In crypto winter, DeFi needs an overhaul to mature and grow

For several months now, the decentralized finance (DeFi) sector has been on the receiving end of a major bear market, so much so that the total value locked within this space has slipped from its all-time high of $150 billion (achieved back in May 2022) to its current levels of just over $50 billion.

Despite this, the amount of capital flowing into this space from “centralized avenues” has grown, largely due to the collapse of FTX alongside other prominent entities like Celsius, Genesis, Vauld, etc. — even doubling trading volumes on many platforms over the course of November 2022 alone. Not only that, amid the recent market volatility, several decentralized exchanges and lending platforms continued to function smoothly, especially in comparison to their centralized counterparts.

Thus, in order for DeFi to truly reach its maximum potential, the sector needs a significant transformation. This is because a large number of protocols operating within this space have been continuing to offer users unsustainable returns for far too long. Moreover, with the recent surge in interest rates, inflation levels — and the so-called “risk-free” rate of return on six-month Treasury bills surpassing 5% — investor interest in decentralized options appears to be diminishing.

In fact, even the rapidly changing macroeconomic environment has affected DeFi, with various established projects implementing significant changes to their reward structures just to remain competitive. For instance, MakerDAO recently voted to increase its Dai (DAI) savings rate tenfold to 1%.

How can DeFi regain consumer confidence?

According to Rachid Ajaja, founder and CEO of AllianceBlock — a decentralized infrastructure platform connecting traditional financial institutions to Web3 applications — DeFi, like all global markets, is going through a cycle right now. And while what happened with Terra, Celsius, Three Arrows Capital and FTX most definitely shook investor confidence, the problem lies with the players operating within the market and not the technology itself. He told Cointelegraph:

“To bolster and maintain consumer confidence, DeFi needs to focus on solutions that put users first and protect them. This means working towards compliant DeFi solutions that focus on identity management, data encryption, data ownership by users, and trustless KYC procedures.”

“These can pave the way for the tokenization of real-world assets and financial instruments, thereby attracting more cash flow into DeFi, including from traditional players and institutions who place a high value on compliance and sustainability,” he added.

Similarly, Varun Kumar, founder and CEO of the decentralized exchange Hashflow, told Cointelegraph that, at present, this niche industry needs stronger products that are capable of solving real-world problems. “The DeFi ecosystem is still in an exploration phase, with lots of projects still identifying their respective market fits,” he said.

However, Kumar claimed that, while there is a direct correlation between consumer confidence and declining dollar volumes, it’s important to consider other factors as well. For example, the DeFi boom of 2021 happened amid a strong macroeconomic environment, which had a significant impact on the sector:

“This quick growth was a great kickstarter for the space and created a lot of opportunity. However, now that conditions are different and volumes are much lower, business models and value propositions are being reshaped. Superior products will always win, from which consumer confidence will follow.”

Juana Attieh, co-founder and chief product officer for Fluus, an aggregator of fiat-to-crypto gateways with a crypto ramping network, told Cointelegraph that DeFi’s decline and loss of trust have been due to centralized entities abusing their power and exploiting their consumers time and again.

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To restore market confidence, she believes DeFi participants must prioritize enhancing transparency and creating standards for sharing information about underlying assets, protocols, governance mechanisms and more.

“Security measures must be significantly improved to protect user assets and information. This could include conducting regular audits, implementing bug bounties, and other measures to ensure the safety and security of DeFi protocols,” she said.

Attieh further believes that it is crucial for the sector to work closely with legislators so as to obtain regulatory clarity and devise governance frameworks that can reduce volatility and uncertainty while restoring confidence.

Not everything looks bad

Even though the market is going through a bit of a lull at the moment, Robert Miller, vice president of growth for Fuse, a blockchain-based Web3 payments ecosystem, told Cointelegraph that DeFi (specifically automated market maker-based applications) seems to have found an enormously successful product-market fit during the last innovation cycle. He said:

“Despite the drop, the fact that $50 billion in liquidity is still currently deployed to DeFi protocols is exciting and unprecedented in the world of finance, where we would typically need to rely on institutional market makers and lenders as the catalyst to get the economy moving again.”

Miller conceded that heightened consumer confidence and demand will only come with improved user experiences. “Even as a seasoned crypto professional, I still struggle with using well-known DeFi apps, so I can’t imagine how difficult it must be for the layman,” he added.

Andy Ku, CEO of Altava Group, a digital content Web3 ecosystem, believes that sometimes things need to get really bad in order for them to eventually become stable. He told Cointelegraph that, in the past, bad actors have loosely used the word DeFi to promote platforms that were more or less fully centralized.

However, in his view, most quality DeFi projects today are firmly rooted in the ethos of transparency, with a growing list of these offerings now undergoing smart contract audits and publishing proof-of-reserve reports to help restore confidence in this space.

“The growing distrust in traditional financial institutions is what has given birth to DeFi. The balancing act now is how to evolve DeFi into something that has more transparency, oversight and accountability,” he said.

Wherein lies the future of DeFi?

Learning from the various high-profile scandals of 2022, Ajaja believes that the next wave of DeFi will put a stronger emphasis on compliance and customer experience. In this regard, she noted that we are already seeing the rise of projects that are focused on providing compliant DeFi solutions that integrate trustless Know Your Customer and Know Your Transaction protocols, which are key for long-term adoption by traditional industries.

Moreover, the concept of self-custody is also fast becoming important in the minds of many users, with more and more DeFi projects working on self-custodial wallet solutions that give full control and ownership of their assets and data. These wallets make it easy to manage and recover assets, store encrypted digital identities and verifiable credentials, and give the users full control over how they share this information.

Attieh believes that, while the bear market may have caused a decline in the usage of some DeFi projects, particularly as investors become more risk-averse, it is likely that the most robust projects with strong fundamentals and real-world use cases will continue to flourish and gain traction, even in challenging economic conditions.

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In a somewhat similar vein, Daniel Fogg, president and chief operating officer for IOVLabs, the firm behind Rootstock — a smart contract platform secured by the Bitcoin Network — told Cointelegraph that the one positive outcome to emerge from the ongoing crypto winter is that it has reduced the white noise surrounding the ecosystem, adding:

“We’re seeing more builders and lesser buzzwords. For the DeFi sector to cross the chasm, teams building crypto projects must focus on accessibility, usability and utility. We need to be building products that solve real problems for real people — paying bills, sending money to family members overseas, getting protection from runaway inflation, finding safe places to save their money.”

Therefore, as we head into a future driven by decentralized technologies, it will be interesting to see how the rapidly evolving decentralized finance paradigm continues to mature, especially with more people looking for avenues that do not use intermediaries.