By Amrit Kumar, President, Chief Scientific Officer and Co-Founder of Zilliqa
In the early months of 2020, the coronavirus pandemic brought the world economy to a near halt as stock prices toppled, sending global financial markets to the brink of collapse. The crypto market was hardly spared from the impact, as prices dropped as low as 40 percent this past March 12. In response, DeFi users were quick to pivot. Amid the market shocks of March, users quickly transitioned from “the long game of lending and borrowing” on decentralized applications, instead flocking to safe-haven assets such as stablecoins.
According to industry site DeFi Pulse, the total value of digital assets locked in the DeFi ecosystem’s financial products had jumped to $7.88 billion on August 30—up from an estimated $700 million last December. With the creation of new services such as stablecoins, decentralized exchanges, borrowing and lending, the DeFi ecosystem has been steadily inching towards maturation. However, amid recent security scares and mounting transaction fees, it seems that the sector’s explosive growth is taking place at the expense of sustainability and stability.
The DeFi utopia
For those in the tech industry, the promise and possibility of innovation is what ultimately underscores every endeavor and the emergence of DeFi is no different. The traditional financial services sector holds tremendous power over our daily lives—though delicate and dynamic by design, it also discriminates. Today, access is afforded to a privileged few, inequitably distributed across different strata of society. For one, the World Bank estimates that there remain 1.7 billion unbanked adults, each unable to access basic financial services across the globe. Meanwhile, the International Finance Corporation (IFC) estimates that 65 million formal micro, small, and medium enterprises (MSMEs) in developing countries see an unmet financing need of a whopping U.S. $5.2 trillion every year. In light of these existing inequalities, the rise of DeFi looks to pioneer a new vision of finance that is open to everyone—irrespective of where they are or their financial standing.
Driven by the goal of enabling a more equitable financial world, much of DeFi’s appeal has to do with its vision to create a more open, inclusive, and transparent financial system. With the potential to radically upend the traditional financial status quo, DeFi could tackle legacy finance’s long-standing problems, from increasing liquidity to driving greater cost-efficiencies. It could also offer novel approaches to assessing risk, breaking down the existing exclusionary measures in place today that limit access to those of modest means, reserving the best instruments for those with more funds.
At this point in time, the majority of today’s DeFi applications tend to focus on investments and trading with the overarching aim of making such activities more accessible to everyone. With lower minimum requirements and accessible from any smartphone with an internet connection, regardless of geographical location, these applications are distinguished by their ease of use. As a borderless, open alternative to financial services such as savings accounts, insurance, loans, trading and more, DeFi holds the potential to accelerate financial inclusion and provide greater opportunities for all, especially for the unbanked and the underserved.
The irrationality of trust and trustlessness
Most DeFi platforms take the form of decentralized apps, known as Dapps, which utilize a series of smart contracts to automate financial transactions. This makes them faster, more efficient, and often more cost-effective than their centralized counterparts. Because Dapps are primarily governed by computer code, it eliminates the need for a central authority and remains inherently neutral, so there would be no issue of bias. The decentralized aspect of keeping a distributed, tamper-proof ledger also means there isn’t a single point of failure; rather, identical records are kept across thousands of computers via a peer-to-peer network.
In addition, dApps will have limited need for middlemen such as trusted third parties (TTP), banks, or clearing houses—this way, DeFi creates a truly trustless system in which users will essentially be custodians of their own assets. Presently, most of our existing monetary and financial systems verify their transactions through a central bank and trusted intermediaries. By leveraging the features of blockchain, DeFi provides the opportunity for us to transition from trust traditionally placed in credit institutions like governments and banks and into code. However, amid frequent occurrences of minor and major security incidents, is there still an appetite for placing trust in code on a mass scale?
Smarter, better, faster… safer?
Despite its promise, DeFi is young and is certainly far from the pinnacle of its maturity. However, there are some trade-offs here: while we’re on the brink of a better world, should we look beyond the risks that come with nascent solutions in favor of creating a more equitable system?
While DeFi platforms may not be at risk of security breaches in the same ways that centralized systems are, the reality is that these platforms are not completely safe from hacks. In the second quarter of 2020 alone, Consensys’ Q2 2020 Ethereum DeFi Report found that the DeFi ecosystem experienced three major security breaches, amounting to approximately U.S. $26 million lost due to hacks across three different projects. With smart contracts responsible for handling a significant quantity of funds, smart contract code risks cannot be underestimated.
The issue with most DeFi platforms and applications is the lack of a quality assurance process—as the space remains mostly unregulated, the security of the platform largely depends on the code it was built on, and the level of audits and security checks that have been put in place to detect potential attacks. Similarly, by leveraging on the open source nature of the space, developers have been increasingly far more transparent about coding flaws in their contracts, issuing detailed blog posts and post-mortems to ensure that their users are kept informed and fellow peers can equally assess their own infrastructures for possible red flags.
As the DeFi ecosystem looks to cement a far more sustainable future, infrastructures need to be built with greater security considerations in mind. Writing test and migration scripts can also be one way to ensure the security and quality of smart contracts. To mitigate human error, programming languages should be built with security in mind. DeFi protocols should take additional steps to safeguard their platforms and eliminate any vulnerabilities within the system—for instance, conducting a full external security audit, and planning for a testnet launch to ensure the functionality of security measures could be useful in enhancing the security of their DeFi networks.
Finally, all of these efforts can be further bolstered with self-regulation and collaborating with governments to hold Dapp operators to a higher standard. The DeFi space would greatly benefit from a credible body auditing and validating reliable projects, explaining where the app might be in its lifecycle. Meanwhile, progressive regulations can help to shape a far more friendly space to encourage compliance across the DeFi ecosystem. For example, the formulation of a cross-border DeFi working group would help to substantiate the technology further, giving it the much-needed growing room and pathways to work with legacy institutions while maintaining the spirit of decentralization and censorship resistance.
Losing the rose-tinted glasses
As protocols grow in number and complexity, more security vulnerabilities and compromises are likely to occur. Though regrettable, these incidents are part of the growing pains of any emerging technology. In order for DeFi to chart the right path towards mainstream adoption, the industry needs to start communicating the risks in order to ensure that newcomers don’t find their life savings disappearing within the labyrinth of indecipherable code. Companies developing DeFi dapps must be measured by their transparency.
Despite DeFi’s promise, the participation or, at the very least, the inclusion of traditional players is largely here to stay. For the time being, the two opposing camps of decentralized finance versus centralized finance must put aside their differences and come together to find a way to minimize collateral damage to investors and unsuspecting users. With security and transparency in mind, DeFi can hope to see a different future ahead of itself—one less defined by quick gains and the sporadic rise and fall of token prices, and instead, a model that ultimately puts long-term sustainability at the fore, underscored by a customer-centric approach that offers mass-usability and inclusion.
About Zilliqa & Amrit Kumar
Amrit Kumar is the President, Chief Scientific Officer and Co-Founder of Zilliqa. Focusing predominantly on areas of security, privacy and applied cryptography, Amrit’s research has been widely published at conferences such as IEEE/IFIP and IFIP TC-11 SEC. Amrit received his PhD from Université Grenoble-Alpes, France and was hosted at Inria’s Grenoble center. Prior to his PhD, Amrit obtained a Master’s Degree in Security, Cryptology and Coding of Information Systems from École Nationale Supérieure d’Informatique et Mathématiques Apliquées de Grenoble, France.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.