The reason for DeFi’s success in crypto is it advantages everyone involved. Crypto holders get a way to earn passive income on their assets through mechanisms such as yield farming, while borrowers can obtain loans in seconds, with advantageous terms no traditional financial institution can match.
DeFi is big in the crypto world. But, if we look at the overall financial industry, it remains a tiny, almost minuscule niche market, albeit one with potential. DeFi is still taking its first baby steps, but, if it’s to stand tall on its own two feet, it desperately needs a way to connect with the traditional financial ecosystem, where it can tap into real businesses and institutional investors.
Enrico Rubboli is the CEO of Mintlayer, a layer 2 solution that allows users to build a decentralized finance ecosystem on the Bitcoin blockchain, opening Bitcoin to DeFi, smart contracts, atomic swaps, NFTs, apps and more.
The issue is that DeFi is plagued by crippling problems that cannot be solved by internal means. One of the biggest restrictions with DeFi is the requirement that borrowers must over-collateralize their loans to account for price volatility. Most DeFi protocols require collateralization above the value of the loan (stablecoin issuer MakerDAO, for example). If someone wants to borrow $1,000, they must put down $1,500. Should the value of that collateral fall below $1,500, they will be hit with a liquidation penalty.
This over-collateralization requirement presents a big risk to borrowers and seriously hinders accessibility. If DeFi is to live up to its promise of making financial services more accessible, it needs to find a way to cater to the millions of businesses globally that struggle to obtain funding elsewhere. At present, most businesses can’t use DeFi as a source of funding, because they’re not allowed to use anything but crypto as collateral.
Also holding back DeFi is the issue of incentivization, which is directly linked to the available liquidity in protocols. When DeFi hit an all-time total value locked (TVL) of $236 billion in November 2021, everyone was happy. Then, along came crypto winter, and by mid-2022 the TVL in DeFi had collapsed to just $40 billion, with the value of most DeFi tokens dropping by 80%-90%. This caused catastrophic damage to DeFi’s incentive system, as lenders are rewarded with yield based on the amount they deposit, paid out in DeFi tokens that were suddenly worth much less.
Fixing DeFi with TradFi
DeFi protocols can become much more relevant by integrating with real-world assets, or tokenized versions of financial instruments such as bonds, equities and debt, and physical assets such as gold, real estate and art. Doing this would introduce more stable assets into DeFi, making users’ investments safer and protocols more accessible.
Tokenization refers to the process of creating digital representations of real-world assets that can be hosted on a public blockchain. This enables assets to be traded transparently and without intermediaries, making transactions faster and more efficient, with lower costs.