Recent events in the crypto world like the Tornado Sanctions, the Ethereum Merge, and the Wintermute DeFi hack have affected DeFi platforms in two different ways. Retail investors have retreated in caution as control falls out of their hands, and skepticism towards newer protocols has led to them either withdrawing their funds or opting for platforms with more skin in the game. On the other end of the spectrum are government and regulatory bodies that have tried to protect retail investors from these kinds of events.
The Tornado Sanction is a perfect example of a government body stepping in and actively trying to regulate, clarify, and give the DeFi space more direction. All these events are shaping how the space moves forward and how protocols are built. Post-Tornado sanction, protocols are being more careful by integrating privacy features. Post-Ethereum Merge, protocols are concerned with decentralization following talks of nodes being controlled by a few entities with miner extractable value (MEV). Post-Wintermute, governments are trying to protect users from experiencing these hacks. Here are six other DeFi trends to look out for moving forward.
The race to solve liquidity issues
There’s no denying that liquidity has been the impetus behind DeFi’s growth, and the protocols most successful at capturing liquidity have lived the longest. Since Uniswap v3 introduced concentrated liquidity, the new model of pooling liquidity has become a trend among the decentralized exchange (DEX) players. This model addresses the shortcomings of the original XYK formula, where the liquidity in the pool is spread across all possible price ranges. Before only market orders were possible, but now that the liquidity is provided in smaller ranges, getting out of that range will stimulate a limit order and liquidity providers won’t incur any IP losses outside a predefined range. We’ll see more protocols following suit and offering custom price curves that align with liquidity providers and their personal goals.
In addition, liquid staking protocols have gained prominence in the crypto economy and increased access to liquidity by enabling owners to use their locked-up assets for investments and yield in other activities. One forerunner is Lido Finance – a non-custodial liquid staking protocol for Ethereum (CRYPTO: ETH), Kusama (CRYPTO: KSM), Solana (CRYPTO: SOL), Polkadot (CRYPTO: DOT), and Polygon (CRYPTO: MATIC) – which lets investors deposit Solana, for example, and get a liquid staked Solana token in return that can be used elsewhere in the market. Despite the decreased demand for staking since May, it will emerge as the key to unlocking the emerging proof-of-stake (PoS) blockchains.
Chains are relying on bridges, but they shouldn’t
The diversity of existing protocols and systems is a double-edged sword. Since we are now in a multi-chain world, questions around cross-chain transactions are at an all-time high. Currently, many DeFi protocols still operate in siloed environments – trapping users in specific ecosystems. That’s why we’re seeing similar finance verticals– DEXs, lending and borrowing marketplaces, insurance platforms, and other trading options – being replicated across multiple chains. On Ethereum, Uniswap is the leading DEX, for Avalanche it’s Pangolin, for MultiversX it’s Maiar, and so on. These protocols don’t share liquidity, so the trading experience between chains is disrupted.
A classic solution to this problem is adding as many bridges as possible to as many chains so users can easily port their tokens from one chain to another. The problem with bridges is that they also fragment liquidity because they’re not compatible – different bridges have different token standards. Security is another issue as there have been several recent exploits at the bridge level. Also, after you bridge, for example, from Ethereum to Solana and there’s a problem on Ethereum, it will disrupt your liquidity on Solana. Ideally, the price should stay pegged, so in the end crypto bridges may not be the winning solution.
The multi-exchange approach is another solution. An exchange like Uniswap (CRYPTO: UNI) is deployed on many chains and there are technologies to let this liquidity interact cross-chain, so no bridge is needed. You can trade on the same platform but on different chains. For example, SushiSwap is a DEX that can swap different types of crypto without having to use a bridge. Another example is Stargate Finance, a protocol that enables omni-chain interaction between protocols and instant finality if there is enough liquidity available on the destination chain.
The DeFi ecosystem is balancing regulations and innovation
Regulation is the biggest challenge and top priority in the DeFi space. Without a properly regulated DeFi and crypto space, DeFi will not move forward. There are countless examples, where DeFi has had to comply with regulations. Tornado Cash was sanctioned and suddenly disappeared. Uniswap was forced to remove tokens from their interface and the derivative tokens from other protocols that were listed on Uniswap. Even the recent discussions by the US House Committee of a potential two-year ban on all algorithmic stablecoins could have major repercussions. Algorithmic stablecoins are integrated into many protocols and if they’re banned, the value of these stablecoins that people are borrowing will be erased.
It will all come down to whether crypto companies are targeting mass adoption. For mass adoption, regulation is non-negotiable. Without this, DeFi will remain a gray area and potential adopters will be reluctant to enter the space out of fear of sanctions and illegal activities. Tornado Cash was a gray area and the users that interacted with it found themselves in the middle – suddenly their money was tainted and unrecoverable.
Companies not targeting mass adoption see DeFi as a niche for certain people and institutions that only care about what the code says and desire a more relaxed, less regulated system. If this is the case, big institutional money will never enter the space as this wouldn’t be the optimal environment for managing hedge funds or pension funds for instance. Big institutional players rely on some form of regulation and can’t just put money where they want to, so regulation will be pivotal for these institutions to interact in the DeFi space.
Building protocols like lego blocks
DeFi startups are starting to manage their protocols more efficiently, and as a result, we’re seeing more and more protocols using other protocols like lego blocks to spawn new utilities. What this mixing of protocols does is enable users to trade with leverage and offer on-chain perpetuals that exist in traditional finance and have existed in DeFi, but haven’t been successful due to their design. The most successful DeFi protocols may be the ones capturing liquidity, but only the protocols that offer solutions to the walled garden, bring new and more productive use cases, and follow a financial model that brings real value like real yield – which creates a level of trust as investors can see where the yield is coming from – will achieve long term sustainability.