While it is one of the most prominent industries in the crypto industry, decentralized finance still has hurdles to overcome before widespread acceptance.
- Users can participate in the DeFi ecosystem more efficiently since there are no centralized middlemen.
- Regulation can benefit the DeFi space, but it contradicts the fundamental values of decentralization.
- Security is a big problem in the DeFi industry, with hostile actors exploiting flaws in bridge protocols and decentralized apps (DApps).
DeFi is a blockchain-based solution for delivering financial services that depend not on centralized intermediaries but on automated algorithms. Smart contracts are automated algorithms allowing users to exchange and transfer assets on the blockchain automatically. Decentralized finance (DeFi) is a burgeoning sector popular among experienced cryptocurrency users. However, there are specific barriers to mainstream adoption for ordinary non-technical investors.
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Decentralized exchanges (DEXs), borrowing and lending platforms, and yield farms are all protocols in the DeFi area. Users may participate in the DeFi ecosystem more efficiently since there are no centralized middlemen. However, there are also more significant dangers. These dangers include protocol codebase flaws, hacker attempts, and malicious protocols. Combined with the extreme volatility of the crypto market in general, these dangers may make it more difficult for DeFi to gain widespread acceptance among typical consumers. On the other hand, workarounds and improvements in the blockchain domain may solve these problems.
DeFi regulatory issues
Regulation can benefit the DeFi space, but it contradicts the fundamental values of decentralization. Decentralization refers to the absence of centralized power or owner for an organization, application or protocol. Conversely, a protocol is founded on smart contracts that perform its functionalities while various people engage with it.
Smart contracts, for example, handle swaps and staking with a DEX, while users offer liquidity for trading sets. What can regulators do to block an anonymous group from artificially inflating the value of a token before actually drawing down liquidity from DEXs, also regarded as rug pulling? Because of the DeFi ecosystem’s decentralized nature, policymakers will face hurdles in maintaining a certain degree of oversight within the space.
Despite the difficulties, regulation in DeFi is not absent. According to virtual asset guidance on regulation, DeFi protocol designers could be held liable in the event of a crisis. Although the protocol is decentralized and automated, the developers and founders could be called virtual asset service providers (VASPs). They may also need regulation depending on where they are located.
Regarding regulatory oversight within DeFi, systems can also create protocols that meet regulatory standards. For instance, Phree is a platform that makes decentralized protocols while taking regulatory consideration whenever possible. One way they do this is by collaborating with conventional financial institutions to develop DeFi protocols that meet standard regulatory requirements. This entails adding anti-money laundering and Know Your Customer checks into DeFi platforms like DEXs and borrowing or lending platforms.
Companies dominate the TradFi arena. The dominance makes conventional finance (TradFi) interoperable with the DeFi ecosystem, assisting in expanding acceptance. Ajay Dhingra, director of research at smart exchange Unizen, notes that incompatibility with the conventional financial ecosystem is one of the most significant issues. There is a need to link the CeFi regulatory framework with on-chain IDs and real-time regulatory reporting so that Defi remains accessible to financial institutions dealing in billions.
After the Terra algorithmic stablecoin crash earlier this year, central bank digital currencies (CBDC) emerged as an alternative to stablecoins. According to Swiss National Bank CEO Thomas Moser, authorities may prefer centralized stablecoins over decentralized ones. However, he also said that it would likely take time and that present banking rules may render the DeFi ecosystem outdated due to competing requirements.
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Concerns about security in the DeFi ecosystem
Security is a big problem in the DeFi industry, with hostile actors exploiting flaws in bridge protocols and decentralized apps (DApps).
According to Adam Simmons, chief strategy officer of RDX Works, the mystery of DeFi currently is that the whole public ledger software package has many identified security issues, as evidenced by the billions of dollars lost in exploits and hacks in recent years.
Exploits in security vulnerabilities continue to occur in the DeFi space. Scammers recently drained the Nomad token bridge of $160 million in cash. So far this year, $1.6 billion in money has possibly gotten looted via DeFi methods. The lack of security in the DeFi sector discourages new users while deterring individuals who have been victims of protocol vulnerabilities.
There should be a greater focus on vetting processes inside the area to uncover weaknesses before hackers can use them. There are existing tools, such as CertiK, that audit blockchain-based protocols by inspecting the smart contract code. However, an enhanced inspection of DApps before they go live remains necessary to safeguard crypto users.
User experience challenges
Another possible barrier for consumers that wish to participate in the DeFi ecosystem is user experience (UX). Investors’ interactions with wallets, exchanges, and protocols are not simple and intuitive. The complexity results in some users losing assets owing to human error. In November 2020, for instance, a trader paid $9,500 in fees to conduct a $120 deal on Uniswap after mixing up the “gas limit” and “gas price” input fields.
In another case, a user sold a $1.2 million rock nonfungible token (NFT) for less than a penny because they placed it for sale at 444 WEI rather than 444 Ether (ETH). These are fat finger errors, in which customers lose money due to mistakes they make while entering values for pricing or transaction fees. For DeFi to acquire extensive acceptance by the general public, the process must get easy for ordinary people.
However, this is not the situation at the moment. Users must have a noncustodial wallet, or a wallet in which they control the private keys, to utilize a DeFi application. They must also back up the recovery phrase and maintain it in a secure location. When dealing with a DApp, users must link their wallets. Linking might be difficult sometimes, mainly when using a mobile wallet.
Furthermore, while making or receiving payments, users must copy the addresses involved in the transactions. In certain situations, users must enter the quantity of gas they want to spend on a transaction. Users who do not understand this procedure may pick a low gas option. Consequently, due to the low gas charge, they must wait hours for their transaction to complete.
Developers in the DeFi domain must make the ecosystem more user-friendly for newcomers and non-technical users. Creating wallets and DApps that avoid fat finger mistakes is an excellent place to start. This is currently the case with centralized exchanges. Nevertheless, for the DeFi industry to thrive, it must extend to noncustodial wallets and decentralized platforms.