How We Could Overcome DeFi’s Pitfalls

By Ankitt Gaur, CEO and Founder of EasyFi Network

Satoshi Nakamoto envisioned a transparent, trustless financial system without the need for intermediaries like banks for day-to-day transactions. Nakamoto’s philosophy peaked with the emergence of smart contracts and decentralized finance (DeFi).

The DeFi sector has grown significantly and its total locked volume (TVL) exceeded $250 billion in 2021. Despite turbulent market conditions, DeFi’s TVL hovered around $230 in April 2022, with Ethereum dominating 54% of the market .

Still, DeFi has its pitfalls. Protocols are often prone to hacks and security breaches. For example, in 2021 users lost around $1.3 billion, a steep increase of over 160% from 2020. The trend continues in 2022, with 97% of all crypto hacks occurring in DeFi . More importantly, the problems start with hacks and scams, but don’t end there.

Innovative permanent solutions are needed. 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 until then, each of us has a role to play in avoiding common pitfalls. And like everything else, improvement starts with knowledge. Because how can we approach the problems if we do not 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 a lot of experimentation going on. Hackers exploit these loopholes, causing downtime and stealing funds. For example, in the first DeFi hack of 2021, 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 are not the only consequence of coding errors, however. A loan protocol became undersecured by nearly $6 million due to a glitch in its code. These are significant defaults, as collateral is essential to minimize counterparty risk in decentralized lending.

DeFi loans are typically trustless, involving anonymous participants. Ensuring timely repayments is therefore essential to mitigate defaults. Otherwise, lenders run too high a risk of incurring bad debts and non-performing assets, thus losing any incentive to lend. Secured loans address this risk factor. And to that end, innovative platforms, such as EasyFi, support various types of collateral – staked derivative assets, non-Ethereum assets, gold, silver, crypto-assets and metaverse assets – for expanded access.

So much for hacks and counterparty risks, which mainly concern internal politics and the operation of the protocol. But DeFi solutions also face external risks, mainly due to market dynamics. A relevant example is impermanent loss. DEXs accept deposits from liquidity providers, incentivizing them with rewards and governance tokens. However, the high volatility of crypto-based markets leads to strong price swings. DEXs are therefore forced to periodically recalibrate token prices to maintain balance, and investors often lose money in the process.

Scalability is another major concern. This causes network congestion, leading to spikes in transaction costs. Ethereum is famous for this, with gas fees reaching $60-$70 during peak traffic. The situation looks bleaker given that Ethereum dominates over 54% of DeFi markets. Because DeFi becomes a liability if fees exceed returns.

Besides these specific concerns, there are some issues plaguing crypto markets that also affect DeFi. There are carpet pulls, pump and dump systems, phishing attacks, dodgy advertisements, and bogus airdrops. Even popular DEXs are not free from such issues – with over 50% fraudulent token listings, making them fertile ground for all-in draws. The Squid Game mat jumper is still fresh in our memories.

Innovative technology and user awareness: a happy marriage

Innovators need to do their part to fix DeFi’s pain points. But they can’t do much without user awareness. There are different ways for individuals to perform due diligence. And they don’t have to compromise.

Progressive DeFi protocols engage third-party auditors to detect and fix vulnerabilities in code. They also offer bug bounties to freelance hackers for this purpose. Users should review these records and filter protocols accordingly. It is also prudent to learn about previous security issues and how the protocol has addressed them.

Overcollateralization is a standard solution to counterparty risk in decentralized lending, as mentioned earlier. But this does not guarantee refunds on its own. Investors need to dig deeper to understand the nature of the collateral. The type of collateral and the percentage available for borrowing are crucial factors. Knowing the conditions under which a protocol liquidates the collateral also makes it possible to detect and avoid counterparty risks.

Interestingly, however, new age lending protocols offer under-collateralized lending to lower barriers to entry, despite optimizing security and minimizing counterparty risk. EasyFi belongs in this league, leveraging its proprietary privacy-preserving algorithms. It is a stepping stone to solving DeFi problems for good.

Anyway, back to safe practices, we have impermanent loss calculators. Users can use them to assess the extent of possible losses with back-calculation formulas. Additionally, historical token price data provides insight into the future performance of the investment, supporting informed decision-making. But it’s also worth noting that predictions based on past performance are never entirely accurate.

DeFi users need to realize this overall – if something is too good to be true, it most likely is fishy. It is therefore mandatory to undertake rigorous research before investing. Be wise and careful, not capricious and greedy. Avoid red flags like anonymous teams, dormant social media profiles, and crazy APYs.

Finally, we should not lose hope or deny that DeFi is doing well, despite its vulnerabilities. Its TVL is currently equivalent to the 2017 GDP of Greece. With innovations and awareness going hand in hand, it will reach new heights. It is the horizon, after all, beyond which lies the future of user-centric and community-oriented finance.

About the Author:

Ankitt Gaur is the CEO and 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 with its MetaFi platform. Ankitt is also a global consulting professional enabling businesses around the world 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.


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