Decentralised Finance clearly has the potential to change the world, but most of what bears that nickname today is by no means truly DeFi.
The ecosystem is full of early versions of DeFi with many flaws: Because the technology is new, because the Blockchains they work on have their own flaws, and because people are greedy and see an opportunity to make a lot of money very quickly by getting the products out without worrying about who ends up paying for their profits. We can do better.
Just as the ICO boom in 2017 sparked a lot of interest in the market for crypt products, DeFi will also draw a lot of attention to our industry. But we must remember that the cost of the run-up to 2017 and the 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 deliver on their promises. Rather than fast-track projects that do not live up to their own stated ideals, we should aim higher to interest the general public in elements of the DeFi that are sustainable and live up to their promise. So far, few do, but we as an industry can deliver on our promises with DeFi.
DeFi fans often point out how broken the existing banking and financial systems are. That’s true, but they don’t realise the even more obvious shortcomings of their own systems. DeFi advocates a democratic opportunity to make money and provides freedom from excessive regulation, while fighting the exclusion of ordinary people from lucrative investment opportunities and the information imbalances that put the little guy at a disadvantage. These are noble ideals that must be realised, but that is not what DeFi products bring us at this time.
So far, the DeFi has given us:
- Developers who build multi-million dollar systems from which they do not benefit.
- Developers who go upstairs to their communities to make money in advance.
- Providers of liquidity by taking out the backing.
- FOMO fans making profits in tokens with endless inflation.
- Government tokens that do not govern and only serve as rewards.
- Votes that are nothing more than a poll that project developers can choose to execute – or not.
- Big bags of tokens pre-mined by the founders at the expense of the community.
- DeFi platforms that fail to provide meaningful incentives to many of their stakeholders.
- DeFi platforms built on smart contract platforms with commissions so high that only large traders can expect to make a profit.
The crypto community can demand more if it only supports projects that really live up to the hype. This requires more critical thinking and a clear set of guidelines that serve as a minimum requirement for an investment project. The cost of the nascent DeFi industry not promoting such a set of requirements is that DeFi projects will follow increasingly shorter cycles of branching, launching, extracting and dumping until it becomes clear that there is no future for these projects. At that point, we are likely to see the general interest in Blockchain technology and cryptomontages diminish again until some future cycle where the industry offers real value rather than schemes to enrich itself at the expense of others.
Simple rules for DeFi projects
There is a simple set of guidelines that we must require before participating in any DeFi project. In short, the project should live up to the principles that are said to make DeFi better than current systems.
First, the founders must be publicly identified and have a definitive background in the Blockchain industry. When the „developers“ behind a project are not identified, the personal cost of running an exit scam becomes incredibly low. Only when people put their own name and reputation on the line with these projects can they begin to have credibility.
Secondly, every crucial member of the ecosystem must be rewarded with a contribution. It would seem axiomatic that if a system depends on the functioning of a certain group, then it should be rewarded in proportion to its importance. Projects that rely on price oracles, traders, influential people, or others in the ecosystem that are necessary but not rewarded are putting those groups in positions that limit or prevent the long-term success of the project.
Third, there must be no pre-mining or funds allocated to developers that can be stolen. Launching with a pre-mining has been a common way of rewarding the founders of the project and also a common way for those founders to throw tokens and cash away at the expense of everyone else. In contrast, developer fees are better earned along the way as the project develops.
Fourth, governance must be taken more seriously. Any governance currency must be released for a limited time. The release of governance currencies must be done with a clearly defined token programme that lasts for a reasonable time. Short issuing periods tend to centralise control only among early adopters, while longer periods distribute ownership better but mask the true tokenisation of a project. Any DeFi project must be controlled on-chain by the token holders, not just through multi-sing and surveys. The open secret of DeFi’s governance tokens is that most are not actually used for governance. If a project is going to claim to be governed by the community, then the results of the voting must trigger action on Smart Contracts, and the voting should probably be incentivised with some form of small rewards to cover at least the cost of the voting, if not some small additional share of the revenue as an incentive.
Fifthly, there should be protection against „carpet-pulling“ by liquidity providers and better security measures to protect DeFi’s reputation in general. A „carpet pull“ from an automated market maker is when a very large liquidity provider behind a pool pulls its liquidity out without warning, leaving other liquidity providers in the pool suddenly in the position of creating high volatility and greatly increasing their chances of so-called „impermanent loss“ – which often becomes permanent very quickly in these circumstances. In addition, people continue to lose tokens due 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 audit of the source code. This situation is exacerbated when the founders are unknown or have no public record. Projects should be open source and independently audited to avoid this.
Finally, the cost of transaction fees must maintain profitability for small investors. Recently, at Ethereum, a single DeFi transaction averaged $40 or more, and trading or staking with tokens could easily take 2-3 transactions just to get into a pool. As a fair guide, the cost of trading on the platform should not exceed the anticipated daily earnings for a
While this list of requirements may seem overly demanding compared to DeFi’s current offerings, it actually reflects more the quality of the current offerings than these very reasonable guidelines for providing a decent platform on which users have the opportunity to do well. Remember, the benefits 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 increased efficiency, participation, and ultimately an increase in the overall value of the system for everyone. However, in too many of DeFi’s current project incarnations, these benefits for some come at the expense of many other participants in a regressive „pump-and-dump“ form that should make investors yearn 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 limits, or whether these will be characterised by the same scams and disappointments that were seen in the ICO craze of 2017, but at a faster pace. Only one of these options has the ability to make DeFi commonplace and deliver on the promise that so many people see even when the projects do not really support them.