DeFi: Stop and Think. Part 2

    06 Jun 2022

    The ongoing cryptocurrency crisis, which coincided with a large outflow of funds from DeFi protocols, is a good reason to momentarily step back from the endless race for profitability and rationally assess the prospects of the decentralized finance industry. Having done so, we will immediately see what we need to change in DeFi to make it more resilient to such shocks.

    We have already written about how decentralized finance has gone down the path of high-yield usury and asset speculation. But it is incompatible with the real economy: regular businesses, manufacturing, or even trade require fundamentally different interest rates. At the same time, DeFi, of course, already has solutions to replace all traditional finance sectors – from insurance to acquiring. However, they didn’t get much distribution, as everyone focused on farming profitability.

    As a result, protocol innovation in DeFi has stalled over the past two years. It is especially true for protocols like MakerDAO and Compound, which have become the market standard. And while many startups have developed derivatives with additional features, most of them have not made much progress in taking market share away from the industry giants.

    A brief recap: MakerDAO started with a simple idea – to create a stable currency (Dai) backed by a volatile asset. Dai’s unified collateral was an amazing achievement – ​​and the first real example of decentralized finance’s potential. Since its inception, MakerDAO has evolved more than any other project and has consistently led DeFi in almost every way: fixed token value, collateral and borrowed assets, governance processes, organizational structure, and technical development.

    Shortly after MakerDAO’s Dai, Compound launched the first iteration of its DeFi money market, where users could provide as collateral and borrow multiple assets. Interest rates increased or decreased with demand. Similar to MakerDAO, the platform was the first of its kind and overcame numerous development hurdles before reaching the second version that everyone knows today. It has introduced the most popular contracts in the crypto business – Governor Alpha and Bravo. Some even consider Compound, which distributes governance tokens to users, as the catalyst for all DeFi. In a short while, the company has become synonymous with safety and modernization.

    The Aave project entered the scene a couple of years after Compound, focusing on technological innovation. They introduced a “stable rate” option and changed the cToken exchange system to the aToken rebase system. Today, the project is renowned for successfully operating multiple networks.

    MakerDAO, Compound, and Aave flourished by implementing new solutions. Compound had the opportunity to learn from MakerDAO, Aave took notes from Compound, and countless other DeFi protocols have benefited from the experience of all three. While there has been relatively little technical innovation over the past two years, the industry has seen remarkable organizational ingenuity in DAOs. In addition, the DeFi ecosystem as a whole has enjoyed astronomical growth, which is certain to continue after the current crisis.

    All DeFi project developers strive to become the industry leader. But to be the best platform, one needs both a well-functioning protocol and top-level work management. It is not enough to create an excellent protocol and expect the technology alone to bring you market dominance. Money markets and lending platforms require thoughtful and consistent supervision to achieve maximum success. After all, their business model is a combination of risk management and intelligent marketing.

    Every protocol needs a proper framework and tools to extend the management capacities with the ability to fine-tune the platform. Since markets and capital are volatile, the DAO behind the protocol needs to constantly reassess its standing and improve. Complacency creates opportunities for competitors. A newcomer to the market might offer a sought-after innovation, but maintaining the obtained leadership is a whole different game.

    The input protocol should be simple, secure, and adaptable. Simple protocols are the safest. Additional features may present more risk management tools, but there is a balance to be struck between simplicity and security. Simple and versatile protocols can be understood by a broader customer base; they encourage innovation in implementation. Importantly, protocols should not evolve so rapidly as to undermine their security; there must be room left for future developments.

    Governance token holders are responsible for maintaining the protocol, which prevents the centralization of power in a DeFi project. It is crucial, as a protocol cannot be safe to use without a solid foundation that is its community. Fair and transparent governance distributes control over the project.

    Maintaining the protocol typically means adjusting LTV, interest rate curves, and other parameters. The community must also consider the future of the platform. DeFi exists in an ever-changing landscape, and good management is necessary to guide the protocol development in changing circumstances, keep it competitive and further increase the platform’s market share.

    DeFi is following the path of traditional finance, moving towards derivatives. The options and derivatives protocols Ribbon and Dopex emerged last year, and although they are yet to gain widespread popularity despite strong monetary backing, there is little doubt that they will advance rapidly after the crisis.

    Still, the crisis first needs to be overcome. Fortunately, there are several optimistic signs on that front. For one thing, while DeFi tokens have performed poorly, the protocols themselves are doing well, having even gained some credibility with traditional finance.

    Secondly, the time has come for unification. There are currently lots of different exchanges and networks on the market, which is typical for a young industry. But after the creative explosion comes consolidation, which would prove beneficial for many existing projects. And the next growth wave could result from the proliferation of bridges, which will open up new markets and more efficient ways to use capital.

    At the moment, the industry is in a bit of a lull as all the obvious ideas have already been implemented. And while the first wave protocols will be with us for years to come (as were the early Web 1.0 and Web 2.0 projects), the long-term development of DeFi is an undeniable fact. The market structure that is being formed right now will become the basis for the financial world of the future – global, transparent and, by default, digital.

    Admittedly, decentralized finance today is facing a deep crisis. But let’s not forget how much work has gone into building DeFi from the ground up over the past few years. The foundation of an entire financial industry has been laid, but this effort is only a down payment. A lot of work still remains to be done, existing protocols must be developed and updated, and new protocols must carefully establish their goals and find a link to the real sectors of the economy. If DeFi is to become a daily routine for billions of people, current projects need to focus on building better protocols and more robust governance.

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