For the last few months, Decentralized Finance (DeFi) has been one of the hottest topics in the finance industry. Everyone is focused on the growth of decentralized finance applications, but one should also take care in thinking about the issues that the new industry will have to face and overcome to compete with the current centralized model.
Before we start looking into the current challenges that face DeFi, let’s briefly explain the concept behind it.
In contrast to the decentralization of money through Bitcoin, DeFi aims for a broader approach of generally decentralizing the traditional financial industry. The core of the initiative is to open traditional financial services to everyone, in providing a permissionless financial service ecosystem based on blockchain infrastructure.
Broadly speaking, DeFi is an ambitious attempt to decentralize core traditional financial use cases such as trading, lending, investment, wealth management, payment, and insurance on the blockchain.
Now, let’s discuss some of the biggest obstacles that DeFi is facing on its present-day level of development. These issues are current, but as time passes and development increases, many of them are likely to be solved. Here are the obstacles DeFi faces.
- Performance issue: Inherently, Blockchains are slower than traditional and centralized finance (CeFi) platforms. This issue also translates to the applications developed on them. This is why the DeFi developers should carefully consider these constricted elements and work on their products.
- High risk of user error: One of the key features of DeFi applications is that they shift the responsibility from the middlemen to investors. This can pose a challenge for many users. Designing products that can minimize the risk of user errors is a daunting task when the products operate on top of irreversible blockchains.
- Bad user experience: The lack of usability of DeFi products make them unintuitive in terms of UX, and often create a poor user experience. To make DeFi applications a core element of the global financial system, they should be able to provide a tangible benefit that incentivizes investors to switch over from the traditional finance platforms.
- Not suitable for HFT: Most DeFi projects are not ideal for high-frequency trading (HFT) because of limited speed. Even they are not suitable for trading large positions either, and traditional finance establishments will not likely get into transactions where they do not know about their counterparts. As of now, institutional traders are shying away from these trade-offs unless they can trust at least one party in the market.
- Identity and reputation: Investors’ ability to access financial services is dependent on most aspects of identity. This may cause serious violations of KYC/OFAC/AML regulations as they will not only result in substantial penalties but may also lead to criminal charges. If a DeFi Relayer coordinates exchanges between unknown parties and those parties violate any of these regulations, the consequences can be grave. As most financial transactions happen through decentralized markets, they can pose serious regulatory and legal challenges.
- High fees: The network’s high fees are a major challenge to the uptake of products. This is mainly because most DeFi contracts are based on the Ethereum blockchain. DeFi allows investors to access a wide range of financial products from any country. However, only those who are ready to pay high fees for each transaction can access them.
- Timing issues: There are timing issues as the blockchain status is updated on average every 15 seconds, which is not common for traditional finance. In DeFi, calculations of prices and interest occur per block. It means for a seamless operation, stable block mining is important.
- The liquidity issue: Currently, centralized alternatives are outpacing DeFi in terms of liquidity. This is crucial because liquidity is a key element for competitive prices in the financial sector. As of now, DeFi protocols cannot keep up with competitors offering low fees.
- Technicals: Smart contracts are all fancy pieces of technology, but they too possess one significant vulnerability. In the case that a smart contract is released with a flawed code, it can result in the loss of funds. Although the chances of this happening are small, there have been a few instances where these particular issues have risen with smart contracts, compromising the blockchain.
- Development issue: For now, DeFi is still at the very early stages of development, and for many people, it’s still hard to understand what liquidity pools are, how they work, how you can lose/earn money, etc.
Regardless of all that the budding DeFi industry has and still has to accomplish, the final question is whether regulators will take steps to snuff it out. While the idea of a bank open to anyone in the world may appeal to crypto enthusiasts, it’s unlikely that the government shares the same view.
To fill the gap between theory and practice DeFi has yet to overcome its core roadblocks: Low liquidity, unintuitive UX and accessibility, capital inefficiency, hidden risks, and regulation. But like it or not, we are heading towards a new financial system that is more liberalized and decentralized than anything.
Despite the challenges, DeFi is barreling ahead into 2021 with the promise of overcoming them, serving up ambitious and impressive projects already.
Check out the Top Ten DeFi Projects to Watch in 2021.
Disclaimer: This article is informational and should not be used as investment advice. Please consult your financial advisor prior to participating in or investing in any blockchain.