Why DeFi is in deep trouble — and what could save it (2024)

Decentralized finance’s mission is to increase economic freedom by lowering the barriers to entry for services typically reserved for slow, cumbersome, and occasionally corrupt banks. While DeFi has enabled open access to such products and services, the sector at large is in a critical state.

DeFi’s stumbling blocks

DeFi has two major problems around growth and value. First, growth has slowed to a crawl. While DeFi saw meteoric growth from the summer of 2020 to the end of 2021, growth in 2022 has been heavily stunted due to market conditions and hesitation from newcomers in the space. The number of unique wallet addresses active in the DeFi ecosystem has remained at around 4.5 million since December of last year.

Negligible growth is bad, but the second problem is even more concerning. DeFi projects, even blue-chip ones, have failed to accrue value. Pretty much every DeFi product with a token has seen a massive depreciation, relative to the price of ETH, the primary benchmark by which DeFi success is assessed. Since DeFi assets have been underperforming the mainnet token, it is hard to convince people that such protocols are preferable investments. This deprives the entire ecosystem of liquidity, which creates a negative feedback loop, perpetuating the problem.

Ultimately, reversing this feedback loop requires mitigating user concerns about DeFi and improving the sector’s accessibility. By focusing on primary user experience and risk mitigation, the DeFi community will be able to broaden its appeal and set the stage for its next bull market.

Step One: Make DeFi more user-friendly for non-crypto natives

The reason for DeFi’s incredible growth is also the reason for its current plateau. Prior to DeFi, people steeped in crypto had an unfulfilled need for on-chain financial products and services. When DeFi reached an inflection point of usability in the summer of 2020, crypto users with even a little bit of technological sophistication onboarded to DeFi, en masse. The entire cohort of users with sufficient technical prowess, but also necessarily high-risk tolerance, had entered by the end of 2021.

DeFi is in a place now where there is not an apparent influx of new users. This can be attributed to several factors, chief amongst them is the difficult onboarding experience and the un-intuitive user interfaces of DeFi products.

We’ve also identified a major barrier in the DeFi ecosystem — how partitioned it is. If a user wants to perform one task, it usually requires navigating several independent DeFi protocols. Novices will not invest the time necessary and frankly, they shouldn’t have to. DeFi needs more integrated solutions if we are to see movement among a mainstream audience

Let’s take a simple well-formed action that many people are interested in doing — earning interest on their money. You can earn more attractive interest rates in DeFi compared to traditional legacy markets. Assuming you don’t have much money to start with, you’ll want to use a low-fee chain. In the current state of mainstream adoption, thisknowledge is not common and only accessed by a small number of DeFi enthusiasts.

Using Avalanche (AVAX) as an example of what it takes to deposit on these platforms, a user must:

1. Swap into the appropriate bridgeable asset, requiring the user to find out which assets are acceptable.
2. Bridge said crypto asset via a reputable bridge protocol.
3. Immediately swap into some AVAX to pay for all future transactions. Also swap into the asset the user wishes to earn yield on if it wasn’t bridgeable. Both require the user to know a reputable decentralized exchange with sufficient liquidity for the pairs the user wishes to trade.
4. Deposit the asset into a lending protocol, such as Aave.

All but very technically proficient crypto users would abandon this at the second step, if not the first. Most would abandon before starting because they wouldn’t know where to begin. All of DeFi is like this: unusable for all beyond a niche community. Should it stay like this, it will never attract a wide audience in its current state. Ever.

What if a user was able to navigate all of this through one wallet app? The experience could be more seamless:

1. Click on the “earn interest” button and browse through different protocols. The wallet will present the user with different rates on different protocols.
2. You choose a crypto asset to swap into. A swap rate and bridge time are given. The user verifies and, behind the scenes, the crypto asset the user chose to swap is bridged, swapped into USDT (if necessary) and added to the appropriate Aave pool.

This example exposes users to the underlying protocols. Others could be even simpler, with nearly one-touch investing. The wallet could offer tiers of use — beginner, intermediate and advanced. Rather than requiring a computer science degree, this new system will simply require two minutes of a user’s time.

Step Two: Building new risk mitigation tools

No user experience, however pleasant, will be an effective incentive if the underlying system is perceived to be unsafe. That’s why strong risk mitigation measures must go hand-in-hand with improved user experience.

People know there are plenty of guardrails if they make mistakes with their traditional bank. They know that even if they make a mistake, there is a high possibility that it can be reversed. Current DeFi users do not have guardrails nor any recourse in the case of errors. This scares away normal people who have neither the time nor the inclination to learn highly complex best practices.

Another unacceptable risk for normal people is the non-trivial chance that the protocol itself will fail. This can happen for a variety of reasons: bugs in code, incompetent coding (the code is acting exactly as intended but with unintended consequences), malicious actions of the developers, and so on. For most public financial products, the government regulates and in many cases insures people against institutional failure. This is not the case in crypto.

To fix these problems, currently guardrail-less DeFi protocols must develop safer front ends. For some modest increase in fees, this front end could enable slower finality and perhaps even the ability to reverse transactions. More advanced users or users willing to take on more risk will always be able to access the faster, unguarded mode.

Second, new DeFi insurance programs should be developed. A robust DeFi insurance system should leverage blockchain’s inherent transparency to objectively assess the risks inherent in protocols using a variety of on-chain metrics. The combination of objective insurance protocols and slower front-end processing for risk-averse users should be sufficient risk mitigation to onboard the next wave of DeFi participants.

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