Decentralized finance faces multiple barriers to mainstream adoption

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Decentralized finance (DeFi) is a growing market that is popular with experienced crypto users. However, there are some hurdles to mass adoption when it comes to the average non-technical investor.

DeFi is a blockchain-based approach to providing financial services that does not rely on centralized intermediaries, but instead uses automated programs. These automated programs are known as smart contracts, which allow users to automatically trade and move assets on the blockchain.

Protocols in the DeFi space include decentralized exchanges (DEXs), lending platforms, and yield farms. Because there are no centralized intermediaries, it is easier for users to get involved in the DeFi ecosystem, but there are also heightened risks. These risks include vulnerabilities in a protocol’s codebase, hacking attempts, and malicious protocols. Combined with the high volatility of the crypto market in general, these risks could make it more difficult for DeFi to achieve broad adoption among average users.

However, workarounds and improvements in the blockchain space can allay these concerns.

Regulatory issues with DeFi

Regulation can benefit the DeFi space, but it also goes against the core principles of decentralization. Decentralization means that a protocol, organization or application has no central authority or owner. Instead, a protocol is built with smart contracts that perform key functions while multiple users interact with the protocol.

For example, smart contracts allow for the staking and swaps with a DEX while providing users with liquidity for the trading pairs. What can regulators do to prevent an anonymous team from pumping up a token’s value before withdrawing liquidity from DEXs, otherwise known as backtracking? Due to the decentralized nature of the DeFi ecosystem, regulators will face challenges when trying to maintain some level of control within the space.

Despite the challenges, regulation is not completely out of the picture with regard to decentralized finance. In the fourth quarter of 2021, the Financial Action Task Force released an updated version of their virtual asset document guidelines. The update outlined how developers of DeFi protocols can be held accountable in a crisis. While the protocol may be automated and decentralized, its founders and developers could be called virtual asset service providers (VASPs). Depending on the state where they are located, they may also need to be regulated.

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In terms of regulation within DeFi, platforms can also build protocols that meet regulatory requirements. For example, Phree is a platform that builds decentralized protocols and takes into account regulations where possible. One of the ways they do this is by partnering with traditional financial entities to build DeFi protocols that comply with standard regulatory requirements. This would involve adding processes such as Know your customer and anti-money laundering checks to DeFi platforms such as DEXs and lending or lending platforms. In addition, making traditional finance (TradFi) compatible with the DeFi ecosystem would help spread its adoption due to the dominance of organizations in the TradFi space.

Ajay Dhingra, head of research at smart exchange Unizen, told UKTN: “Incompatibility with the traditional financial ecosystem is one of the biggest challenges. It is necessary to connect the CeFi regulatory framework with on-chain identities and real-time regulatory reporting so that Defi accessible to financial institutions trading in trillions.”

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Central bank digital currencies (CBDC) have been proposed as a response to stablecoins following the collapse of the Terra algorithmic stablecoin earlier this year. Thomas Moser, director of the Swiss National Bank, previously said UKTN regulators may prefer centralized stablecoins over decentralized ones. However, he also said it would likely take time and current financial regulations could render the DeFi ecosystem obsolete due to conflicting principles.

Security vulnerabilities within the DeFi ecosystem

Security vulnerabilities are a major concern within the DeFi sector, with malicious space actors taking advantage of vulnerabilities within bridging protocols and decentralized applications (DApps).

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Adam Simmons, chief strategy officer of RDX Works – builders of the Radix protocol – told UKTN: “DeFi’s dirty secret right now is that the entire ledger technology stack has a myriad of known security vulnerabilities, as demonstrated by the billions of dollars lost to hacks. and exploits in recent years.”

Vulnerabilities still occur in the DeFi space. Recently, the Nomad token bridge has been emptied of $160 million in funds. It is also estimated that $1.6 billion in money has been stolen from DeFi protocols this year alone. Lack of security within the DeFi space makes it less likely for new users to join, while discouraging those who have fallen victim to protocol exploits.

Addressing this problem requires greater emphasis on vetting protocols within the space to discover vulnerabilities before hackers can take advantage of them. There are already platforms like CertiK that audit blockchain-based protocols by checking the smart contract code, so that’s a good start. However, the industry needs to see more scrutiny of DApps before they go live to protect users in the crypto space.

User experience issues

User experience (UX) is another potential obstacle for users seeking to engage with the DeFi ecosystem. The way investors interact with portfolios, exchanges, and protocols is not a simple intuitive process, resulting in some users losing their money due to human error. For example, in November 2020, a trader spent $9,500 in fees to execute a $120 trade on Uniswap after mixing up the “gas limit” and “gas price” entry boxes.

In another example, a $1.2 million rock nonfungible token (NFT) sold for less than a cent when a user put it up for sale at 444 WEI instead of 444 Ether (ETH). These examples are known as fat finger mistakes, where users lose money due to mistakes they make when entering values ​​for prices or transaction fees. In order for DeFi to be widely adopted by the masses, the process must be simple for ordinary, everyday people.

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However, that is currently not the case. To use a DeFi application, users must have a non-custodial wallet, or a wallet in which they manage the private keys. They should also back up the recovery phrase and keep it in a safe place. When interacting with a DApp, users need to connect their wallet, which can be complicated at times, especially when using a mobile wallet.

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In addition, when sending or receiving payments, users must copy the addresses involved in the transactions, and in some cases, they must enter the amount of gas they want to spend on a transaction. If a user does not understand this process, they may use a low gas setting and end up waiting hours for their trade to be sent because the gas price is so low.

The process gets even more complicated when it comes to tokens built on networks such as the ERC-20 and BEP-20 standards. When you transfer these tokens, you must pay for the transaction with the cryptocurrency of the network it belongs to. For example, if you want to send an ER-20 token, e.g. USD Coin (USDC), you have to keep ETH in your wallet to pay for the gas, which makes the transaction more complicated.

Developers in the DeFi space need to make the ecosystem more user-friendly for beginners and regular non-tech users in the space. Building wallets and DApps that prevent big finger mistakes (by, for example, automatically entering values) is a good start. This is already the case with centralized exchanges, but it needs to be brought to decentralized platforms and non-custodial wallets for the DeFi sector to grow.