Decentralized finance clearly has the potential to change the world, but most of what carries that moniker today is not at all truly DeFi.
The ecosystem is crowded with early versions of DeFi with many flaws: Because the tech is new, because the chains they run on have their own shortcomings, and because people are greedy and see a chance to make a lot of money very quickly by rushing products out without concern for who ends up paying for their gains. We can do better.
Much like how the ICO boom of 2017 brought widespread interest to the crypto market, DeFi will also shift many eyes toward our industry. But we need to remember that the cost of the 2017 runup and ICO boom was an eventual loss of general interest and a prolonged crypto winter that followed when the vast majority of these projects failed to live up to their promises. Instead of fast-tracking projects that do not meet their own stated ideals, we must aim higher to interest the general public in elements of DeFi that are sustainable and fulfill their promise. So far, few do, but we as an industry can fulfill our promises with DeFi.
DeFi fans frequently point out how broken the existing banking and finance systems are. That’s true, but they’re oblivious to the even more glaring shortcomings of their own systems. DeFi espouses a democratic opportunity to make money and provides freedom from overreaching regulation while fighting the exclusion of regular people from lucrative investment opportunities and information imbalances that put the little guy at a disadvantage. These are noble ideals that should be realized, but it is not what DeFi products are bringing to us at the moment.
So far, DeFi has given us:
- Developers building multi-billion-dollar systems from which they don’t benefit.
- Developers submarining their communities to cash out early.
- Liquidity providers pulling the rug from the system.
- Fans FOMOing profits on tokens with endless inflation.
- Governance tokens that don’t govern and only serve as rewards.
- Voting that is nothing more than a poll that project developers may choose to execute — or not.
- Big sacks of tokens pre-mined by founders at the expense of the community.
- DeFi platforms that fail to meaningfully incentivize many of their stakeholders.
- DeFi platforms built on smart contract platforms with fees so high that only large traders can hope to profit.
The crypto community can demand better by only supporting projects that truly live up to their touted virtues. This requires more critical thinking and a set of clear guidelines that serve as a minimum requirement for an investable project. The cost of the nascent DeFi industry failing to promote such a set of requirements is that DeFi projects will follow ever-shortening cycles of fork, launch, mine and dump until it becomes patently clear that there’s no future to these projects. At that point, we are likely to see general interest in blockchain and cryptocurrency wane again until some future cycle when the industry offers real value instead of schemes to get rich at the expense of others.
Simple rules for DeFi projects
There is a simple set of guidelines we should demand before taking part in any DeFi project. In short, the project should actually live up to the claimed tenets of what makes DeFi better than current systems.
First, the founders should be publicly identified and have definitive experience in the blockchain industry. When “developers” behind a project are unidentified, the personal cost of exit scamming becomes incredibly low. Only when people put their own names and reputations on the line with these projects can they begin to have credibility.
Second, every crucial member of the ecosystem should be rewarded commensurate with a contribution. It would seem axiomatic that if a system relies on a certain group to function, then they should be rewarded in proportion to their importance. Projects that rely on price oracles, traders, influencers or others in the ecosystem who are needed but not rewarded are putting those groups in positions to limit or prevent the long-term success of the project.
Third, there should be no pre-mine or development funds to be robbed. Launching with a pre-mine has been a common way to reward project founders and also a common way for those founders to dump tokens and cash out at everyone else’s expense. Instead, developer fees would be better earned along the way as the project develops.
Fourth, governance must be taken more seriously. Any governance coin should be released for a limited time. The release of governance coins must be done with a clearly defined token emission schedule that lasts a reasonable amount of time. Short emission periods tend to centralize control among early adopters only, while longer periods better spread out ownership but mask the true tokenomics of a project. Every DeFi project should be controlled on-chain by token holders, not just through multisignatures and polls. The open secret of DeFi governance tokens is that most aren’t really used for governance. If a project is going to claim to be community-governed, then the outcomes of votes must trigger smart contract actions, and voting should probably be incentivized with some form of small rewards to at least cover the cost of voting, if not some small additional sharing of revenue as an incentive.
Fifth, there should be protection from liquidity provider “rug pulls” and better security measures in place to protect the reputation of DeFi overall. A rug pull of an automated market maker is when a very large liquidity provider behind a pool pulls out their liquidity without notice, leaving other LPs in the pool suddenly in the position of creating high volatility and greatly increasing their chances of so-called “impermanent loss” — that often becomes permanent very quickly under these circumstances. In addition, people are still losing tokens to errors or hacks against smart contracts that are not open source or, more commonly, that are open source but have not received an independent source code audit. This situation compounds when the founders are unknown or have no public track record. Projects should be open source and independently audited to prevent this.
Finally, the cost of transaction fees must retain profitability for small investors. Recently, on Ethereum, a single DeFi transaction averaged $40 or more, and swapping or staking tokens could easily take 2–3 transactions just to get into a pool. As a fair guideline, the cost of performing actions on the platform should not exceed anticipated daily profits for a <$100 investment that is done by making 2–4 trades per day. Otherwise, DeFi remains as privileged as any other form of finance where only those who are already rich have a chance of really participating.
While this list of requirements may seem overly demanding when compared to today’s DeFi offerings, that really reflects more on the quality of current offerings and not these very reasonable guidelines for providing a decent platform where users have a chance to do well. Remember, the profits in any of these systems must come from somewhere. In the best version — the version that will attract new participants and build a healthy ecosystem — they will come from improved efficiency, participation and, ultimately, an increase in the overall value of the system for everyone. In too many of the current incarnations of DeFi projects, however, these profits for some come at the expense of many other participants in a form of regressive pump-and-dumps that should make investors long for a comparatively fair zero-sum game.
What is at stake for the entire DeFi industry is whether we deploy reasonable products that actually expand economic and financial opportunities beyond their current bounds, or if these will be characterized by the same scams and disappointments seen in the 2017 ICO craze — just at a faster pace. Only one of these options has the ability to make DeFi go mainstream and fulfill the promise that so many people see even when the projects don’t really support them.
The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.