By Ankitt Gaur, CEO & Founder of EasyFi Network
Satoshi Nakamoto imagined a trustless, transparent financial system without the need for intermediaries like banks mediating everyday transactions. Nakamoto’s philosophy reached its zenith with the emergence of smart contracts and decentralized finance (DeFi).
The DeFi sector grew significantly, and its total volume locked (TVL) surpassed $250 billion in 2021. Despite turbulent market conditions, DeFi’s TVL hovered around $230 in April 2022, with Ethereum dominating 54% of the market.
Yet, DeFi has its pitfalls. Protocols are often prone to hacks and security breaches. For example, in 2021, users lost around $1.3 billion, a sharp jump of over 160% from 2020. The trend continues into 2022, with 97% of all crypto hacks happening in DeFi. More importantly, the problems begin with hacks and scams but don’t end there.
Innovating permanent solutions is necessary. Promising developments are already underway. Nevertheless, we must remember that technology takes time to realize its full potential. DeFi will overcome its shortcomings permanently—it’s not a question of if but when. But till then, each of us has a role to play in avoiding common pitfalls. And as with everything else, improvement begins with knowledge. For how can we tackle problems unless we recognize them well?
What Doesn’t Kill DeFi, Makes It Stronger
DeFi currently has various ailments, of which bugs and coding errors are the most common. It’s a nascent industry, after all, with much ongoing experimentation. Hackers exploit these gaps, causing downtime and stealing funds. For example, in 2021’s first DeFi hack, the attackers targeted a bug in a popular DeFi app and drained $11 million from its vault. Similarly, in another incident in July 2021, users of a decentralized liquidity network lost $8 million to two consecutive hacks in one week.
Hacks aren’t the only consequence of coding errors, though. A lending protocol became undercollateralized by almost $6 million due to a glitch in its code. These are severe lapses since collateralization is key to minimizing counterparty risks in decentralized lending-borrowing.
DeFi loans are usually trustless, involving anonymous participants. Ensuring timely repayments is thus critical to mitigating defaults. Otherwise, lenders run too high a risk of incurring bad debts and non-performing assets, altogether losing the incentive to lend. Collateralized lending addresses this risk factor. And to this end, innovative platforms, such as EasyFi, support diverse collateral types— staked derivative assets, non-ethereum assets, gold, silver, crypto-assets and metaverse assets — for broadened access.
So much for hacks and counterparty risks, which primarily relate to the protocol’s internal policy and functioning. But DeFi solutions also face external risks, mainly due to market dynamics. One pertinent example of this is impermanent loss. DEXs accept deposits from liquidity providers, incentivizing them with rewards and governance tokens. However, the high volatility of crypto-based markets causes steep price fluctuations. DEXs are thus compelled to recalibrate token prices periodically to maintain equilibrium, and investors often lose money in the process.
Scalability is another severe concern. It causes network congestion, which leads to spikes in transaction costs. Ethereum is famous in this regard, with gas fees reaching $60-$70 during peak traffic. The situation looks grimmer considering that Ethereum dominates over 54% of DeFi markets. Because DeFi becomes a liability if charges outstrip returns.
Besides these specific concerns, some problems plaguing crypto markets also affect DeFi. There are rug pulls, pump-and-dump schemes, phishing attacks, dubious ads and fake airdrops. Even popular DEXs are not free from such problems – with over 50% scam token listings, making it a breeding ground for rug pulls. The Squid Game rug pull is still fresh in our memories.
Innovative Technology & User Awareness: A Happy Marriage
Innovators must do their part to resolve the pain points in DeFi. But they can’t achieve much without user awareness. There are various ways for individuals to do their due diligence. And they mustn’t make any compromises.
Progressive DeFi protocols engage third-party auditors to detect and rectify vulnerabilities in the code. They also offer bug bounties to independent white-hat hackers for this purpose. Users need to review these records and screen protocols accordingly. It’s also prudent to read up on any previous security glitches and how the protocol addressed them.
Overcollateralization is a standard solution to counterparty risks in decentralized lending, as mentioned earlier. But this doesn’t guarantee repayments all by itself. Investors must dig deeper to understand the nature of collateralization. The collateral type and the percentage available for borrowing are crucial factors. Knowing the conditions under which a protocol liquidates collateral also helps detect and avoid counterparty risks.
Interestingly, though, new age lending protocols offer undercollateralized loans to lower entry barriers, despite optimizing security and minimizing counterparty risks. EasyFi belongs to this league, leveraging its privacy-preserving proprietary algorithms. It’s a stepping stone to solving DeFi’s problems permanently.
Anyway, returning to safe practices, we have impermanent loss calculators. Users can leverage them to assess the extent of possible losses with back-calculation formulas. Moreover, historical token price data gives a sense of the investment’s future performance, fostering informed decision-making. But it’s also noteworthy that predictions based on past performances are never entirely accurate.
DeFi users must realize this overall—if something is too good to be true, it’s most likely fishy. It’s thus compulsory to undertake rigorous research before investing. Be wise and cautious, not whimsical and greedy. Avoid red flags like anonymous teams, dormant social media profiles, and crazy APYs.
Lastly, we mustn’t lose hope or deny that DeFi is faring well, despite its vulnerabilities. Its TVL is currently equivalent to Greece’s 2017 GDP. With innovations and awareness going hand-in-hand, it’ll scale new heights. That’s the horizon, after all, beyond which lies the future of user-centric and community-oriented finance.
About the author:
Ankitt Gaur is the CEO & Founder of EasyFi Network, a universal layer-2 lending Protocol for DeFi focused on scalability, composability, and adoption. EasyFi is redefining lending in the metaverse through their MetaFi platform. Ankitt is also a global consulting professional enabling enterprises across the globe to adopt and benefit from progressive technology.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.