Decentralized Finance (DeFi) refers to financial applications built on blockchain networks that aim to replace traditional financial intermediaries with smart contracts and decentralized protocols. DeFi saw tremendous growth in 2020 and early 2021, with the total value locked in DeFi protocols rising from $670 Million in January 2020 to over $80 Billion by May 2021. However, the crypto market downturn since mid-2021 has led to a decline in DeFi activity. A new catalyst is needed to trigger another bull run in decentralized finance.
One of the biggest bottlenecks hindering further DeFi adoption is scalability. Ethereum currently dominates as the main smart contract blockchain for most DeFi applications. However, it can only process 15-30 transactions per second, leading to network congestion and high gas fees during periods of peak demand. Upgrading to Ethereum 2.0 and its proof-of-stake consensus will help scale transaction capacity.
Rollups like Optimistic and zk-Rollups that bundle transactions off-chain and submit only transaction data on-chain can improve Ethereum’s throughput. Sharding to spread network load across 64 new chains will also add scale. Alternatively, DeFi apps may migrate to more scalable smart contract platforms like Solana, which already does 50,000 TPS. As blockchain scalability improves, it will expand DeFi’s capacity and facilitate another growth cycle.
Real-World Assets in DeFi
The ability to incorporate real-world assets into DeFi protocols instead of only synthetic crypto assets will be a driving factor for mainstream adoption. Platforms like Centrifuge create tokenized representations of real-world assets like invoices, mortgages, and real estate on the blockchain. Having real-world collateral opens the door for more practical DeFi use cases in decentralized lending and other verticals than overcollateralized crypto lending.
MakerDAO’s addition of real-world tokenized assets as collateral for its DAI stablecoin is a significant development. Integrating real assets with the transparency, liquidity, and programmability of DeFi creates an attractive combo. More real-world asset inclusion in DeFi can position it for non-crypto native users and expand the user base.
The majority of activity in DeFi relies on decentralized stablecoins like DAI to avoid the volatility. However, even stablecoins have failure risks, as seen by the collapse of the Terra USD collapse. Algorithmic stablecoins need to evolve with better reserve mechanisms and oracles. Asset-backed stablecoins can also scale using diversified collateral and establish transparency with on-chain attestations.
An improvement in efficient, scalable, and secure stablecoin systems will provide a more dependable base layer for DeFi products. This can instill greater confidence in participants and drive a fresh wave of adoption.
Insurance and Derivatives
DeFi protocols are exposed to smart contract risks, hacks, and market volatility. Developing robust decentralized insurance and derivatives solutions can limit counterparty risks and insure against technical flaws or market crashes. Platforms like Nexus Mutual, CDx, Opyn and InsurAce cover various DeFi risks.
As insurance coverage expands across more DeFi protocols, it can entice risk-averse institutions and retail users. Innovations, like covered call options, futures, swaps, and other on-chain derivatives, can also hedge risks and stabilize sectors like decentralized lending. Mature insurance and derivatives landscapes will promote sustainable, long-term growth of DeFi.
One of the major advantages of DeFi is open composability between decentralized applications and protocols. Money Legos allow old protocols to be mixed and matched to create new derivative products. However, issues like fragmented liquidity across DEXs limit seamless composability.
As bridges, interoperability solutions and automated smart contract composition improve, it will expand the pace of financial innovation in DeFi. Cross-chain capabilities can also link assets across different blockchains like Ethereum, BSC, Solana etc. to boost composability. More composability expands the pace at which new “Lego” products can be assembled to drive user adoption.
Usability and Regulatory Compliance in DeFi
Many DeFi applications suffer from subpar user experience, with confusing interfaces overloaded with technical jargon. The high gas fees on the Ethereum blockchain also severely limit access for small retail investors and traders. However, solutions are emerging to improve usability and reduce friction.
Transitioning to lower fee Layer 1 blockchain like Binance Smart Chain, Solana or Avalanche can significantly reduce transaction costs compared to Ethereum. Layer 2 scaling solutions such as Optimistic and zkRollups can also enable low-cost transactions by handling bulk transaction processing off-chain. Additionally, fiat-to-crypto on-ramps like MoonPay are streamlining the process for new users to directly purchase crypto with a credit card to use in DeFi protocols.
Beyond cost, DeFi projects must focus on clean, easy-to-use interfaces comparable to mobile banking and finance apps that everyday users are accustomed to. Removing technical language and unnecessary features to create a simplified user experience is key. Partnerships with traditional finance companies can bring mainstream design expertise to the DeFi world. Educational resources, explainers, and 24/7 customer support can further enhance usability for non-crypto native users.
Regulatory uncertainty has always been an obstacle to DeFi’s growth. However, select jurisdictions are starting to provide clearer guidelines that legitimize DeFi activities without suppressing innovation. For example, Wyoming’s blockchain and crypto-friendly policies are attracting DeFi projects like AAVE to establish special purpose depository institutions (SPDIs) in the state to offer decentralized financial services through a regulated entity.
Additionally, the SEC’s recent settlement provided guidance to BlockFi on parameters for offering lending products without violating securities laws. Increased regulatory clarity gives builders and users more confidence to engage with DeFi protocols while opening the door for larger traditional financial institutions to participate. Overall, enhancing the usability and compliance of DeFi will be key to unlocking the next wave of mainstream adoption.
During the next crypto bull run, resolving these issues, such as scalability, real-world assets, better stablecoins, risk management, usability, and regulation, can set the stage for exponential DeFi growth. It may take a combination of these factors to put DeFi back on an aggressive adoption trajectory akin to 2020-2021. The building blocks are falling into place for DeFi to disrupt traditional finance this decade. However, another surge in innovation is needed to gain mainstream traction and for DeFi to deliver on its promise of an open, transparent, and user-owned financial system.