boil down to turning into pyramid schemes. A recent example that has shaken the DeFi industry and cast serious doubt on the majority of platforms offering impressive returns on investments involves the infamous SafeMoon protocol.

The project was audited by the renowned blockchain security company HackEx and found to have numerous vulnerabilities in its smart contract code. 12 critical vulnerabilities are exposing the funds of over 20 million platform users to risk. Given that the protocol boasts a valuation of over $3.5 billion, the implications of even the slightest attempt at hacking could be disastrous. The critical vulnerabilities remain unaddressed, highlighting the disregard major protocols are demonstrating towards their responsibilities before users and the reputation of the DeFi market as a whole.

In Light Of

The growth of such a volatile and insecure market as DeFi is not leaving states indifferent. The regulators of various countries are well aware of the economic risks posed by the uncontrolled and swelling growth of a market that is detracting considerable liquidity from the financial system. The result is the mounting connection of state regulators and financial authorities to the decentralized sector.

DeFi #3

Stablecoins, namely state-issued, controlled and pegged stablecoins are being viewed as the instrument that can stem the tide of funds into DeFi. Given their virtues of being launched on the blockchain with all of its inherent qualities, and the fact that they will be enjoying the stability of national currency exchange rates and the backing of the state, Central Bank Decentralized Currencies are a powerful instrument that many states will soon be launching to counter the unrestrained billowing of the DeFi market.

China was always in the lead in its stance on cryptocurrencies and is also the pioneer in CBDC issuance with its crypto Yuan. Other states are catching up, namely Turkey with the crypto Lira, Britain with its recently announced ‘Britcoin’, and Russia with the crypto Ruble that seems to be around the corner.

DeFi #4

Stumbling Against Convenience

The convenience of DeFi instruments, namely peer-to-peer loans, is the biggest hurdle that financial regulators are facing in their fight against the growing influence of the market. The risks involved in the spread of such instruments are twofold.

First, decentralized loans are capable of democratizing the banking and financial systems, essentially negating the influence of the traditional institutions and detracting considerable liquidity from their reserves. That is a threat to the stability of the economy and a considerable barrier to controlling monetary flows that can easily spiral down the drain into illegal sectors of the shadow economy.

Second, DeFi is wrought with a number of inherent risks that affect all industry participants and can result in either considerable financial losses or the meltdown of the market as a whole under its own burgeoning weight.

Technological Risks

DeFi #2

DeFi is based on blockchain technologies, and no expert is willing to admit that decentralized ledgers and their systems are perfect. The Ethereum network continues to play host to the majority of DeFi projects, and it is still imperfect in the technical sense, subject to bottlenecks, poor throughput, and high network transaction fees. For instance, in March of 2020, a massive network congestion led to the failure of several DeFi applications, leading to over $8.32 million worth of cryptocurrency being auctioned off at prices far less than market value.

Apart from scalability issues, DeFi is subject to hacker attacks. In 2020, over $120 million was stolen from DeFi protocols throughout 15 major attacks. Another 23 attacks took place by Q2 of 2021, and on August 10, some hackers stole more than $600 million from a leading platform.

The “flash loan attack” remains a favorite among the hackers, exploiting the deficiencies of DeFi platforms, as was the case in April of 2021, when a DeFi platform founder’s computer was attacked, resulting in the loss of around $80 million in user funds.

Asset Risks

Asset risks are just as relevant in DeFi space, since the market is heavily reliant on volatility. The risks that investors undertake include sharp declines in asset prices, and “bank runs” that send token prices plummeting after negative news or rumors.

Bitcoin, the most important and vaunted asset in DeFi space, is a shining example of volatility after having lost over 80% in value in 2018 alone and experiencing equally painful drops throughout the ensuing 3 years. DeFi protocol tokens are just as volatile, as evidenced by Uniswap, which loses as much as 10% in value overnight at times. Other examples are the Galaxium and Crypto Village Accelerator tokens, which lost 60% overnight.

Compliance Risks

DeFi platforms are operating without incorporated entities, which frees them of compliance before even the territories of their operations. Given that such platforms rely on decentralized software as their main infrastructure of operation, the result is a moot and uncertain regulatory environment. More frightening is that states cannot control DeFi sectors, meaning that legal frameworks are inapplicable.

In addition, the full anonymity of users in DeFi space, the lack of proper KYC and AML procedures, as well as the absence of legal obligations, makes the market a highly risky space for anyone hoping to make some profits on its bounty.

DeFi #5

Regulatory Action

The big questions aimed at DeFi space are related to who and how should be responsible for regulating the market and based on which guidelines.

The SEC

The SEC has stepped up recently to take the leading role on regulating DeFi space as SEC Chair Gensler stated that the agency will be ready “to bring cases involving issues such as crypto, cyber and fintech,” under its ruling.

SEC Commissioner Hester Peirce has also voiced his opinion on the matter that DeFi should be regulated much like securities and asset management. His latest proposal was to create a three-year safe harbor for crypto investors. The combined opinions of SEC representatives make it clear that the agency wants to bring the DeFi sector under the jurisdiction of federal securities laws.

CFTC

The CFTC is also expressing its desire to regulate DeFi in terms of anti-fraud and anti-manipulation authority. An example of the organization’s power can be found in the case against BitMEX, when the platform was charged with accusations of enforcing poor anti-money laundering procedures and KYC.

Since, the CFTC has expressed its intention to exercise authority over crypto exchanges that do not comply with regulations. Commissioner Dan Berkovitz also stated that any DeFi protocols acting without licenses in the US will be deemed illegal. He also mentioned that CEA requires futures contracts to be traded on a designated contract market (DCM) licensed and regulated by the CFTC.

Conclusion

The DeFi sector is still risky territory and regulation, or lack thereof, is one of the biggest challenges to its mainstream adoption. Along with volatility risks, underlying technologies are imperfect as well, giving ample reasons for regulators to consider exercising their power over market participants and platforms willing to enter financial markets.