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DeFi Faces Multiple Challenges On Its Way To Dominate Crypto

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DeFi incentivizes users by offering them more predictable returns than trading. A combination of promised yields and FOMO has driven DeFi growth. DeFi has its challenges, such as security, sustained returns, and stable prices.

Source: Adobe/pavel1964

While Bitcoin (BTC) maximalists remain skeptical, many other industry players believe that DeFi, or decentralized finance, is set to become the dominant sector within the cryptoasset industry. Decentralized finance has already been one of the fastest-growing sectors for a couple of years now, while the acceleration of its growth in recent months has brought even more attention to it.

As industry commentators told Cryptonews.com, DeFi is really the only sub-sector within crypto that has provable traction and an easily understandable value proposition. That’s why they believe it could become almost synonymous with the wider crypto industry.

The magic of more predictable returns

For basically everyone working in the space, yields are the reason why DeFi has grown so impressively in recent months. Brendan Forster, Co-founder of Dharma, an Ethereum-based crypto lender, said that DeFi incentivizes users by offering them more predictable returns than trading.

“The overarching driver has been ‘yield farming’ or ‘yield harvesting’,” he told Cryptonews.com. “Basically, several projects – Compound, Balancer, Synthetix – have introduced or revamped incentives for supplying capital to their projects. These incentives have catalyzed the inflow of a lot of capital into the systems.”

According to DeFi Pulse, assets worth USD 1 billion were locked into DeFi platforms as of June 1, yet this passed USD 2 billion by July 7. That’s a doubling in a single month.

Source: DeFi Pulse

Spartan Capital’s Jason Choi said that a combination of promised yields and FOMO (fear of missing out) has driven such growth.

“Compound launched its liquidity mining which incentivizes users to use the platform in return for rewards in COMP, a native governance token,” he told Cryptonews.com.

“At one point users were paying close to 20% APY [annual percentage yield] to borrow stablecoins simply to earn the rewards; many projects followed suit, with the notable exception of Aave, leading to an explosion in DeFi activity.”

Calculations from CoinMarketCap indicate that DeFi currently offers handsome returns.
Analyzing Compound, it estimated that lenders can earn interest and a rebate in COMP worth up to 68% of what they loaned, depending on the cryptoassets they lock into the platform.

Maintaining growth, solving problems

It may look very seductive right now, but DeFi has its challenges and problems. Working out how to sustain a healthy user base after the initial growth spurt has ended is perhaps the most urgent.

As Jason Choi warned, “I think the key for most projects that seek to use liquidity mining as a way to ‘hack’ adoption need to make sure that by the time their rewards run out, there’s enough value offered by the platform for users to stay, and not just cycle capital to the next yield mining farm.”

In other words, there’s a worry that the rewards offered by DeFi may not be sustainable. Another is that DeFi’s appeal is actually quite a niche right now, and that it can grow only when the primary crypto market is quiet or bearish.

“You often need to deposit 150% of your loan value in collateral before you can borrow money on any lending protocol,” said Jason Choi.

“That’s why most people who use DeFi tend to be speculators seeking leveraged exposure, or to engage in opportunistic plays (e.g. borrowing for governance, shorting assets). After all, what’s the point of borrowing USD 100 if you already have USD 150?”

For certain DeFi platforms, security is also an issue, particularly if the underlying platform is decentralized to an extent where hacks can’t easily be blocked. Decentralized exchange Bisq was hacked in April, while decentralized lending/margin-trading platform bZx was hacked in February, and attackers stole USD 500,000 from Balancer in June.

Lastly, there’s also the obvious point that DeFi’s growth depends on stable crypto prices.

From speculations to mainstream

Despite such issues, observers believe DeFi will continue to grow strongly in the coming years.

“I think it’s a matter of time before DeFi turns from a speculator’s playground to seeing more ‘mainstream’ adoption,” said Jason Choi. “For instance, Aave announced a new credit delegation model where users may borrow money with no credit checks or collateral, simply by relying on off-chain reputation.”

How far exactly can DeFi go? For Brendan Forster, DeFi could end up becoming ‘one’ with crypto itself.

“I believe that over the next 10 years, in order for crypto to succeed, the industry has to embrace and become ‘DeFi’,” he said. “I think the ongoing reliance upon centralized custodians for asset trading and storage is a meaningful danger to the entire industry, and that we’d be much better off embracing DeFi.”

(Learn more: Crypto Researcher Warns Of a Growing ‘Existential’ Risk To Bitcoin)

For some industry figures, the sky’s the limit for DeFi. CryptoMondays partner Lou Kerner says, “If you define DeFi broadly, then it’s a USD 1+ trillion market, just in stablecoins in five years.”

For Jason Choi, “DeFi is the only vertical with signs of provable traction.” He pointed out that DeFi platforms may offer mainstream investors a more familiar and convincing value proposition than cryptocurrencies themselves.

“Investors in traditional assets – both retail and institutional – can easily value many DeFi assets,” he said. “For most DeFi tokens, by purchasing the asset you are betting on the growth of the underlying platform, not on the proliferation of some spontaneous meme about why a token can be a better type of store of value than the fiat you’ve used since you were born, or Bitcoin.”

It’s for such reasons that DeFi’s recent growth isn’t likely to be a blip. Especially, if the sector can resolve security challenges and also work out how to sustain returns.


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