Critical Problems Facing Decentralized Finance (DeFi) Ecosystems Today

Data & Research / 24.07.2020

Blockchain technology brought about several new developments, among them, decentralized finance. Although blockchain has continuously thrived in different sectors, its use in finance and DeFi is quite impressive. Thanks to DeFi ecosystems, there are now more decentralized networks and peer-to-peer networks to solve financial banking issues, borrowing and lending, and advanced financial instruments. 

Despite the notable success of these ecosystems, DeFi is still in its infancy. Therefore, the ecosystems are often plagued with certain risks that hinder their progress. What are the significant challenges and vulnerabilities facing DeFi adoption in today’s world? We take a look at the dangers facing DeFi ecosystems.

DeFi Ecosystem Risks

Serious DeFi ecosystem risks are brought about by smart contracts, lack of loan insurance, user error, and asset liquidity

Since smart contracts are the central middlemen of DeFi systems, their vulnerabilities may affect the DeFi ecosystems’ organization. The following are some of the smart contract vulnerabilities that may be risks to DeFi.

  • Reentrancy attacks, which are so prevalent in the smart contracts system, are the main fighters against all finances’ automation. Reentrancy attacks may lead to transaction participants losing all their monies. 
  • DOS attacks are also a leading smart contract vulnerability. DeFi systems will also be prone to DOS attacks. If a flawed smart contract is sent to an ecosystem, there may be a severe loss of funds.

Once new vulnerabilities are discovered in the DeFi ecosystems, then the risk of increasing vulnerabilities grows. The above was well seen in the bZx attack. In the attack, a hacker was able to take advantage of flash loan vulnerabilities to get away with hundreds of thousands worth of coins. The hackers went in for a second attack and stole even more money from the system.

Another error that may occur due to smart contract vulnerability is user error. These types of errors have led to people losing millions of their money. The Guardian reported an excellent example of a developer losing $300 million worth of crypto due to small errors. The developers were trying to fix another bug that led to their hack and loss of $32 million when they unknowingly transferred ownership of all their assets to one individual, the process which they were unable to revert.

Lack of loan insurance is another danger that DeFi ecosystems have been unable to solve. The existence of flash loans is a big problem in DeFi ecosystems. As earlier discussed, attackers were able to garner hundreds of thousands of USD by taking advantage of the flash loan. For its lack of intermediaries for any lending, DeFi ecosystems are putting investors at risk of losing money from untrustworthy customers. Market volatility is also a serious vulnerability that affects DeFi systems.

Another problem that may affect DeFi is government regulations. At any time, a project may change its operations, who runs it and thus fall prey to government regulations. These regulations may render the projects illegal, thus leading to lots of investor loss. Even when mistakes are impossible other factors still increase the DeFi ecosystem’s weaknesses.

Why Criticise The DeFi Adoption?

There are still other market and system factors that affect the adoption of DeFi systems. These include over-collateralization, centralization, and liquidity issues.

DeFi is not entirely decentralized since all controls depend on the developers. They are the ones tasked to develop and fix all the bug issues relating to DeFi. The developers being the central providers, make decentralization of the system, and finance hard. Another problem that comes with developers’ dependence is the possibility of them being dishonest, thus misappropriation of clients’ funds. Progressive decentralization is the only way to fix such problems. 

Overcollateralization is another problem that leads to an imbalance in the DeFi ecosystems. Since lenders cannot meet one on one with the borrowers, they may take advantage and ask for a humongous amount of money as collateral. Lenders will not give out loans if the borrowers cannot attain their high collateral rate. The above threatens the essential function of borrowing.

Another possible issue is market volatility and liquidity. Since they are trading with a diverse set of assets, it may not always be easy for all assets to attain proper liquidity.

DeFi Road To Adoption

Many are trying to find possible solutions to all of the above-listed risks and problems. Smart contract vulnerabilities and bugs disabling DeFi are now getting solutions progressively. Governments can create regulations that can regulate digital assets. Perhaps it’s more important now to focus on providing better liquidity and volatility. 

Atomic swaps are also solutions to DeFi criticism. They allow for direct transfer of value from one blockchain to another. The above is done by the use of smart contracts with execution deadlines.  

Conclusion

Since its inception in cryptography, DeFi has seen significant growth in its risks. However, some factors have increased the vulnerability of DeFi ecosystems since their introduction, which is meant to assure proper financial management and decentralization of financial processes like borrowing and lending.

The positives of having DeFi ecosystems is that they delineate third party influence on financial services. DeFi has, in recent years, proven to be an essential pillar in cryptography. DeFi is proper proof that blockchains and crypto can transform the financial systems. However, before they fully address their challenges, their adoption into the market will be anything but reality.

Adam is an outgoing young lad who likes adventures and discovering new things. Despite his boring life, he loves writing about cryptocurrencies and exploring what blockchain technology can do for the coming digital world where all adventures will be virtual.