While the DeFi movement has the potential to provide meaningful benefits over centralized alternatives, there are many practical challenges the DeFi industry needs to overcome first. User adoption may be the biggest impediment to the development of the industry at present, new risks compounded across protocols may be the biggest threat to its sustainability. An in-depth look at the 7 most pertinent challenges follows.

1.) Identity and Reputation

The first step in entering into a financial transaction often requires the identification of transacting parties. However, a core tenant of DeFi is that one’s ability to access financial services should not be dependent on most aspects of identity. This is problematic as violations of KYC / AML / OFAC regulations can not only result in large fines but could result in criminal charges. If a DeFi Relayer (an entity that hosts on order book on a DeFi protocol) facilitates an exchange between unknown parties and those parties turn out to violate any of these regulations, the consequences may be serious. Furthermore, without a way to enforce identity, most proposals for decentralized governance of these projects are quickly reduced to plutocracy.

While still far from complete solutions, projects are researching ways to allow for KYC (know your customer procedures) without introducing centralization. For example, Relayers on 0x can opt-in to implement a permissioned liquidity pool that ensures that pool is only accessible to whitelisted Ethereum addresses that meet certain requirements, such as those required by AML (anti-money laundering) and KYC policies. However, this method still doesn’t ensure identity in a way that allows one to know that a counterparty is trustworthy without excluding those outside of the traditional financial system and introducing centralization. Several parties have issued EIPs (Ethereum Improvement Proposal) to incorporate KYC/AML compliance into ERC-20 tokens. However, in many cases, these proposals would still require service providers to work together off-chain via a consortium to review each others’ KYC policies and it is still unclear whether these proposals would fully satisfy regulatory requirements.

Establishing reputation in blockchain networks is a distinct challenge. This is a strong industry focus as the range of possible products expands when there is a sense of on-chain reputation. There are currently two main ways to attempt to establish reputation in these networks:

Allowing everyone to start on an equal playing field under the assumption that network participants are good actors. Participants that prove to be untrustworthy / uncreditworthy would subsequently be slashed (punished.) Underwriters on the Dharma network fall into this category, wherein they gradually build reputation over time via an on-chain record of their accuracy and behavior.

Porting existing credit data to a blockchain network via an oracle. This is hardly an improvement over the traditional finance system in terms of allowing for fair access.

The lack of an on-chain reputation method that doesn’t require users to reveal too much about their personal identity means most DeFi projects require (over)collateralization in lieu of being able to establish trustworthiness.

2.) Capital Inefficiency

The overcollateralization required by DeFi projects is capital inefficient. MakerDAO requires users to deposit 1.5x the value of ETH to establish the collateralized debt position underpinning Dai (CDPs will be covered in more depth in Risk Off or On?: Decentralized Lending and Derivatives.) Even still, most people choose to keep their “loan-to-value” ratio at 300 percent in order to avoid double digit liquidation penalties.¹ Similarly, Compound requires a 2x collateralization ratio, which the company says will decrease over time.² However, some users indicated a willingness to post 4x–5x the required collateral.²

Until a decentralized reputation system is developed, there is little choice but to require users to lock up excess capital, dulling the benefit of taking out these positions to begin with. Even when/if reputation is solved, the volatility of the underlying positions could result in a persistent preference to overcollateralize.

3.) Oracles

Corruption of on-chain oracles (the mechanism that finds and submits real-world data to a smart contract) is a huge concern for these systems since liquidation occurs automatically in the event that collateral levels drop below their specified “loan-to-value” ratios. Different DeFi projects approach oracles in different ways, but many projects in the space are using MakerDAO’s oracle. MakerDAO’s oracle is currently designed to support single collateral Dai (backed entirely by ETH) but will be re-designed to support multi-collateral Dai (backed by a pool of different cryptocurrencies) in the near future. MakerDAO’s oracle pulls data from sixteen different sources for its oracle feed. These sources are comprised of Ethereum addresses voted on by MKR token holders, which are then submitted to an autonomous smart contract. The oracle chooses the median of all sixteen submitted data points. This system allows for 51% tolerance as it excludes the outliers which are more likely to be submitted by malicious actors.¹ Importantly, MakerDAO also utilizes an oracle security module in which the second layer of the protocol can activate an emergency shut down. This shut down freezes the system at its last known “safe state” if it has reason to believe the oracle may have been compromised. If an emergency shutdown occurs, users can convert their Dai to ETH at the equivalent of 1$/1 Dai, according to the state of the ledger at its last determined “safe state.¹”

Single collateral Dai oracles update every time the price of ETH fluctuates by +/-1.0% but multi-collateral Dai (MCD) oracles will update once an hour.¹ This allows the sixteen oracle inputs to be viewable for an hour before they are acted upon, increasing transparency. However, such a long lag time may not be appropriate considering the volatility of cryptoassets. The company’s argument that this delay can be compensated for by the risk model is questionable. Furthermore, liquidation of collateralized positions (essentially defaults) will be executed via auction with MCD, which means it will “six hours or more” to liquidate positions as the protocol accesses “all the arbitrageurs and liquidity across the whole marketplace and ecosystem.¹” The impact of having to wait 6 hours to unwind a single position during times of market distress, or failure, would be significant.

Compound takes a different approach with its oracle, aggregating and averaging price feeds from a series of exchanges and posting them on-chain consistently. The data updates every time the underlying value fluctuates by +/- 0.1%, but data is updated on-chain every 15–30 seconds, confined by the processing speed of Ethereum.² Given the importance of oracles in these systems, DeFi projects may want to more closely consider which method they use or choose to implement their own methods.

4.) Network: Platform, Liquidity, Scale

Most current DeFi solutions are built on top of Ethereum and therefore DeFi’s adoption is tied to the scalability and usability of the Ethereum network. The scalability debate is well known (and addressed below) while usability remains a challenge as mainstream users still struggle to easily interact with Web 3.0.

While the composability of protocols built on Ethereum creates even larger switching costs, it also introduces network risk. As more projects build on Ethereum, it may become harder to upgrade the base layer protocol in a way that allows for backwards compatibility.

Part of the power of DeFi is that it allows for the creation of new markets. However, decentralized markets suffer the same circular problem that all new markets do: adoption is required to generate liquidity, but liquidity is a driver of adoption. While DeFi can enable new markets and allow new participants to access them, it does not automatically create liquid markets for these products. This is a problem because assets that are illiquid tend to trade at a discount to their liquid counterparts.³ It also creates inefficient pricing as opportunities for arbitrage go uncaptured since it remains difficult to move quickly and seamlessly between crypto markets.

Alex Evans of Placeholder VC breaks down the models of current DeFi networks into three broad categories:

Those that require users to find peers to trade with. Augur, 0x, Dharma

Those that pool “maker” assets and offer them to “takers” for a fee. Compound, Uniswap

Those that set parameters through governance, allowing users to trade directly with a smart contract. Ex: MakerDAO

Each model has implications for liquidity. The lack of requirement to find a specific peer with which to trade seems to be the design advantage of the top protocols. These protocols also tend to offer fewer options in terms of products / use cases, which pools demand, facilitating better liquidity. Alex Evans also believes automatic and consistent processes (MakerDAO) better facilitate liquidity than bespoke and varied ones (Augur.) This seems to have been one of the drivers behind UMA and Dharma deciding to set tighter parameters on their products (relative to a completely open system in which individual users set all parameters.)

“At least initially, the markets that have built deep pooled liquidity in a handful of important markets appear to have the adoption lead versus those that have tried to create a multi-asset infrastructure.” — Alex Evans

Assuming these markets find a way to bootstrap the necessary liquidity, blockchain infrastructure is not yet scalable enough to process volumes similar to those processed by centralized exchanges. For a sense of the limited scale of current DeFi networks, investor at Paradigm, Arjun Balaji, predicts that December 2019’s aggregate volume on 0x will lag a single day’s volume on Coinbase. While advances are being made in Layer 2 scalability and innovative solutions such as StarkDEX (currently partnering with 0x) show promise, current blockchain infrastructure has a long way to go before it can support volumes similar to those supported in traditional markets.

**Front-running, and other opportunities for manipulation, on DeFi networks will be addressed in Trade-Offs: Decentralized Exchange.**

5.) Business Models Still Undefined

While there are many options, most DeFi projects have left their monetization method “undefined” and are focused on “defining the incentives of the protocol at large.⁴” However, at some point these projects will need to generate revenue if they are to persist.

dYdX highlights three main monetization models for DeFi projects:

Value accrual via a native token. MakerDAO (MKR)

Monetization via fees. Potentially Compound

Monetization via a user facing application. dYdX, Dharma, etc.

In most cases, a native token monetization model introduces another layer of friction to user adoption. For other projects it might not make sense. For example, a token monetization model doesn’t make much sense in networks where ownership / voting percentage can be determined by participation, which is recorded on-chain.² Nadav Hollander of Dharma points out that a fee model implemented at the protocol level, in addition to being somewhat anathema to blockchain ideology, could easily be forked away.⁴ However, Compound is not against keeping a small amount of the interest flowing through the system in a model akin to the AUM model in traditional finance.²

The latter appears to be the prevailing model. Dharma, dYdX, and others found that they needed to build out full stack products (Expo on dYdX, for example) because they found that developers weren’t willing to invest the time necessary to build on these new protocols. While the 0x model is often touted as the exemplary model, 0x’s success was enabled, in part, because there was already an existing market for DEXs (decentralized exchanges.) 0x’s protocol opened into an existing market, whereas these new DeFi protocols have to create new markets from scratch.

In an effort to bypass many of the challenges of creating a two-sided marketplace from scratch, it’s likely that new DeFi protocols will continue to build out full stack services and monetize those, at least over the near term.

It is important to remember that creating a marketplace is a service business and that is unlikely to change. Whatever entity enables a marketplace also has to offer services to both the demand and supply sides. Marketplaces can’t be created out of thin air, even by the smartest protocols. They will always require a team / company to support the ecosystem with the services that allow marketplaces to live and grow.

As a result, designing businesses with “minimal viable decentralization” may be a more efficient way of launching of products and approaching early governance⁶ although its likely to be viewed less favorably by those that prioritize decentralization above all else.

DeFi business models are not constrained to the above mentioned models. For example, Arwen is planning to monetize via a revenue sharing agreement with centralized exchanges for the trades referred by Arwen⁵ (further details will be provided in Trade-Offs: Decentralized Exchange.)

6.) New Risks Compounding Across Protocols

Cryptocurrencies and blockchain-based markets have fundamentally different characteristics than their traditional counterparts. DeFi protocols benefit from composibility which leads to faster innovation, but also results in higher levels of interdependancy. Therefore, it’s fair to assume that the risk profile of these products, especially in combination, is not yet fully understood. While each project claims to have developed its own robust risk models, the complexity of analyzing these new risks across interdependent protocols is non-trivial. It’s also worth noting that most risk models weren’t very useful in 2008. In some cases, these models failed because just one assumption was flawed.

Many of these projects utilize concepts that contributed to the 2008 financial crisis, but more importantly, they utilize them in new and untested ways. For example, the rehypothecation of collateral, fractional ownership of structured products, and pooling of risk were all elements of the 2008 financial crisis. DeFi takes these concepts and applies them to highly volatile and hard to value assets in relatively illiquid markets with insufficient safeguards. The combination of all of these factors, combined with the complexity of creating a cohesive view of collateral rehypothecated across protocols, creates an entirely new risk profile for which there is little precedent. Superfluid collateral? Let’s not do this.

In this context, it’s worth considering what a market failure would look like. MakerDAO is an experimental network upon which the success of many other projects depends. It is important to remember that in the case of market failure, CDPs and other DeFi products are not insured and a third-party is not likely to step in to recapitalize small cap crypto start-ups (moral hazard debate aside.) Investors, users, and token holders will be responsible for recapitalizing this highly interdependent DeFi system.

The systemic impact would likely be jarring. Dai is commonly traded on 0x Relayers as a pair with ETH. It is often deposited on Compound and then lent out again to hedge funds to be used for risk-on trades. dYdX is also dependent upon MakerDAO since its short ETH token is long Dai. dYdX further depends on Dharma (which lends in Dai) and the 0x protocol (which facilitates the trading of Dai) to access liquidity. The cascading effect of a failure of any one of these protocols would likely cause a systemic unwind that is rapid (due to volatility of underlying, rehypothecation, and automated execution of smart contracts), jarring (these markets are not as liquid as traditional markets), and significant. The rewards may be high, but the risk is at least commensurate.

Cryptoeconomics don’t defy the principals of regular economics and cryptofinance (DeFi) can’t escape the classic risk/reward constraint of regular finance.

7.) Regulation

The primary concern regarding regulation of the industry doesn’t seem to be that current regulations are too restrictive, but rather the concern is related to the ambiguity as to how existing regulations will be applied in regards to blockchain-based networks and cryptocurrencies. Many of the startups in the space don’t know how to determine whether they should launch or not because the regulatory environment they are operating in is so unclear. The cost of all this uncertainty is high.