The Way Forward is DeFi, but it needs to evolve

Recent developments in crypto markets have confirmed the value proposition decentralized financing (DeFi) is one of the essential building blocks for the future of digital assets. The changes in the market have also affected the DeFi space, as many of the most prominent participants have disappeared. This is a combination of events that creates friction for DeFi’s future. DeFi protocols should be encouraged in some ways because of the problems with central financial institutions (CeFi). However, the market conditions that led to the DeFi summer have changed. Although we all agree that DeFi should play a significant role in the next phase, the details of DeFi are complex and will likely require major changes to the industry.

Jesus Rodriguez is the CEO at IntoTheBlock. This article is part Crypto 2023.

The DeFi adoption paradox

DeFi represents the only movement that truly embraces decentralization and financial inclusion. The DeFi rush of recent years was marked by both an incredible level of innovation in protocols and a disproportional wave artificial incentives that created unsustainable yields. It also attracted participation from some the most prominent companies in crypto. Recent changes in the composition of the crypto market have resulted in some protocols’ total value locked (TVL), at a multiyear low, and virtually no activity in DeFi ecosystems. DeFi protocols remain remarkably resilient, despite the fact some of the largest central institutions in crypto having collapsed.

CeFi and DeFi are almost inextricably linked to the crypto market, which is small. The DeFi infrastructure was able sustain recent market shocks. However, the collapse in CeFi institutions has put tremendous pressure on DeFi protocols.

Simply put, DeFi blossomed in a market that doesn’t exist anymore. DeFi must continue to evolve in order to fully realize its potential within the new crypto reality. However, this evolution can lead to huge opportunities. Five key areas are needed to help DeFi become the financial services foundation for the crypto space.

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Capital efficiency

The principles of democratizing financial services and capital efficiency were the foundations of the first DeFi primitives to dominate the market. Although automated market makers (AMMs) are a great innovation that fosters transparency in financial markets they lack the efficiency and efficacy of central order books. Overcollateralized lending has powered amazing innovations like flash loans – but it is the textbook definition of capital inefficiency.

It is essential to create a new wave DeFi protocols that are capital efficient and have strong capital efficiency foundations in order to streamline the adoption. Ideas such as hybrid decentralized exchanges (DEX) that combine order books and AMM mechanics or semi/undercollateralized lending protocols are likely to unlock some of the value in this area.

Credit

The crypto credit market has been in stress over the past few months. Many market leaders in discretionary lending are no longer available or have closed their doors. Building transparent credit mechanisms has been one of the most appealing opportunities in crypto. DeFi can improve credit by creating new forms or semi-collateralized loans. There have been some attempts, but they cannot be considered DeFi. These efforts have also suffered from the inherent risks associated with lending to market makers. It might be worth exploring alternative options that lend to parties with predictable activity on the chain, such as miners, staking providers or DeFi protocol.

New financial primitives

Today, the majority of activity in DeFi is controlled by two primary protocol primitives: lending and market making. Although these components are essential, they are not enough to build a functional financial market. DeFi needs financial primitives that can achieve the same level as AMMs and other lending protocols.

Derivatives appear to be the most obvious place to expand the set of financial primitives within DeFi, as they play a part in capital efficiency and risk control. DeFi’s derivatives industry has seen steady growth. Protocols like Ribbon or GMX are a good example of its potential. However, most DeFi derivative protocols still haven’t achieved meaningful adoption and more innovation is certainly needed in the space.

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Insurance and risk management

Risk management is now a top requirement for institutions that wish to be part of DeFi. DeFi presents risk in a different way than traditional markets. This means that new technologies are required to manage this risk. DeFi’s first risk management efforts were focused on technical smart contracts exploits. However, these exploits only cover a fraction of the risks involved in DeFi.

The biggest opportunity to encourage institutional adoption of DeFi is in economic risk management. Solutions that manage economic risk conditions such as pool compositions, depegging scenarios, slippage, whales’ impact and many others are required to establish the level of rigor that large capital market institutions need to adopt DeFi at scale. Insurance products will be one of the most intriguing forms of risk management. DeFi’s economic insurance remains a problem that is largely unsolved. This limits the possibilities for sophisticated, institutionally structured products to be created on DeFi rails.

TradFi bridges, real-world utility

DeFi has been a crypto-tocrypto market for the past two years with limited exposure to other-chain applications. The crypto-centric dynamic is key to innovation in the space but it has also limited the viability of DeFi as financial market. Sustainable yields in financial markets don’t just come from market asymmetries, but also from the creation of utility in businesses in reality. DeFi must recreate a similar dynamic.

Bridges to traditional finance applications (TradFi), can be a useful tool that brings a new level of utility to DeFi and opens up new avenues for financial activities. MakerDAO has been exploring this area through loans to financial institutions.

Careful regulation

There are few issues that are more polarizing than the discussion about regulation when it comes to DeFi. It doesn’t matter what side you fall on in the regulatory debate, it’s hard to argue that the recent changes made to the crypto market have led to a more aggressive regulatory agenda which will touch DeFi at some time.

Although regulations can be harmful to innovation in DeFi, they offer an interesting opportunity for institutional adoption when implemented well. Regulated financial institutions often struggle to reconcile the financial benefits and potential opportunities offered by DeFi with the uncertainty surrounding the space. It is possible to fill this vacuum with protocols that implement regulations. Although most of the initial attempts to enforce know-your-customer routines on DeFi protocols have not been adopted, there are intriguing opportunities to use on-chain data to assist with regulatory assessments. DeFi could be severely affected by brute force regulation, but it is possible to open up new avenues for institutional adoption with thoughtful regulatory controls.