Algorand <> DeFi - the perfect match.
We have all been watching the DeFi boom with excitement and wonder, growing 7,500% in 12 months with no signs of slowing down. Even so a majority of the market equity is not deployed, for example less than 1% of Bitcoin is currently working in DeFi. Hence even though the growth has been extreme we are still at the tip of the iceberg for what this opportunity holds.
Let’s look at the challenges DeFi faces and there are several, including cost, speed, risk, compliance and scalability. To understand these issues better, I explore the overarching elements of each below.
Cost:
The first thing that comes to everyone’s mind is transaction costs, which forms a large part of the issue as it limits usability and functionality. For example, smaller trades, automated distribution and returns / APY (chipped away by gas fees) are all impacted by high costs. In products such as DEXes the future value drivers for liquidity providers should be focused around the business models of centralised exchanges where the fees from trades provide returns.
But with a majority of DeFi taking place on the Ethereum network, transaction costs create serious issues, small transactions aren’t economical, pooling is needed to be more cost efficient but also impermanent loss compounds the issue removing the likelihood that trading fees would be a strong enough return as in many cases the fees don’t cover this loss. This in turn has meant more and more yield is being delivered in added token rewards, a great idea and quite a powerful marketing tool and adoption driver. But having to counter high fees and make up for impermanent loss means it creates in essence a false economy and even so the returns aren’t maximised. Meaning if projects want to deliver a certain level of returns their runway for delivering inflated yield (with what I call marketing tokens) is shortened. This might be ok if the pool returns (by the time the runway ends) are strong enough to stand alone. But while the above issues remain this doesn’t seem likely.
Speed & Finality:
The market drop in May 2021 really demonstrated how important speed is, with so many users needing to recapitalise their loans to avoid liquidations along with the flurry of usual trading we saw a dramatic increase in transaction costs on the Ethereum Network. Culminating at an eyewatering top of USD$71.72* (May 19, 2021). Considering how much room there is for the market to grow this issue will only be exacerbated. Speed when combined with certainty of finality also creates comfort and usability, particularly with broader adoption. Purchasing coffee, withdrawing funds from a yield pool to redeploy, collatorising a loan, trading via a DEX (no front running) or staking to participate in a DAO vote are all great examples of where speed, certainty and ease of use help promote global adoption.
Risk & Compliance:
There are a few elements to what makes up risk in DeFi, tech risk being the largest. Though there isn’t necessarily counterparty risk in the traditional sense, there is in a platform / smart contracts sense. Hacks or gaming the system has caused some of the largest market thefts (in some cases better described as exploitation of tech loopholes) to date. Though these risks will always remain as more sophisticated products come to market and we see broader adoption, minimising the risk is the aim. For example having to pool assets in order to reduce transaction costs creates a larger target (pot of gold) for would-be attackers. Which means one of two things, greater security is needed and the need for new ways to effectively execute many of the current market products. One of the key benefits of Algorand is it removes certain types of risks. For example, Algorand doesn’t fork (particularly useful for NFTs), you can not jump the queue (removing front running risk) and has instant finality. This also means projects can channel the energy usually needed to address these issues into other risk areas.
Compliance is probably one of the least popular topics as it generally evokes emotions of frustration and even sometimes anger from that feeling of being stripped of our privacy by Big Brother. The blockchain community needs to look at ways to bridge the gap, creating new ways to manage privacy while meeting future compliance issues needed for broader adoption. The challenge is how to best improve the system, with the world becoming more decentralised and digital there are elements of accountability that can also leverage a new system of identity. Essentially creating the ability to have a singular identity that can be kept private yet verifiable, meaning we wouldn’t see the issues of multi account scammers, we could trade on one of the only currencies we all have equally — our reputation, while allowing broader adoption.
I believe this may also play a role in the ways some future DAOs function, with the ability to have a KYC consensus of membership without having to compromise individuals’ privacy could be a fantastic way for DAOs to become more powerful. A key piece in the future of DeFi.
Scalability:
It is easy to see that DeFi in its current iteration faces tremendous scaling issues. With only a fraction of the crypto market equity being utilised and $90T in equity in the traditional financial markets yet to make its way in, scaling is an uncompromising necessity.
Algorand:
When taking into account the above issues DeFi faces, it becomes clear why Algorand is a perfect match. Low cost, lightning fast, fork free, scalable, instant finality, native atomic swaps, carbon neutrality, decentralised, proven reliable tech, secure and trusted.
Trusted being an important component that can often be overlooked, in order to see broader adoption safety and certainty in the underlying technology will be a must. With a majority of the world earning a living wage and institutions generally being mandated with low risk tolerances, the need for confidence in the safety, security and quality of the blockchain technology being used and in turn the team behind it is paramount to future success. With Silvio Micali at the helm of an all-star team that includes Nobel peace winners and some of the brightest minds in economics, business and computer science they are well equipped for the challenges ahead.
With all this said it is now time for the Algorand ecosystem to grow and to challenge and with so many incredible products coming to market it is going to be an action packed period ahead.
Finally, if we lean into the philosophy behind what blockchain is meant to enable, my first thoughts go to independence and equality. Enabling a trustless ecosystem where we have learnt from the failings of the past and collectively change for the better. One thing to keep in mind is in order for this to be true, we must ensure that the value delivered isn’t just financial and isn’t centred around financial value. Though it can be a means to an end it can not be the only driving factor in a better future.
* https://ycharts.com/indicators/ethereum_average_transaction_fee
