DeFi - A gold mine to be excavated
At the moment, DeFi has been battle-tested to be one of the biggest applications of Crypto and has led the growth of Crypto in various aspects, from application diversification to market capitalization, total value locked,...
As an immature market, DeFi undoubtedly has numerous limitations. Nevertheless, within those problems lies our opportunities. If we are able to find the solutions to those challenges, there is a high probability that we can gain massive profits. That is how “trends” are born, and we would want to get into those trends as soon as possible.
In the aforementioned DeFi 2.0 article, the previous trends which came about like solutions for DeFi problems are:
- Fragile liquidity ⇒ Projects released airdrops or incentives for users to earn yields, encouraging them to participate in the market.
- Low scalability ⇒ Different Layer 1 and Layer 2 solutions appeared in order to improve transaction speed and cost.
- Lacking decentralization ⇒ DAOs (Decentralized Autonomous Organizations) are born.
- Capital inefficiency ⇒ Fresh and innovative dApps are introduced to tackle that problem.
Realizing relevant shortcomings, multiple projects have developed suitable products regarding those problems. For those successful, their native tokens have easily gone up 10x to 100x. Finding these “gems” is the opportunity that we are looking for.
In the next parts, I’ll go deeper into each DeFi limitation along with some products that are developing relevant solutions.
7 limitations of DeFi
From my point of view, DeFi is currently having 7 problems:
- Security & Privacy.
- Capital Efficiency.
Scalability is the ability of a network to expand in the number of applications and transactions that it can handle. If Crypto were to be adopted by the mass, blockchain platforms would have to be capable of handling hundreds of thousands of transactions within seconds and at a low cost. It must have been as smooth as using the internet nowadays.
A typical example of how scalability is the current problem of DeFi is Ethereum. For retail investors and Crypto/DeFi newcomers, using Ethereum is a far-fetched idea. The network can only handle about 15 transactions per second (which is extremely low) with an average transaction fee of $20. Especially during congested periods, Ethereum gas fees can get up to hundreds of dollars.
1. Other Layer-1 Blockchains.
Different blockchain platforms have been released as alternatives to Ethereum, and they have successfully created a strong market wave in 2021. Solana, BNB Chain, Terra,... have reached the top 10 tokens with the highest Market Cap. Nevertheless, they are still imperfect and possess flaws, such as:
- Solana is frequently congested and frozen.
- Avalanche has high gas fees compared to its competitors.
- BNB Chain is centralized.
- Terra depends too heavily on its inorganic yield.
If such blockchain networks wish to exist and continue developing, they need to solve their problems as well as grow a stronger network effect (like that of Ethereum).
2. Layer-2 solutions and sidechains.
Ethereum Layer-2 solutions have received massive attention lately. Theoretically, they will be the key to the scalability of Ethereum as they not only expand the Ethereum network but also maintain its security. However, these Layer-2 are still in the early stages of development and have yet to release their native token.
As they are not well-developed, this may be the chance for us to seize. This is a potential market niche that you should pay attention to, with some notable projects as:
- Layer-2: Arbitrum, Optimism, zkSync, Starkware.
- Sidechain: Polygon.
Liquidity is like the blood of any market. For a market to grow, there must exist both buy and sell demand. However, for a primitive market like DeFi, low liquidity is a serious pain point curbing its growth.
1. Amend current Fiat on-ramps/off-ramps solutions.
In short, Fiat on/off ramps are ways to deposit and withdraw your money in and out of Crypto wallets.
Remitano is the most used application for Vietnamese Crypto newcomers with millions of users. Nevertheless, it does charge a large amount of fee for each transaction. Improving such applications would draw more new users into the market.
At the moment, top-ranked CEXs like Binance, Coinbase,... have all supported Fiat on/off-ramps with quality services. Besides, a number of 3rd-party projects (e.g. Ramp Network) and non-custodial wallets themselves (e.g. Metamask) have recently supported direct money deposit and withdrawal.
2. Resolve liquidity fragment via Cross-chain bridges/Multichain.
At the moment, most blockchain platforms have developed to a certain extent. Each of them has possessed a massive amount of assets and a large number of unique users, which is now a totally different case compared to that of Bitcoin and Ethereum dominance a few years ago.
Nevertheless, there now exists too many blockchain networks (over 100), shattering the already fragile liquidity of DeFi. Cross-chain bridges came in as a solution to this problem.
Multichain is another approach as multiple applications have supported using specific assets on a variety of platforms simultaneously. To some extent, this has helped centralized the fragmented liquidity across the space.
Some notable Cross-chain bridges can be listed as:
- Bridges: Hop Protocol, Multichain, Connext, Across Protocol.
- Bridge Aggregator: Coin98 Wallet, Orbiter Finance, Li Finance, Rango Exchange.
3. Attract liquidity via incentives.
Ever since the DeFi Summer in 2020, Liquidity Mining has been a familiar term for Crypto users. Projects, along with their product releases, usually announce Liquidity Mining programs to incentivize users and liquidity to their platforms. However, this is a double-edged sword:
- Liquidity Mining programs can attract users and liquidity in short term.
- But in the long run, this model cannot be sustainable: APYs decline ⇒ Farmers dump their tokens ⇒ Users and liquidity leave and find other opportunities ⇒ Repeat the situation with other platforms.
To tackle this challenge, some specific protocols have been developed:
- DeFi 2.0 projects to work on Capital Efficiency.
- Innovative methods like vesting, using NFT, or lockdrop to curb sell pressure.
This problem will be the primary focus of current DeFi projects when the approach to attracting users and liquidity has changed. New kinds of incentives are needed to suit the current market’s needs.
4. Deepen NFT liquidity
NFT is an extremely potential market, not only for its user-friendly attributes but also for its integration utilities. NFT can be easily adapted by non-crypto users, as well as integrated into DeFi and GameFi platforms.
Still, its liquidity has not been leveraged and fully utilized. Some use cases that can help leverage NFT liquidity are:
- NFT Fractionalization: Fractional, NFTX.
- NFT Lending & Borrowing: reNFT, Gradient Protocol;
- NFT Valuation: Abacus.
- NFT Tokenization: ApeCoin (APE).
It is undeniable that most Crypto projects are centralized to some extent at the moment. Even though the benefits of centralization cannot be overlooked (like better decision making, faster reaction to challenges,...), decentralization is the ultimate goal of Crypto and DeFi. Over time, no projects in Crypto can exist without decentralization.
Solutions: Decentralized Autonomous Organizations (DAOs)
DAOs make use of smart contracts to conduct every change and decision through governance. It means that there needs not to be any leader or operator - the projects can run on their own independently.
DAO is a rather gigantic category to begin with. It exists from blockchainn platforms and DeFi protocols to even smaller govenance groups and really specific organizations.
A few specialized DAOs that you pay attention to:
- DAO Operating Systems: Aragon, Colony, Tribeca,...
- Protocol DAOs: Those that create their own games and wars based on governance weighting, like Curve Finance (Curve Wars).
Security & Privacy
As mentioned earlier, Crypto is an immature market and now developing breakthrough ideas along the way. And for any market like such, vulnerability is an inevitable factor. There have been a large number of hacks and exploits in Crypto, causing asset losses in the value of millions of dollars.
Besides, most users are still not carefully aware of such risks and have not acknowledged how to protect their funds in the right way. Sadly, these fundamentals have been eclipsed by Crypto’s nature: huge gains and profits.
The security aspect of DeFi can be seen in 2 ways:
- From the project: The projects themselves have to be secure as they are directly in charge of users’ assets. Some risks arise from the project side are:
- Smart contract risks.
- Oracle risks.
- Rug-pull risks (Project’s intention).
- From the users: Users in DeFi have to be extremely careful with delegating their assets’ control to other project(s). Some risks associated with DeFi users are:
- Lack of knowledge.
- Lack of awareness (focusing only on profits).
- Acknowledge all basic tips for protecting assets and funds in Crypto.
- Constantly update on news and knowledge to quickly and correctly react to different market situations.
- Carefully select projects and wallets before using them. Do not overlook the security aspect over the profit aspect.
Besides bug bounty events that various projects propose, there have been a few products aiming towards attracting the help of white hat hackers. Hats Finance is an example.
Moreover, there are also numerous insurance protocols like Nexus Mutual, Insure DeFi, InsurAce,... which are attempting to protect users from DeFi risks. Yet, such products have not been able to prove their efficiency, as well as gain the market’s attention.
Privacy is a prerequisite for the continuing development of Crypto. It does not only allow freedom in investing and speculating but also provides investors with satisfaction in mind.
- Prepare to be anonymous when participating in Crypto.
- Use privacy services like Mixing Service.
- More and more privacy-specific projects are appearing. Some notable among them are:
Capital Efficiency is how much your capital is being used in ratio to the original number. The higher the number, the better it is.
At the moment, DeFi is still having a variety of boundaries restraining Capital Efficiency. Here are some possible approaches to improve this:
1. Optimize the TVL of AMMs
AMM is the core protocol of every blockchain ecosystem, at the same time being the primary liquidity pool of the whole network. However, besides reducing transactions’ slippage, there are mostly no other use cases for that massive amount of TVL, indicating that it has not been fully utilized.
Some AMM DEXs have addressed this problem via innovative approaches. For example: Uniswap introduced Concentrated Liquidity; Balancer leveraged locked assets by supplying them on Lending & Borrowing platforms like MakerDAO, Aave,...
2. Optimize Lending & Borrowing
For the time being, DeFi lending has had a few limitations as:
- Lending & Borrowing APYs constantly fluctuate and vary across different platforms.
- A number of lending protocols allow capital to be leveraged and supplied in a loop, but manually (inefficient).
- Most projects apply over-collateral, meaning users can only borrow less than supply.
- Develop platforms that automatically supply assets at high APYs and borrow assets at low APYs. These can be done by swapping between assets, meaning the protocol can choose the asset offering the best rate to use as collateral. Flash Loans can also be implemented for further diversification.
- Capital should be automatically leveraged to push the APY to as high as possible. At the same time, there should also be auto-compounding for Lending & Borrowing products.
- A Reputation System (or Credit System) to maximize the possible Supplying/Borrowing amount. This works similarly to banks that enable under-collateral lending. A number of projects working on this idea: Credefi Finance, Sublime Finance, Wing Finance, GoldFinch Finance.
- Lending & Borrowing protocols can get access to a wider range of customers by connecting and cooperating with other applications/banks to increase Capital Efficiency.
3. Optimize Farming
Yield Farming is an amazing tool to incentivize liquidity and enable fair token distribution. However, it is being abused by an overwhelming number of projects with unbelievably high APYs. This led to the farm & dump situation, creating a negative flywheel for the protocol.
Most protocols implementing Yield Farming have failed simply because they cannot create a revenue stream. OG products like Yearn, Curve,... can survive for long since they can generate real revenues ⇒ The governance token becomes valuable ⇒ Yield Farming is backed up with real value and demand. As it can be clearly seen, products should focus on developing their products and producing actual value, while regarding Yield Farming only as a side tool.
Currently, the most used Yield Farming compounding model, for example, is: Farming gOHM/ETH on SushiSwap to receive SUSHI. Sell SUSHI, buy more gOHM/ETH, and compound to the pool. Repeat.
This has added extreme sell pressure on the project’s native token. To ameliorate this negativity, different methods have been introduced:
- LP > Single Staking: Farm DPX/ETH on Dopex ⇒ Single Stake rewarded DPX tokens.
- Single Staking > LP: Single Stake DPX ⇒ Sell DPX to buy DPX/ETH.
- LP > LP: Farm DPX/ETH ⇒ Sell DPX to buy rDPX/ETH.
- Single Staking > Single Staking: Stake DPX ⇒ Sell rewards to buy rDPX.
These alternative models help reduce constant sell pressure on farmed tokens. Among them, the 1st approach has the most positive impact on the price of tokens as it incentivizes staking instead of selling.
Besides original Farming, leveraged Farming is another commonly-used method to earn Yields since it returns higher profits compared to the traditional one. For both models, managing your Farming positions is of the utmost importance: from tracking position to controlling leverage level, organizing yields and risk/rewards,...
Some great dashboards for managing Farming positions can be seen as: Debank, Zapper.
The Derivatives market is rather enormous with myriads of different applications. Along with the original use cases such as Margin Trading, Perpetual Trading, Options, Synthetic Assets,... this specific category can be expanded into various creative ways to tackle current problems.
A few interesting use cases are:
- Gas Derivatives: Create a market for Gas fees trading.
- Interest Swap: Allow users to trade their assets’ interest. Some projects working on this: Pendle Finance, Element Finance, Timeless Finance, TimeSwap.
5. Integrate NFT to leverage other features
As mentioned above, NFT if used correctly can be really effective in creating and leveraging other Crypto features to the next level. At the moment, DeFi projects have the tendency to apply NFT to their products, especially with airdrops. Numerous protocols have airdropped users with NFTs instead of tokens, and required users to use those NFTs and interact with the project to receive rewards.
Some examples are: Uniswap uses NFT as LP token, Orca implements NFT Staking,...
Tokenomics is one of the most important factors to evaluate a Crypto protocol. As you may know, Crypto is a Zero-Sum game and almost all participants within the market came for profits. Each tokenomics model will have a specific impact on the price of tokens. As an investor, knowing the game and your position within it is a must.
Crypto market, like any other market, is directly affected by Macroeconomics. Currently, wars, inflations, regulations,... are a few of many factors that have impacted Crypto. Each of them can severely affect the Crypto market, which is why we have to be prepared for any situation, as long as Crypto and DeFi remain unstable.
And that are the 7 limitations of DeFi Coin98 has put in together. What are your viewpoints on the aforementioned problems? Which specific category should we keep an eye on in the next few months or years?
Disclaimer: Research carefully before investing. This is Not Financial Advice.