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Written by Yemu Xu | ARPA Network and Bella Protocol
The advantages that Decentralized Finance (DeFi) offers over Traditional Finance (TradFi) are becoming more apparent by the day. Many of us working in the blockchain industry experience them every day. However, we must also acknowledge that despite these advantages, DeFi as a whole is far from perfect… Where DeFi leads in issues such as privacy and efficiency, it lacks in areas like stability and support.
There are a number of problems that can arise when DeFi doesn’t have the proper safety protocols in place. But rather than reinvent the wheel and wait for completely new approaches to problems that have plagued the financial industry before, let’s draw from the past to take the best of what works. While DeFi represents a new way of thinking and has the potential to address systemic issues that have held many people back, there is a lot that we can learn from TradFi to get over the hurdles we still face.
It may be a tough pill to swallow… but there are some learnings in TradFi that we can apply to DeFi, which may be necessary to move the industry forward.
The advantages of TradFi
For DeFi to learn from TradFi, let’s consider a few advantages. For many people, TradFi provides all of the services they require and can do so effectively.
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Regulation and security – Traditional financial institutions are regulated by governments and are subject to a number of security systems. When they fail or commit fraud, customers and victims have a well-established means of finding compensation. If the movements by the SEC are to be trusted, more regulation is coming to DeFi, and the reaction to it by the industry should be positive given the legitimacy it brings.
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Financial Stability – Traditional financial institutions are backed by governments, have strict regulations in place, and generally behave in predictable ways. This helps to ensure many TradFi institutions are highly stable and can be expected to remain so. While failures do happen, they are considered catastrophic events. While DeFi cannot provide the exact same security to its customers, the industry should strive through improved practices and shared standards to reach its own version of stability that it can tout to the public.
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Customer Support – As anybody who has ever been on hold for an hour can tell you, no customer support system is perfect. However, as a rule, most TradFi institutions have better customer support systems in place than DeFi institutions. DeFi protocols, which often have little to no customer support systems, must create and expand these networks to increase ease of use.
Perhaps most importantly, there are a number of services that TradFi can offer that DeFi is not yet prepared for. Loans are still a difficult area for DeFi, with many protocols requiring over-collateralization of issued funds. Traditional banks rarely face this problem. Most traditional financial institutions are insured by the FDIC in the United States or similar organizations in other countries – a comparative rarity in DeFi.
How DeFi Can Make Progress
There are a number of ideas from both within and without DeFi that can help overcome some of the issues facing the sector. Here are just a few.
Perhaps the first problem that DeFi must overcome is the issue of trust. While DeFi protocols are designed to be trustless, this does not mean that users can operate on these platforms without any trust at all. Users still need to trust the underlying technology, the security of the smart contracts, and the developers behind the protocol. Unfortunately, many folks still do not trust crypto or directly associated financial systems.
A credit rating might be a system worth introducing but not completely cloning. For example, one mechanism that needs to be reconsidered is the practice of the issuer paying for the rating services. This severely undermined the impartiality of agencies such as Standard & Poor’s and Moody’s during the 2008 financial crisis. In the world of DeFi, the ratings can be conducted in a decentralized way that leverages the collective wisdom of all the stakeholders with transparency guaranteed by on-chain data. Theoretically, DeFi platforms can create a credit scoring system that is unbiased, tamper-proof, and resistant to fraud.
Additionally, many DeFi institutions are becoming more serious about regular audits and proving their reserves. This, which is also practiced and often required by law in TradFi, would go far in restoring trust in the sector. While it may be some time before government inspectors confirm the stability of DeFi protocols, nothing is preventing these protocols from undertaking their own audits or calling upon a trusted auditing company.
Security is also an issue. Theft and exploitation of bad code is a menace that steals millions and causes further limitations. One of the biggest challenges in DeFi is ensuring that users can interact with the protocols in a safe and secure manner. Easier UI to reduce risks to customers and industry standards on software could reduce accidents.
The challenge of course is incorporating these changes while still remaining true to the ethos of DeFi. It is entirely possible that DeFi could learn the wrong lessons from TradFi and repeat the recent crisis in Centralized Finance (CeFi). The failure of FTX is a recent example and appears to have been caused by a combination of fraud, poor management, and a failure to properly incorporate TradFi ideas into crypto by those in charge. In addition to incorporating TradFi ideas of focusing on ease of use for the customer, it appears to have taken vices of greed, placing publicity above ethics, and acquiring more assets than it could handle.
Overall, DeFi institutions are providing a number of financial services in ways that traditional institutions cannot. However, they are still subject to failures, and the nature of their operations can expose them to certain vulnerabilities. A number of possible improvements for DeFi exist, both in other DeFi operations and in TradFi. As a sector, DeFi should consider these possibilities for the sake of improvement.
Why This Matters – The Repercussions When DeFi Can’t Do What It’s Supposed To Do
The reality is that DeFi platforms can fail. And when they do, they can lead to losses for both customers and investors. Theft of money from institutions, such as the $622 million Ronin Bridge incident or the $190 million Nomad Bridge event, can lead to substantial losses for the individual.
These thefts are tied to hacking events that exploit key features of DeFi institutions. The dedication to transparency seen in DeFi means that many apps and protocols have open-source code. While this is an effective way to be transparent, it also allows bad-faith actors to pinpoint vulnerabilities or flaws that can be exploited. The rapid pace of development in the sector contributes to this, as the need to get a protocol launched quickly can limit the time dedicated to quality control.
When there is no theft, sometimes there is simply poor planning. As a number of analysts pointed out, some protocols failed to find an adequate source of revenue, have poorly structured tokenomics systems, or rely on overleveraging. Good values can’t save poor design, and many protocols and Dapps were poorly designed.
Some other vulnerabilities include:
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Reliance on Markets – DeFi is subject to the same market volatility and occasional liquidity shortages as TradFi. Just this year, Everland, a Solana-based platform, announced that it would cease operations as the result of a liquidity shortage and a downturn in the lending market.
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Lack of Regulations – Preparing for and complying with regulations can be onerous enough… This is exacerbated when the regulations themselves remain unclear. The specter of new, currently undetermined, regulation, poses a risk to confidence in DeFi.
Lastly, DeFi has faced a slight trend toward centralization over the past few years. Maker has been criticized for the concentration of its governance tokens, its reliance on centralized assets, and how dependent the rest of the DeFi system is on it. While, in this case, MakerDao shifted back towards decentralization, DeFi may not always be so lucky.
These failures are often of a different kind than happen in TradFi. Importantly, when TradFi institutions fail, there are often a number of options for customers to attempt to recover their losses. For example, banking insurance in the United States guarantees depositors at insured banks protections for two hundred and fifty thousand dollars in the event of a bank failure. No such system exists in DeFi. When a person sends money to the wrong person in TradFi, they may be able to expect that money back. In DeFi, this is rather unlikely.
Yemu Xu is a serial entrepreneur, investor, and early adopter of crypto assets. He is Co-Founder at Coinbase-listed ARPA Network and Binance-listed Bella Protocol, as well as ZX Squared Capital, an option strategy--focused crypto hedge fund. He is recognized by Forbes Magazine as one of the 30 Under 30 in Asia (2022), Forbes 30 Under 30 China (2022).