Decentralized finance (DeFi) is a growing market popular among power users of cryptocurrencies. However, there are some barriers to mainstream adoption when it comes to the average non-tech investor.

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DeFi is a blockchain-based approach to providing financial services that does not depend on centralized intermediaries, but instead uses automated programs. These automated programs, known as smart contracts, allow users to automatically trade and move assets on the blockchain.

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Protocols in the DeFi space include decentralized exchanges (DEXs), lending and borrowing platforms, and income farms. Since there are no centralized intermediaries, it is easier for users to get involved in the DeFi ecosystem, but there are also increased risks. These risks include protocol codebase vulnerabilities, hacking attempts, and malicious protocols. Combined with the high volatility of the cryptocurrency market as a whole, these risks could make it difficult for DeFi to be widely adopted by mainstream users.

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However, workarounds and advances in blockchain can solve these problems.

Regulatory issues with DeFi

Regulation can benefit the DeFi space, but it also goes against the core principles of decentralization. Decentralization means that a protocol, organization or application does not have a central authority or owner. Instead, the protocol is built with smart contracts running their core functions while multiple users interact with the protocol.

For example, smart contracts take care of staking and swaps with the DEX, while users provide liquidity for trading pairs. What can regulators do to prevent an anonymous team from pumping up the value of a token before withdrawing liquidity from the DEX, also known as pulling the rug? Due to the decentralized nature of the DeFi ecosystem, regulators will face challenges trying to maintain some level of control in the space.

Despite the challenges, decentralized finance regulation is not entirely out of the question. In the fourth quarter of 2021, the Financial Action Task Force released an updated version of its guidance on virtual assets. The update outlines how DeFi protocol developers can be held accountable amid the crisis. Although the protocol can be automated and decentralized, the founders and developers can be called Virtual Asset Service Providers (VASPs). Depending on the state they are based in, they may also need to be regulated..

In terms of regulation within DeFi, platforms can also create protocols that comply with regulatory requirements. Phree, for example, is a platform that builds decentralized protocols while respecting regulations where possible. One way to do this is to work with traditional financial institutions to create DeFi protocols that meet standard regulatory requirements. This will entail adding processes such as Know Your Customer and anti-money laundering checks to DeFi platforms such as DEX and lending or borrowing platforms. Additionally, making traditional finance (TradFi) interoperable with the DeFi ecosystem will help spread their adoption due to the dominance of organizations in the TradFi space.

Ajay Dingra, head of research at smart exchange Unizen, told Cryptooshala: “Incompatibility with the traditional financial ecosystem is one of the main challenges. The CeFi regulatory framework needs to be linked to on-chain identity and real-time regulatory reporting to make Defi accessible to trillion-dollar financial institutions.”

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Central bank digital currencies (CBDCs) have been proposed as a response to stablecoins following the collapse of the algorithmic stablecoin Terra earlier this year. Swiss National Bank chief executive Thomas Moser previously told Cryptooshala that regulators may favor centralized stablecoins over decentralized ones. However, he also mentioned that this would likely take time and that current financial regulations could render the DeFi ecosystem obsolete due to conflicting principles.

Security Issues in the DeFi Ecosystem

Security issues are a major concern in the DeFi sector as attackers in this space exploit vulnerabilities in bridge protocols and decentralized applications (DApps).

Adam Simmons, director of strategy for RDX Works, creators of the Radix protocol, told Cryptooshala: “The dirty secret of DeFi right now is that the entire public ledger technology stack has a huge number of known security issues, as evidenced by the billions of dollars lost in hacks. and exploits over the past few years.”

Vulnerability exploits are still happening in the DeFi space. Recently, $160 million was spent from the Nomad token bridge. It is also estimated that $1.6 billion worth of funds have been stolen from DeFi protocols this year alone. The lack of security in the DeFi space reduces the chance of new users getting involved and scares off people who have been victims of protocol exploits.

To combat this problem, more attention needs to be paid to validating protocols in space to find vulnerabilities before hackers can exploit them. There are already platforms like CertiK that audit blockchain-based protocols by checking the smart contract code, so this is a good start. However, the industry needs to strengthen the auditing of DApps before they go live to protect users in the crypto space.

User Interface Issues

User experience (UX) is another potential hurdle for users who want to participate in the DeFi ecosystem. The way investors interact with wallets, exchanges, and protocols is not a simple intuitive process, which results in some users losing their funds due to human error. For example, in November 2020, a trader spent $9,500 in fees to complete a $120 trade on Uniswap after confusing the “gas limit” and “gas price” input fields.

In another example, a $1.2 million non-fungible token (NFT) was sold for less than a cent when a user listed it for sale at 444 WEI instead of 444 ether (ETH). These examples are known as fat finger errors, where users lose money due to mistakes they make when entering price values ​​or transaction fees. For DeFi to be widely adopted by the masses, the process must be simple for ordinary people.

However, this is currently not the case. In order to use the DeFi application, users need to have a non-custodial wallet or a wallet in which they control the private keys. They also need to back up the recovery phrase and keep it in a safe place. When interacting with a DApp, users need to connect their wallet, which can sometimes be difficult, especially when using a mobile wallet.

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In addition, when sending or receiving payments, users need to copy the addresses involved in transactions, and in some cases they need to enter the amount of gas they want to spend on a transaction. If the user does not understand this process, they can use the low gas setting and end up waiting for hours for their transaction to be sent as the gas fee is very low.

The process becomes even more complex when dealing with tokens built on networks such as the ERC-20 and BEP-20 standards. When you transfer these tokens, you need to pay for the transaction with the cryptocurrency of the network to which it belongs. For example, if you want to send an ER-20 token like USD Coin (USDC), you will need to hold ETH in your wallet to pay for gas, making the transaction more difficult.

Developers in the DeFi space need to make the ecosystem more user-friendly for beginners and general non-technical users in the space. Building wallets and DApps that prevent fat finger errors (for example, by automatically entering values) is a good start. This already applies to centralized exchanges, but for the DeFi sector to grow, it needs to be transferred to decentralized platforms and non-custodial wallets.