Problems of DeFi in 2023

DeFi, short for Decentralized Finance, refers to the application of blockchain technology and smart contracts to create financial services and instruments that operate without the need for traditional intermediaries such as banks or brokers. It offers users the ability to access various financial services, including lending, borrowing, trading, and asset management, in a decentralized and permissionless manner.In simpler words, DeFi is about usual banking services, but in crypto, and without the banks themselves.

The current situation in DeFi has seen significant growth and innovation since its inception. Total Value Locked (TVL), which represents the amount of assets locked in DeFi protocols, has experienced exponential growth, reaching billions of dollars. As of April 2023, the DeFi TVL was $48.78b.

New DeFi projects are emerging regularly, introducing novel concepts and products to the market, and contributing to the expanding DeFi ecosystem. However, despite its rapid growth and potential, DeFi faces several challenges that need to be addressed for its sustainable development in 2023.

First Problem: Limited Access for Big Players due to AML and KYC Laws

One of the significant challenges faced by the DeFi ecosystem in 2023 is the limited access for big investors, primarily driven by Anti-Money Laundering (AML) and Know Your Customer (KYC) laws. While traditional financial markets have established regulatory frameworks to ensure transparency, prevent illicit activities, and protect investors, the decentralized nature of DeFi currently lacks these structures. As a result, big investors are hesitant to enter the DeFi market, as they are uncertain about how their funds will be utilized and whether their investments comply with legal requirements.

AML and KYC laws are implemented by countries worldwide to combat money laundering, terrorist financing, and other illicit activities. These regulations require financial institutions to verify the identities of their customers and maintain records of their transactions. While these laws contribute to a safer financial system, they pose challenges for DeFi companies that operate outside traditional financial frameworks.

In the United States, for example, the Financial Crimes Enforcement Network (FinCEN) enforces strict AML regulations through the Bank Secrecy Act (BSA), obligating financial institutions to establish comprehensive AML programs. Similarly, in the European Union, the Fifth Anti-Money Laundering Directive (5AMLD) sets out stringent guidelines for financial institutions to combat money laundering and terrorist financing. The United Kingdom also adheres to strict AML and KYC regulations, including those outlined by the Financial Conduct Authority (FCA).

The absence of clear AML and KYC frameworks in DeFi creates a barrier for big investors who are accustomed to complying with these regulations. Without proper verification and transparency mechanisms in place, big investors may face legal uncertainties and reputational risks. This limitation hinders the inflow of significant capital into the DeFi market, restricting its growth potential and overall adoption.

To address this problem, it is crucial to introduce solutions that enable DeFi companies to implement KYC and AML practices while preserving the core principles of decentralization, privacy, and user autonomy. These solutions should strike a balance between regulatory compliance and the benefits of DeFi's open and permissionless nature.

One potential approach is the development of decentralized identity (DID) solutions that empower individuals to maintain control over their personal data and selectively share it with DeFi protocols when necessary. DIDs utilize cryptographic techniques like Zero-Knowledge Proof to establish verifiable and privacy-preserving identities, reducing the reliance on centralized verification authorities. Implementing DID frameworks within DeFi protocols would allow for the verification of participants' identities without compromising user privacy or exposing sensitive personal information.

Second Problem: Bear Market and Decreased Crypto Revenue

Another challenge facing DeFi in 2023 is the impact of bear markets in the cryptocurrency space. Cryptocurrencies are known for their volatility, and when the market experiences a downturn, the value of crypto assets can significantly decrease. While DeFi protocols generate revenue in cryptocurrencies, the reduced value when exchanged for fiat currencies leads to smaller revenue in cash terms.

In the past, popular tokens have experienced periods of depreciation during bear markets, resulting in financial challenges for DeFi projects that rely on these tokens for revenue. This situation can make it difficult for DeFi companies to sustain their operations and attract new users and investors.

A possible solution to this problem is to exercise patience and wait for market conditions to improve. Bear markets are a natural part of the cryptocurrency cycle, and history has shown that they are often followed by periods of recovery and growth. DeFi projects can focus on optimizing their operations, building robust ecosystems, and establishing strong partnerships during bear markets, positioning themselves for future success when market conditions improve.

Third Problem: Scalability Issues and Transactions Cost

Scalability remains a significant obstacle for DeFi in 2023. Most blockchains, including Ethereum, which is the dominant platform for DeFi applications, are still in the early stages of development. As a result, these blockchains face limitations in terms of the number of transactions they can process per second (TPS). Considering the nature of DeFi, which involves complex smart contract interactions and numerous transactions, scalability issues hinder the growth and usability of these protocols.

To address scalability challenges, a potential solution lies in transitioning from the current Proof of Work (PoW) consensus mechanism to Proof of Stake (PoS) or other more scalable technologies. PoS systems, such as Ethereum's Ethereum 2.0 upgrade, offer the potential for significantly higher TPS, making DeFi protocols more efficient and capable of accommodating larger user bases.

While transitioning to new technologies takes time and effort, it represents a long-term solution to scalability challenges in DeFi. By patiently waiting for these advancements and actively participating in the development and testing of scalable blockchain solutions, DeFi can evolve into a more accessible and user-friendly ecosystem.

Fourth Problem: Hacks

The decentralized nature of DeFi platforms, while offering immense benefits in terms of transparency and accessibility, also brings inherent risks. Unlike traditional financial institutions, there is no central authority or intermediary responsible for overseeing transactions and safeguarding user funds. Consequently, malicious actors have exploited vulnerabilities in the smart contracts and protocols underpinning DeFi platforms, leading to devastating consequences.

Over the years, various high-profile hacks have taken place, resulting in the loss of millions of dollars worth of cryptocurrencies and tokens. These incidents have severely damaged the reputation of the DeFi industry and raised concerns about its overall security. To address this critical issue, industry stakeholders have recognized the urgent need for enhanced security measures, and one of the key solutions that have emerged is the implementation of robust Know Your Customer (KYC) and Anti-Money Laundering (AML) procedures.

KYC procedures require users to verify their identities using government-issued identification documents, proofs of address, and other relevant information. By gathering this data, DeFi platforms can establish a deeper understanding of their users and distinguish legitimate users from potential bad actors. This knowledge empowers platforms to take preventive measures and restrict access to suspicious or unauthorized entities.

Conclusion: Attracting Capital Investors for the Future of DeFi

Addressing the problems faced by DeFi in 2023 is crucial for its continued growth and success. To attract capital investors, DeFi companies need to implement solutions that ensure compliance with AML and KYC laws while maintaining the core principles of decentralization and privacy.

Additionally, patience and strategic planning are required to navigate bear markets and optimize operations during challenging market conditions. Finally, fully transitioning to more scalable technologies, such as PoS, will enhance the usability and capacity of DeFi protocols, paving the way for broader adoption and sustained growth.

By overcoming these challenges, DeFi has the potential to revolutionize traditional finance and offer inclusive financial services to individuals worldwide, empowering them with greater control and accessibility in their financial lives.