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It’s do or die for DeFi:  How crypto’s latest craze can save itself It’s do or die for DeFi: How crypto’s latest craze can save itself
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It’s do or die for DeFi: How crypto’s latest craze can save itself

Don’t be fooled by total value locked (TVL): DeFi is on life support.

Still, by almost every measure, DeFi appears to be skyrocketing. TVL has increased from just over $550 million a year ago to $11.2 billion at the time of this writing, according to DeFi Pulse. The leading DEX’s fortunes have swung wildly, propelling Uniswap suddenly to star status, while its SushiSwap fork went from zero to $1.46 billion TVL in days.

The headlines covering DeFi’s rise are breathless. The podcasts are perpetual. The excitement is visceral. However, a big question hovers over it all: what legitimate value is DeFi delivering today?

At its core, DeFi is the promise of Bitcoin scaled exponentially. The first decentralized cryptocurrency sought to disrupt currency as we know it. DeFi’s founders aimed to do the same for traditional trading, lending, derivatives and payments, replacing a closed, centralized system with one built on cryptography, blockchain, and smart contracts. With DeFi, banks are no longer the gatekeeper for most financial products, bypassed by an open and permissionless architecture that encourages collaboration.

The result is multiple financial improvements, including:

  1. Financial products with unprecedented interoperability — Credit/lending services, DEXs, payments, custody, and stablecoins can work together in exciting new ways.
  2. Code, not corporations — DeFi removes the intermediaries and replaces them with smart contracts, reducing costs and friction.
  3. Ease of access — If cryptocurrency “banks the unbanked,” then DeFi at its best “bankers the unbanked,” empowering anyone with Internet access (and an appetite for risk) to execute complex financial strategies.

Look past the giddy numbers of 2020’s DeFi explosion, however, and the practical purpose of DeFi today fades away. How many people are benefiting from the meteoric rise in TVL, and how is that value positively impacting the broader crypto ecosystem? That’s when DeFi’s nefarious nature comes into focus—a heart of darkness that could lead to destruction, either by its own hand or by regulators that crush it straight to the Dark Web.

The possible fatal disadvantages of DeFi include:

  1. Economic experiments—new DEXs, forks, and tokens can be launched with code that may or may not have been thoroughly audited. Other people’s money gets locked into a Great Unknown that could work perfectly, mistakenly crash, or intentionally scam.
  2. Relatively unregulated—Founders of $1 billion TVL + DeFi protocols are making up their self-regulation as they go along. They’re also skipping critical AML/KYC steps—daring government regulators to catch up. When they do, look for big fines, cease and desist orders, additional criminal indictments, and some protocol deaths.
  3. Unprotected users—The DeFi community today is wildly enthusiastic. But the longer that protocols fail to conduct proper, independent security code audits or execute exit scams, the more their users’ trust and participation will erode — in lockstep with liquidity and volume.

Emergency action is required asap to address these flaws. Without some essential fixes, DeFi will die.

A Hazardous Path

DeFi’s downside became clear with YAM’s swift rise and fall, a disastrous “minimally viable monetary experiment” that attracted $600 million in capital and then ceased to exist within just 48 hours. More recently, SushiSwap co-founder Chef Nomi withdrew about $13 million of Ethereum from the SushiSwap developer allocation just days after launching the DeFi protocol.

Chef Nomi returned the funds after an indignant public outcry. That was too late, however, to change the narrative that YAM and SushiSwap aren’t anomalies—they’re microcosms of a DeFi culture that’s been resistant to self-regulation.

As Donna Redel and Olta Andoni recently opined here in CoinDesk, this mindset is descending DeFi into an increasingly perilous state. The longer DeFi goes without self-regulation, the more powerful a case its players make for government regulators to step in and make DeFi into a relatively safer space.

That kind of intervention is, of course, anathema to the DeFi mindset. While many DeFi solutions spring from progressive intentions that rightly call centralized finance into question, others were intended from day one to get around regulatory compliance. It’s rarely mentioned, but avoiding taxation is integral to these protocol designs: users can bridge their Ethereum-based transactions into an off-chain, non-compliant space where funds can eventually be transferred onto pre-paid crypto cards and transacted.

Tracking down DeFi capital gains presents a complex web to the IRS and similar agencies worldwide, but they will make it their business to decode the money trail and collect. DeFi will look a lot less attractive to traders whose wallets come under increasingly sophisticated scrutiny, followed by a tax bite into their income.

Just as troubling is that most decentralized platforms are not undertaking AML/KYC measures. There’s an undeniable convenience factor to an exchange that doesn’t ask for formal ID or personal details. The tradeoff is that there is no way to know who has joined your liquidity pool. DeFi participants should—and will— become increasingly uncomfortable with the anonymity of their trading counterparts.

For most people, doing direct business with money launderers, terrorists, and other criminal elements is not OK. Bitcoin transactions were once thought to be anonymous, but that myth has been dispelled—they are imminently transparent and traceable. As investigators become increasingly adept at connecting the DeFi dots, they will likewise erase its anonymity. Yield farmers will get some nasty surprises when bad actors on the platform begin to be unmasked. Beyond the buzzkill of discovering that terrorists were the ones who sold DAI for their ETH, legitimate users could get linked to outlaws in a criminal investigation. DeFi participants will disappear in droves if this disturbing scenario becomes a reality.

DeFi will die without these legitimate users. Today’s DeFi traders are a mostly enthusiastic community, but many protocol founders are clearly not acting in their customers’ best interests. The phrase “ICO Scam” is so 2017, outpaced by “Exit Scam” in 2020 thanks to the questionable actions of pseudonymous DeFi founders like Chef Nomi. They launch protocols to cash out on a whim, leaving a mess and plummeting market cap behind.

Expect traders who are savvy enough to engage in yield farming’s complex strategies to get smart about something else: the current absence of safeguards in the larger DeFi marketplace. The lack of protection from fraudulent tokens and DEXs will lead them to take their money elsewhere, shrinking liquidity and volume levels so low that legitimate projects will find it much tougher to survive.

Time for Tough Love

These sharp criticisms may sound like heresy to some, but being honest about DeFi’s most serious shortcomings is essential to saving it.

These drawbacks are why legions of serious, ethically-oriented retail and institutional traders are on the sidelines, vowing to keep away from the DeFi numbers game — and maybe crypto altogether. Centralized exchanges will also keep playing it safe with DeFi, remaining cautious about tokens whose roots lay outside of dependable governance or AML best practices. TVL can only rise so high under these conditions—a severe downturn, or even a complete collapse, is even more likely.

Circuses are fun to watch, but only a madman wants to witness a fall from the highwire. DeFi must embrace regulation, unmask its leadership, protect its users, and realize how its direction impacts the crypto ecosystem. If it can’t do that, then cover your eyes—DeFi is about to die.

Posted In: DeFi, Guest Post