Can DeFi Fill the Vacuum Left by FTX?

By Nick Saponaro, CEO of Decentralized Payment Platform Provider, Divi Labs

As FTX fell last November, trading volumes on decentralized exchanges (DEXs) began to peak. They tripled on Uniswap, one of the world’s largest and most trusted DEXs, to $4.2B, while the total across the industry hit $107B. An increase of 110%.

This was to be expected. As the ground opened beneath Sam Bankman-Fried and his reckless and fraudulent centralized exchange, users fled the sinking ship and made their way to the relative safe haven of the cryptosphere. I say “relative” because DEXs are not without their issues.

Security is Priority One

From the Ronin Network hack to the Wormhole Bridge, by exploiting vulnerabilities in smart contracts, hackers have cost users $billions in 2022 alone. To overcome these issues, code must be held to a higher standard. Rooting out vulnerabilities is critical, as is ensuring services are robust, test-driven and scalable. 

However, it isn’t only smart contract code that requires immediate attention. It’s also the rules that govern the exchange’s use, which is also open to exploits. As with the recent Mango Dex scam, a bad actor drained $100m of users’ assets from the liquidity pool by exploiting a loophole in the exchange’s rules.

Ultimately, these technical issues can and will be ironed out. Compared to the seasoned professionals who built the mainstream services that are now ubiquitous in our daily lives, DeFi devs are relatively immature. By implementing development standards from the “traditional” world, developers and the DEXs they support will be better equipped to defend against exploits. 

Once done, vulnerabilities in the code and the rules that underpin user activity will have much tighter controls. In addition, DEXs will likely be regulated to a degree and subject to some form of KYC (know your customer) compliance.

My younger self would abhor the thought of KYC applied to decentralized services. But the older, more weathered me understands that compromises will be needed to ensure an alternative finance system can rise. I’m willing to give up privacy if it means maintaining financial sovereignty. I recently ran a poll on Twitter, confirming many others are too.

Rooting Out Rug Pulls

Two further factors must be addressed before DEXs can establish themselves as the successor to the centralized exchanges’ crown. That of stability and usability. Let’s look at stability first and the need for greater sustainability in the underlying tokenomics of a decentralized exchange. 

Whereas a traditional, centralized exchange will have a variety of profit centers, streams of income and the ability to take on debt based on their balance sheet (or their customers’ funds), their decentralized counterparts do not share in this luxury. Decentralized Exchanges are just that, decentralized. As such, their primary revenue stream comes from collecting fees from trades on the liquidity pools and staking yields generated by users of the platform.

In some cases, DEXs also have their own token, which can earn the platform yield through staking or by taking profits when said tokens increase in value. Because of this dichotomy of incentives, when platform operators are at risk of serious losses, it is not uncommon for them to “pull the rug” by withdrawing and selling all assets under their ownership, which in most cases, is the majority of the liquidity on the platform. 

A report published by blockchain research company Chainanalysis found that rug-pull scams were responsible for more than $2.8 billion in illicit activity in 2021 and that 37% of all crypto-related scams were in DeFi. In fact, rug pulls are so prevalent entire websites devoted to helping users to navigate the relative safeness of DEXs have appeared. 

To ensure users feel safe using a DEX, they must be convinced that the underlying platform token is secured by sustainable economics and not “Ponzinomics.” This can only happen when the platform can sustain itself without having to leverage the assets on the platform or perform actions/make sudden decisions that make those assets more volatile than they already are. 

This leads us to a new category emerging in crypto, RealFi, which refers to using real-world assets to subsidize a platform’s stability.

RealFi happens when the business behind the DEX is built on a solid foundation of assets that don’t rely on the exchange to grow in value and are not subject to the volatility of the cryptosphere. For example, when the DEX is just one product in a suite of services, like Divi, which has multiple revenue streams generated from building its own products and white label partnerships. 

Similarly to investing in traditional enterprises, this type of sustainable structure is something on which investors in decentralized businesses will also be focused. Right now, DeFi is not a significant enough revenue driver for it to be a self-sustaining entity. But it could be a consequential part of a larger organization. It’s a sentiment we’ve already seen gaining momentum in the NFT space.

After the calamitous loss in value of the NFT industry, the owner of Fanatics, Michael Rubin, announced he had divested 60% of his stake in Candy, saying, “it has become clear that NFTs are unlikely to be sustainable or profitable as a standalone business,” and “We believe digital products will have more value and utility when connected to physical collectables to create the best experience for collectors.”

Attracting the Mainstream User

The complexity of using decentralized services, combined with speed/convenience, are the key factors that drew users to centralized exchanges in the first place. To become a viable alternative for the mainstream, the final piece in the DEX puzzle is usability. 

The stability of both coins and the services on which they are built will only be achieved through mass adoption. But mass adoption can only happen when things are made simple and straightforward.

The challenge with many of the platforms that have come before is they were built for people who both enjoyed and had the insight, understanding and technical prowess to take part in the Thermodynamic Ponzinomics and game theory that these platforms were built upon.

But what about the mainstream user who wants to trade crypto or take some leverage on the crypto they already own? Today, no money manager will advise their clients to jump into DeFi in its current state. For that, it needs to be elevated so that it’s useful to everyone, with services that can be accessed via the click of one button and can be used as an instrument for sustainable yield versus just being a crazy bet.

This last point opens the debate around what truly is the intention of crypto. The question we must all answer is this; is it somewhere that people willing to take on the risk and volatility can make significant gains? Or are we trying to build something that will benefit humanity?

About the author:  

Nick Saponaro is the co-founder and CEO of Divi Labs, developers of a decentralized payment ecosystem that aims to improve people’s lives by making crypto easy and accelerating its mainstream adoption. A dedicated proponent of the founding principles of the crypto movement, Nick is working towards delivering a new paradigm for financial services. One that is truly decentralized, accessible to all, and works for everyone.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.