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DeFi has withstood market tests, but there are still challenges that need to be addressed.

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The opportunity to build a new generation of financial services on the DeFi track has never been greater, but this industry needs to address some significant challenges.

Original Title: "DeFi is the way forward, but it needs to evolve"

Original Author: Jesus Rodriguez & Co-founder of IntoTheBlock

Translated by: Block unicorn

The technological foundation of DeFi has been proven to have incredible resilience to the catastrophic market events of the past few months. The opportunity to build a new generation of financial services on the DeFi track has never been greater, but this industry needs to address some significant challenges.

The recent events in the cryptocurrency market have once again confirmed the value proposition of decentralized finance (DeFi), which is one of the core components of the future of digital assets. However, the DeFi space has also been affected by market changes, as many of its top participants have actually disappeared, creating a very strong friction for the future of DeFi. In some ways, the challenges of centralized financial (CeFi) institutions should be beneficial to the adoption of DeFi protocols. On the other hand, the fundamental market conditions that sparked the recent DeFi summer no longer exist. While we all agree that DeFi should be a key component of the next phase of the cryptocurrency market, the specific details are not insignificant and may require significant industry changes.

DeFi Adopts Paradox

From a philosophical perspective, DeFi is a movement that embodies the true spirit of decentralization, resistance to censorship, and financial inclusivity. The recent DeFi craze has seen both tremendous levels of protocol innovation, but also an unsustainable wave of artificial incentives that have fueled disproportionate yields and attracted some of the biggest players in the cryptocurrency space. Recent changes in the composition of the cryptocurrency market have led to all-time lows in total value locked (TVL) for some protocols and near non-existent activity for some DeFi ecosystems. Nevertheless, DeFi protocols have largely maintained an incredible resilience, while some of the largest centralized institutions in the cryptocurrency space have completely collapsed.

The cryptocurrency market is relatively small, and CeFi and DeFi are intertwined in an almost contradictory way. Although DeFi infrastructure can maintain recent market fluctuations, the collapse of CeFi institutions has put great pressure on DeFi protocols.

In short, DeFi is thriving in a market that no longer exists. In order to fully realize its potential in new cryptographic implementations, DeFi needs to constantly evolve. However, this evolution can be transformed into a huge opportunity. To find its place in the financial services foundation of the cryptographic field, DeFi needs to improve in five key areas.

Capital Efficiency

The first generation of DeFi primitives that dominated the market embodied the principle of democratizing programmable financial services, but they came at the cost of sacrificing capital efficiency. Automated Market Makers (AMMs) are an incredible innovation that can promote transparency in financial markets, but they lack the efficiency of a centralized order book.

Excessive collateralized loans have driven astonishing innovations such as Lightning Loans, but this is a textbook definition of low capital efficiency. Building a new wave of DeFi protocols with a strong capital efficiency foundation is crucial to simplifying DeFi adoption. Ideas such as hybrid decentralized exchange (DEX) platforms that combine order book and AMM mechanisms or semi-collateralized/collateralized loan protocols may unlock some value in this field.

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translates to

Credit

Over the past few months, the cryptocurrency lending market has been under pressure. Many market leaders who offer fully delegated loans have either gone bankrupt or are still unable to operate. Therefore, establishing new credit mechanisms in a transparent manner has become one of the most attractive opportunities in the cryptocurrency market. One way to improve DeFi's credit is to establish new forms of low-collateral or semi-collateralized loans. Although there have been some attempts in this field, they are difficult to be considered as DeFi and suffer from inherent risks of lending to market makers. An alternative solution to provide loans to parties with predictable on-chain activities, such as collateral providers, miners, or DeFi protocols, may be worth exploring in this area.

New Financial Terminology

Today, most of the activities in the DeFi industry are dominated by two main protocol primitives: market making and lending. While these factors are certainly important, they are not enough to establish an effective financial market. DeFi urgently needs new financial primitives to achieve the traction levels experienced by AMM and lending protocols.

It seems that derivatives are an obvious area for expanding the financial primitive set in DeFi, as they play a role in capital efficiency and risk management. The DeFi derivatives sector has been steadily growing, with protocols such as Ribbon or GMX undoubtedly demonstrating the potential of this field. However, most DeFi derivative protocols still have not gained meaningful adoption, and more innovation is certainly needed in this area.

Risk Management and Insurance

The events of the past few months have made risk management the primary requirement for institutions participating in DeFi. In DeFi, the forms of risk are very different from traditional markets, so new forms of risk management technology are needed. Initially, DeFi's risk management efforts focused on the use of technical smart contracts, which, although important, only represent a portion of the risks faced by investors participating in DeFi.

Economic risk management is one of the biggest opportunities for catalyzing institutions to adopt DeFi. Solutions for managing economic risk conditions, such as fund pool composition, decoupling, slippage, and the impact of whales, require the level of rigor that large capital market institutions need when adopting DeFi on a large scale. One of the most interesting forms of risk management will be insurance products. Economic insurance in DeFi is still a fundamentally unsolved problem, limiting the choice of creating complex institutional structured products on the DeFi track.

TradFi's Bridge and Real-World Applications

Over the past two years, DeFi has been a cryptocurrency-to-cryptocurrency market with limited exposure to off-chain applications. While the cryptocurrency-centric dynamics have been key to accelerating innovation in the field, it has limited the sustainability of DeFi as a financial market. For example, sustainable returns in financial markets come not only from market asymmetry, but also from creating impact in real-world enterprises, and DeFi needs to recreate a similar dynamic.

Building a bridge to traditional finance (TradFi) applications can bring a new wave of opportunities for DeFi, transforming it into a new avenue for financial activities. Protocols like MakerDAO have already attempted this idea by providing loans to traditional financial institutions.

Thoughtful Regulation

Speaking of DeFi, there are few topics that polarize opinions as much as discussions about regulation. Regardless of which side of the regulatory argument you agree with, it is hard to deny the fact that recent changes in the cryptocurrency market have given rise to a more aggressive regulatory agenda that will eventually touch on DeFi.

Regulation will definitely be harmful to the innovation happening in DeFi, but if implemented thoughtfully, it represents an interesting opportunity for institutions to adopt this space. Many regulated financial institutions are struggling to reconcile the financial benefits and opportunities of DeFi with the regulatory uncertainty surrounding the space. Protocols implementing forms of regulatory control can certainly fill this void. Most initial efforts to enforce Know Your Customer (KYC) procedures on DeFi protocols have been limitedly adopted, but the opportunity to assess protocols for regulatory compliance using on-chain data is intriguing. Heavy-handed regulation could be very harmful to DeFi, but thoughtful regulatory control could open the door for a new wave of institutional adoption.