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DeFi’s path to overtake traditional finance

The summer of 2020 witnessed the mania of Decentralized Finance (DeFi) which swept the crypto world with its market value once exceeding US$1 bn and hundreds of billions of digital assets involved in the financial services provided by DeFi products. As the market gradually cools down, you might as well wonder apart from being characterized with high APY, how DeFi should further develop, and what products and functions should be created for it to outstand from traditional financial institutions and even to replace some of its counterparty’s functions thus, bringing people who are not accessible to traditional finance the convenience of financial services.

This article starts from analysis of current financial products in DeFi, followed by a comparison on the advantages and disadvantages of DeFi versus traditional finance, and at the end of the article presents personal opinions on future development of DeFi. We believe that DeFi, for now, has its most value in permissionless and anti-surveillance while current services in DeFi have their deficiency in privacy, scalability, usability and liquidity. Under current landscape, only when a stable coin that fully supports anonymity and cross-chain interoperability and the relevant DeFi protocol being created can the tremendous value of DeFi be released and deployed, and it is at this point that DeFi will have the chance to overtake the traditional financial industry.

Current DeFi financial products mainly include 1) Stable coins, insurance, payment and custody services. 2) Decentralized exchange. 3) Credit lending services, which demonstrated a gradual development of DeFi initiated since the creation of MarkerDao in 2015. On one hand, MarkerDao is the first stable currency with real assets backed and decentralized adjustment mechanism in decentralized finance, followed by the development of decentralized payments. However, it was not until Uniswap, which created an efficient decentralized exchange system through AMM that the DeFi world embraced the real market adjustment — just like how the market adjusts through currency exchange in traditional finance. On the other hand, the lending business launched by MakerDao and Compound is the embryo of financial services in DeFi. Thus, a decentralized financial services system is supposed to have a stable coin that has the basic purchasing power, a token exchange system and relevant lending services.

For understanding the nature of DeFi, we first need to clarify its definition — DeFi generally refers to the financial services originally conducted by centralized financial institutions but now moved onto and carried out via blockchain technology. What’s worth noting here is that although DeFi does not require users to trust centralized institutions, it doesn’t mean it is “Trustless (no need to trust)”. Still, users are supposed to have trust in the security of a specific distributed computing system. Despite that the recurring hack attacks imply a high cost in trust, this cost, compared to that of centralized financial institutions, can be extensively reduced when codes are transparent and auditable.

Secondly, financial services in DeFi have their advantage in permissionless. Compared to traditional finance, the current DeFi does not require the approval or authorization of a third-party organization. Any user who master relevant tech-operating knowledge and network infrastructure can have access to its financial services. This is where one of the core values of DeFi lie in, and where a potential opportunity emerges for it to satiate the financial needs of 1.7 billion unbanked people around the world by providing seamless financial services and improving equality in the industry of financial services.

Thirdly, DeFi is anti-surveillance. Out of specific interests and competition purposes, governments, financial institutions or third-party institutions will close the accounts of individuals or companies or even countries and restrict their transactions. In weakening confrontation and potential threats from political opponents and countries, the government will also restrict or block the financial services of these entities. US financial sanctions imposed on Iran and other countries are examples of these kinds. Similarly, loan applications could be rejected and certain investigations could be performed in case the subjects are politically sensitive. In a decentralized world, credit to its permissionless, centralized institutions are not able to review or restrict users’ financial services without tracing users’ digital assets back to their identities.

However, DeFi still has issues in privacy, scalability, interoperability, usability, and liquidity. Analysis on these short comings is as follows:

1) Privacy

Although the current distributed ledger is characterized by a brand-new payment model without the participation of third-party financial institutions, due to the transparency of blockchain technology, most of the cryptocurrency transactions are still traceable. In countries where cryptocurrency is strictly regulated, taxation or judicial departments can locate the holder’s encrypted assets via specific cryptocurrency public keys. However, it is undoubtedly that companies and individuals are reluctant to share their transaction flow information and be controlled by competitors or third-party organizations that may affect their business interests or receive advertising or phone frauds. Thus, the decentralized system in which transaction records are available to the entire network makes it hard for users to retain privacy and anonymity. It hugely dims the advantages of DeFi in permissionless and anti-surveillance as regulators can easily trace the encrypted assets holders through public addresses and bring them under supervision.

On the contrary, in centralized financial services, users’ transaction amount and assets information have long been only inaccessible to anyone except the financial institutions, which actually is privacy-friendly. Whatsmore, centralized financial payment services such as Alipay supports the function of sending and receiving money anonymously as well. Thus, although centralized institutions bear systemic risks and single point of failure, their products actually meet the privacy and anonymity need of users.

In cryptocurrency, with the development of privacy computing and cryptography technology, anonymous tokens are intended to meet the needs of anonymity. From the advent of CryptoNote, the first protocol for solving digital privacy issues in 2012, to the later Monero, Dash, and ZCash, anonymous tokens have become an important sector in the crypto world. As of November 6, 2020, its total market value has reached US$3.53 bn., taking up 1.2% of the total encrypted tokens market value. Nevertheless, the current development of technical solutions for privacy tokens is unbalanced – the volatility in anonymous tokens and its restrictions in scalability and low cross-chain interoperability impede its application in DeFi.

From the perspective of technological development, zk-SNARKs has achieved end-to-end complete anonymity, i.e. the sender can prove the legitimacy of the transaction to the verifier without revealing the transaction amount, address and other details. If stable coins can deploy similar technology mentioned above, from a technical perspective, anonymous transactions can be satisfied in the decentralized world. Also, given that the protocol is open-source and auditable, cost efficiency and system security can be both achieved.

Graph :Privacy technology traits




Sender privacy Receiver privacy Currency amount privacy Anonymity No third-party involved
Private address No Yes No Yes Yes
Ring signature Yes No No Yes Yes
Coinjoin Yes Yes No Strongest No
zk-SNARKs Yes Yes Yes Weakest Yes
RING-CT No No Yes Yes Yes
Mimblewimble No Yes Yes Yes Yes

Sources: Token Roll, Fenbushi Digital

2) Scalability and interoperability

The scalability issue in the crypto world mainly lies in the scalability constraints on Bitcoin and Ethereum. Although a sound infrastructure is constructed on top of Ethereum Turing (with its complete smart contracts and programming language Solidity) and Ethereum Virtual Machine, it can only process 15-25 transactions/second, the major barrier for it to be a “killer application”. In this, large-scale transactions tend to cause network congestions and high gas fees and eventually extremely uplift transaction costs. Thus, it is not ideal for basic financial services such as small-sized transactions and loans. However, what’s contradictory now is that due to the maturity of the smart contract platform, user awareness, and a large number of ERC20 assets, more than 90% of DeFi projects are built on Ethereum. We also notice that competition emerges not only from competitors such as Polkadot, Cosmos, and Tron but also from the upgrade of Ethereum itself (v.2.0) and its expansion solutions for better performance

Compared to centralized cryptocurrency financial service platforms. The current cross-chain interoperability of DeFi still needs improvement. Due to the different formula in protocol among public chains, it is hard to complete transactions and information transmission between mainstream cryptocurrencies in a decentralized manner, resulting in transaction difficulty across different public transactions on DeFi platforms. The later emerged tokens such as WBTC and synthetic assets are solutions to this problem to a certain extent, but improvements in terms of transaction speed and ease of use are still areas that need huge progress

In comparison to other solutions, the over-centralized design of TRON and the hidden security risks of Cosmos bestowed the design of Polkadot’s heterogeneous cross-chain with a superior advantage. Transactions on Polkadot can be distributed in different areas while ensuring security. At the same time, its high interoperability ensures seamless links between public networks, private chains, oracles and unauthorized interfaces, enabling independent blockchains solution to exchange information through the Polkadot parachain. From the perspective of a developer, they can develop DeFi services at a very low cost with the Substrate framework. Besides, Polkadot has funded more than 120 projects and incubated a rich ecosystem that includes stable currencies and synthetic asset platforms such as Acala, Laminar, Equilibrium, etc., which will allow Polkadot users to use and own financial services and assets on other blockchains.

3) Usability and liquidity

We believe that these two are endogenous factors. The current projects such as Uniswap and Compund have proved that DeFi does have strong usability and can guarantee sufficient liquidity. However, future limitation lies in how to ensure further scalability and to provide financial services with high cross-chain interoperability. Ethereum and other public chains face the same issue as well and are seeking viable solutions to these problems.

In conclusion, despite the basic coverage of basic financial services on DeFi, the market potential, and advantages (low cost of trust, permissionless, and anti-surveillance), DeFi is also facing issues in terms of privacy, scalability, and interoperability, as well as availability and liquidity. For now, we need an easy-to-use protocol based on zk-SNARKs for end-to-end complete anonymity, high throughput, high cross-chain interoperability (support mainstream cryptocurrency and stable currency), and security (open source and auditable code). From the perspective of infrastructure, other than the unforeseeable Ethereum 2.0, the development of Polkadot based on the Substrate framework would be a better choice to accomplish the above functions. We believe the real potential of DeFi will be released by the stable coins, swap trading platforms, lending platforms, and synthetic asset platforms further developed from such protocol.

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