Since the DeFi summer of 2020, decentralized finance (DeFi) has led the crypto space’s rapid growth. Sadly, that feels like a lifetime away as the markets have tumbled, protocol vaults are being pilfered at will by nefarious elements, and investor confidence has gone so low that Total Value Locked in DeFi has plummeted. 

Without an iota of doubt, the wider global market downturn has played a role, but so has recklessness among developers when it comes to both cybersecurity and (often self-serving) inflationary token models. But how did DeFi get here? 

Built on Sand: Unsustainable Yields and Indiscriminate ‘Minting’

The self-destruct mode into which DeFi has launched itself is predicated on a tripod of problems. First, a significant chunk of DeFi has been built on shaky foundations — on tokens minted from nothing or tokens that finance other tokens at high interest rates, with no part of the entire activity having any real underlying economic activity to back the yields offered. You would not be wrong in describing DeFi as an estate with skyscrapers built on shaky foundations. 

As many investors have ultimately found out, investment prospects that look too good to be true often turn out to be just that. The DeFi summer of 2020 and early 2021 gave rise to several projects that promised yields that were not undergirded by any real economic activity. Some of the yields were at rates as high as 200%, and many were paid for by minting more of the same arbitrarily created tokens — essentially inflationary tokenomics or outright Ponzi schemes. 

DeFi often promises very high yields. Source: Trader Joe’s

This arrangement essentially created a system that required an ever-increasing number of new users to create demand as many rushed in due to FOMO. The promised yields could only be sustained as long as new users were forthcoming (essentially ponzis). 

Eventually, several DeFi operations offering tokens with high yields suffered catastrophic failures (Terra, Voyager, and 3AC to name a few), leading to a liquidity crisis that sent DeFi into a coma. 

It is important to state, however, that high yields are not inherently a problem in DeFi. Several projects have demonstrated the possibility of providing high yields with deflationary tokenomics. The problem with many DeFi projects, however, has been the indiscriminate minting of new tokens to sustain these high yields. 

Cybersecurity Has Not Been Prioritized 

More importantly, DeFi has become a breeding ground for hackers and other bad actors. Security issues, hacks and exploits of DeFi contracts and bridges have been widespread, and most notable DeFi platforms have suffered some form of exploit. The entire ecosystem has become a free-for-all vault where cyber criminals pilfer investors’ hard-earned funds with breathtaking ease. 

This year, a different summer came on board: The DeFi ‘hack’ summer. In the first half of 2022 alone, data have shown that losses from thefts, fraud, and hacks amounted to almost $2 billion at the end of Q3 2022. In 2020, this figure for the entire year was $1.9 billion. We saw 175 hacks in the first half of 2022, almost double the 90 we saw in H1 2021.

From bridge hacks to flash loan attacks, DeFi protocols across the board have been affected. Examples include the Ronin network, Polygon, Blizzard, Wormhole, Meter Bridge and, most recently, one of crypto’s golden children, BNBchain (BSC). Some of the hacks demonstrated how lightly DeFi protocols have taken their security practices, to put it mildly.

Many protocols lost a good portion of their reserves, and it took days or weeks before anyone noticed or disclosed a breach. There were also examples of protocols undermined by smart contract developers that the operators apparently hired without fully validating their identities. 

Poor Standards for Defining DeFi Contracts 

Lastly, the lack of a uniform standard for defining DeFi contracts has limited DeFi to native smart contract platforms and tools, which also limits potential for growth, universal clients and, ultimately, global adoption and eventual replacement of TradFi. 

That said, how does DeFi pick up the pieces and limp away from these doldrums? 

Securing DeFi to Secure Adoption 

While the global adoption of DeFi is inevitable, there is one factor that slows down its growth: Lack of security within DeFi space as a consequence of the increasing number of hacker attacks. Quite simply, DeFi will go nowhere without addressing the question of security and trust. 

Implementing fundamental security practices such as independent system monitoring and alerts would be beneficial, in addition to more rigorous and careful vetting and development. DeFi projects that will prove successful in the future will be those that approach security in a more fundamental and principled way while learning from these issues and events, given that these are DeFi’s early days.

DeFi Must Finance Real Economic Activity

One of the touted and expected benefits of blockchain technology is its potential to bring more of the unbanked into the global financial system. This represents a huge potential for the growth and uplift of certain deprived communities.

However, it has been a missed opportunity for DeFi thus far. Much of DeFi has simply focused on financial products for those already in the crypto community by building those products around the shuffling of crypto tokens and other ‘degen’ things that have no real utility. 

DeFi’s maturation would be bolstered by addressing the aspirations of the unbanked and underbanked in the real world. More emphasis on DeFi as a vehicle of banking and insurance would do DeFi more good than the current narrative where DeFi exists primarily as a vehicle of investment, and, in some cases, getting a quick buck. 

For instance, taking advantage of the ability to tokenize real-world items using similar standards as ERC-721 for nonfungible tokens (NFTs), “buy now, pay later” (BNPL) DeFi products are beginning to surface. Some of these products are built on certain utilities such as lending to finance tokenized real-world items such as smartphones as a work tool, and recently even mortgage financing.

The DeFi products are secured by those real-world items, able to accommodate a decentralized set of customers and agents, and are based on the actual yields that are achievable for such financial transactions. More products designed to underwrite real-world financial needs and address underbanked communities are likely to continue to emerge, giving DeFi a real chance of being adopted.

It Is Time to Develop a Standard for Representing DeFi Contracts

Standards can be a significant catalyst for DeFi’s growth. The ERC-20 standard, for instance, helped the development of fungible tokens by making them easier to interpret across different platforms and applications. For instance, an ERC-20 token can be defined on Ethereum, Avalanche, or BNBchain, and a user can manage them with clients developed by teams independent of those projects.

Examples of such clients include Brave, MetaMask, or, indeed, any client implementing the ERC-20 standard. There are many developments that this has enabled, including token bridges across blockchain networks. Similarly, the ERC-721 standard has been a catalyst for the growth of nonfungible tokens, allowing users to utilize different platforms and clients for minting and managing NFTs.

A standard for representing decentralized financing for DeFi’s end users will likely have similar effects as the ERC standards. For one, the implementation of a unifying standard will allow various development teams and projects to represent DeFi products in a consistent manner, which would reduce a lot of ad hoc interpretations and coding of DeFi contracts and aspirations. It will allow users to manage their DeFi products on different clients, platforms, and browsers that support the standard. This would include automatic payment for DeFi loans or lines of credit, as well as potentially providing portability for DeFi products across these different platforms.

What Would a Defined Standard for DeFi Contracts Look Like? 

A DeFi standard would necessarily need to be encompassing enough to be able to define various types of DeFi products. This would include secured and unsecured DeFi loans, lines of credit, BNPL contracts, DeFi mortgages, and even crypto yield products currently prevalent in the crypto community.

Illustration of the components for a potential DeFi standard. Source: Ken Alabi 

This standard is defined such that it could be utilized for any DeFi contract, and would be based on a generalized form of DeFi consisting of an asset provider or a lender, a borrower, and a potential repayment structure— in the case of decentralized lending. For instance, a BNPL contract would be similar to a secured loan, having a principal amount, payment duration, collateral, and other terms, but where the interest rate would typically be 0%. Overall, the standard would define such broad and overarching ways to successfully define DeFi contracts. The standard would improve on existing DeFi contracts by allowing such contracts to be more portable, potentially transferable, and more tradable as collaterals by having a consistent form used by all users of the standard.

The Future of DeFi: Looking Ahead 

Assets need to have utility, for therein lies their true value. They also need to provide rewards for those who own and deploy them. When these constructs work correctly in identifying and pairing those with funding with those in need of funding (who are also able to deploy their resources efficiently and repay asset providers), they have been an important driver of growth and development in diverse human societies.

These constructs drive enterprise and small businesses; they fund commerce, mortgages and provisions of shelter; and they galvanize every sector of any nation’s economy. Societies that have developed more successful ways of identifying borrowers with lower default rates, utilizing credit scoring and other computerized means, including even AI, have tended to be more successful at lifting more members out of poverty than those societies that have not.

DeFi has the promise and ability to reach billions not currently served by the traditional banking and finance system. This potential has a greater chance of being realized if DeFi shakes off its initial incarnations that focus more on offerings with bogus yields that are not underlined by any real value creation and rely more on indiscriminately printing unbacked tokens.

Developing and utilizing uniform standards in the creation of DeFi contracts would be a catalyst for leading the growth of DeFi when applied to well-thought-out, responsible and well-grounded contracts and products, intended to cover both the banked and the unbanked.

This article is written by Chidera Anushiem as a part of enter.blog's bounty program. Do you have an interesting topic, series or subject you think would be fitting for enter.blog? 

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