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Velo Labs

But she changes from day to day: DeFi shortcomings part 2

In the past two months, DeFi projects have experienced unprecedented growth — at least as measured by capital inflows. According to DeFi Pulse, more than USD 7.5 Billion in total value is currently locked in DeFi projects; more than USD 6 Billion of which has entered the market since June. Projects like Aave, Maker and Curve Finance each currently hold more than USD 1 Billion and are far outpacing the gains experienced by traditional cryptocurrency powerhouses like Bitcoin and Ethereum. While investors reap the benefits of skyrocketing DeFi token prices, market sentiment has become overwhelmingly positive and the mood is increasingly resembling that of 2017 — the peak of the ICO craze.

But don’t let the hype fool you. There are still major drawbacks to DeFi in its current form.

This article is the second in a series outlining three major drawbacks of DeFi. Namely, issues with smart contracts, market volatility, and a lack of liquidity.

Market Volatility

While hype season has the potential to attract new users to the blockchain sphere, the swelling excitement surrounding DeFi is creating an environment poised to victimize vulnerable investors. A cursory glance at the DeFi landscape reveals communities of amateur investors mesmerized by the prospect of overnight riches. Like moths to a flame, deceitful actors are poised to pounce.

Compounding this issue is the fact that cryptocurrency enthusiasts either refuse or are unwilling to learn from past mistakes and cautionary tales. Even ignoring the clear parallels between today’s DeFi explosion and 2017’s ICO boom, projects with recent checkered pasts continue to have significant influence on the market. Yam Finance, after suffering a devastating single-day 98% crash in token value following the discovery of fatal errors in its smart contract code, spurred the DeFi community to rally and save the project. Coordinated efforts including industry veterans such as CoinGecko allowed Yam Finance to recapture governance over its protocol. Worse still, Yam Finance successfully relaunched as YAM 2.0 and now boasts of a “community-funded audit.”

Tone Vays, Bitcoin analyst and organizer of The Financial Summit, told Cointelegraph:

The only thing useful that came from YAM is to show that these projects can lose you all your money in two days — but I already see people waiting for YAM 2.0 so the lesson was not learned.”

So long as this volatility is normalized in the market, there will be potential for nefarious actors to prey on innocent bystanders. Indeed, seemingly anticipating YAM’s rebound, someone created a token called ymd.finance (YMD) and listed it on Uniswap. The token creator added about USD 40,000 in liquidity. Within two hours, the same entity had doubled its investment and removed over USD 80,000 from Uniswap. It is reasonable to infer that YMD syphoned investment traffic from Yam Finance’s YAM token relaunch.

This isn’t to say that DeFi projects are doomed to fail. Far from it! To be successful, DeFi projects — like any other financial product — need to present a tolerable risk while offering the potential for a suitable return. This isn’t inherently wrong. It is a simple matter of risk and return. When measuring risk and return, one needs to look at the project’s value fluctuations and compare them to the requisite investment.

When examining DeFi projects from this perspective, two important-and-related pitfalls emerge. First, DeFi assets are extremely high risk due to their volatility. Second, this volatility encourages overcollateralization. Overcollateralization occurs when the value of the asset staked against a loan exceeds the value of the loan itself. These pitfalls are most evident in the DeFi lending market, where popular projects such as Maker and Compound allow users to stake equally-volatile cryptocurrencies as collateral for digital assets and tokens. In the DeFi lending market, the removal of relatively-stable-value traditional collateral creates several failure points.

For instance, if the price of the staked cryptocurrency spikes after the issuance of a loan, the borrower finds him or herself in a state of overcollateralization. Alternatively, if the price of the staked cryptocurrency plummets after the issuance of a loan, the lender, adept at measuring tolerable risk, will begin to demand increasingly valuable collateral to counter the heightened risk stemming from market volatility. In extreme scenarios, this leads to a situation where lenders are not be willing to engage with borrowers unless the borrower already owns comparatively valuable assets. This undermines the very philosophy underpinning DeFi — which is to democratize access to financial products; to provide banking to the unbanked and underbanked. Practice and intent become unaligned.

Velo Labs bridges this contradiction with the Velo Protocol — the world’s premiere federated credit exchange mechanism.

Beyond distributed and decentralized networks, federated networks are collaborative networks wherein each node maintains a state of semi-autonomy. The Velo Protocol powers a unique federated network able to bridge the multiple, formally disconnected networks that comprise international remittance. This enables the Velo Protocol to solve the problems with today’s international remittance industry as it allows for the coordinated sharing and exchange of information, credit and value between semi-autonomous, decentralized market participants across the five layers of today’s international remittance system.

Through the Velo Protocol, Trusted Partners can issue digital credits corresponding with any fiat currency for use in their day-to-day operations, with everything recorded and tracked using blockchain technology. These digital credits are collateralized by VELO tokens that bind the digital credits to fiat deposits or traditional assets. The Velo Protocol, through its Digital Reserve System, ensures a consistent and stable peg between the collateralized assets and the issued digital credits, thereby sidestepping the issues of market volatility that plague real-world blockchain and DeFi adoption.

Because the VELO token is a “bridge asset” linking the value of traditional assets to digital credits, the VELO token serves as the Velo Ecosystem’s universal collateral. As the VELO token’s price fluctuates in the market, the Velo Protocol automatically re-balances the Trusted Partner’s collateral pool to ensure that, at any given time, the locked VELO token collateral is of equivalent value to the digital credits. Not only does this protect the Trusted Partner against default, this also minimizes the likelihood of overcollateralization scenarios and empowers the Velo Protocol to enable trustless and secure digital credit transfers between two parties, without the need for middlemen. Velo Labs ensures that the issues of market volatility and overcollateralization inherent to DeFi do not negatively impact the real-world usability of the Velo Protocol.

Velo Labs is releasing a series of write-ups highlighting some of DeFi’s current risks. Read part 1 here! Stay tuned for part 3 of this series!

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The Velo Protocol is a blockchain financial protocol enabling digital credit issuance and borderless asset transfer for businesses using a smart contract system. The Velo Protocol can issue digital credits pegged to any fiat currency.

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Velo Protocol

Velo Protocol

A blockchain financial protocol enabling digital credit issuance and borderless asset transfers for businesses using a smart contract system

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