How to Make DeFi Safer

This article was written in partnership with InsurAce.

The promise of decentralised finance (DeFi) is great: providing financial inclusion and possibilities to all, irrespective of their socio-economic status. However, mere promises are not enough. What is holding the industry back from achieving this promise is the absence of safety standards in the DeFi space – especially in comparison to the well-established, matured and regulated world of traditional finance (TradFi). Accordingly, it is our firm view that if the nascent DeFi landscape is to emerge out of this phase as a matured industry that interests investors external to those in the ‘degen’, ‘retail investor’ and ‘crypto-native’ categories, the current infrastructure needs significant improvements through various iterations. These improvements are not technical but rather ideas that take inspiration from TradFi. This article will dive into certain areas of DeFi lacking innovation and possible steps forward to maturing the space.

Treasury Management

Token treasuries play a crucial role in many decentralised projects by providing a source of funds to support the application’s development and finance crucial initiatives. However, there are two main problems with token treasuries: lack of monetization and high beta, that is, correlation, with the wider market. Lack of monetization refers to the funds in the treasury not being used to generate additional revenue; instead, they just sit idle in wallets to be used to cover operational expenses and guarantee a project’s runway. Whilst this is important, not leveraging the resources to earn an ongoing yield can be detrimental to the long-term success of the project, especially during market troughs. Additionally, having a high correlation with the market means that the value of the treasury is highly dependent on the price of the token, which itself moves in price with the overall market. This creates a vicious cycle whereby a decentralised application’s (dApp) treasury loses value in a bear market, causing them to sell into less volatile tokens to cover costs; this, however, applies downward pressure on their token, further reducing the size of their treasury. 

The effective monetisation of token treasuries is fundamentally important to the growth and development of the DeFi space. Treasuries can provide a source of funding for new projects and initiatives, allowing the ecosystem to flourish. By generating additional revenue, treasuries can support the launch of new dApps and ensure the ongoing operation and burgeoning of existing projects. Monetisation also promotes experimentation and innovation in the DeFi space, and reduces reliance on venture capitalist funding, which can be restrictive and stifle decentralisation. The constant optimisation of treasuries can also lead to the introduction of unique tokenomics mechanisms, providing investors with long-term benefits and adding value to the project’s native token.

Clearly, when considering the importance of treasury management and the existing failures, a hands-on solution is needed. This solution exists, yet it does not originate from the crypto space, but rather the TradFi industry. Structured products are a popular financial instrument leveraged by TradFi traders to obtain customised investment solutions that cater to their specific investment needs and preferences. Traditionally, structured products are created through the combination of different securities and derivatives, hence are suited for investors looking for unique and targeted market exposure. Despite being created in the TradFi industry, they are also available in the crypto world. Certain products, namely covered calls, can enable a treasury to utilise its idle tokens to generate a yield in stablecoins. This yield can go to a range of areas, including operational expenses, growing the treasury, providing grants to facilitate the growth of the project’s ecosystem and more. Evidently, the use of covered calls can overcome one of the inherent problems with treasuries – a lack of monetization.

Other derivatives in the crypto space can similarly enable token treasuries to hedge their exposure to the overall market, rectifying the remaining problem of individual cryptocurrencies having a high correlation to the wider market. Delta hedging helps to mitigate the risk of price fluctuations in the underlying assets. This is accomplished by continuously adjusting the portfolio to ensure that the overall value of the position remains neutral. Remaining sufficiently hedged when managing a treasury enables the value to become substantially more stable through the dampening of volatility. Mitigating the likelihood of this loss is highly important to DApps as it lowers the potential of their runway, which, of course, is based on the value of their treasury, from being atrophied by external market conditions.

Risk Management: Counterparty Risk & Smart Contract Audits

As well as effectively managing a treasury, considering must go into whereabouts DApps are holding their tokens and the accompanying risks. Given the underlying ideologies that permeate most aspects of the crypto space, trust is strongly discouraged. Accordingly, most hold their crypto in web3 wallets like MetaMask; these custodial solutions reduce the need to trust a third party, however, expose individuals, DApps and other entities to new risks. These include smart contract risks, phishing attacks and more. 

In response to this, numerous solutions have been proposed, researched and developed – all of which are fundamentally based on nuanced cryptography. However, the majority of these custody approaches come with their own trust assumptions. For example, the institutional-grade custody solution offered by Fireblocks, MPC-CMP, splits one’s key into three independent shards. Despite the utility and safety of this solution, the crypto community remains hesitant to custody their assets with centralised companies. Notably, although these risks extend to centralised exchanges, many investors choose to ignore this counterparty risk because of its ease of use and simplicity.

To resolve this, a uniform method of evaluating counterparty risk is needed. Without attempting to reach a social consensus around which institutions and companies herald risk and which do not, many innovations built to benefit the space will remain out of reach. If managers of DeFi treasuries were aware of the risk they are taking when making use of centralised platforms, they will be able to make use of different trading products offered by exchanges and institutions to elongate their runway.

The provision of a uniform approach to ascertaining counterparty risk from a centralised authority will likely not be adopted by the community. Accordingly, a decentralised method could be used to determine what a platform’s credit score is; based on this data point, treasuries can decide whether or not the benefit of utilising a product is worth the risk of depositing funds into a centralised solution. This decentralised credit score will be based on a plethora of factors, ranging from the provider’s transparency and long-run effectiveness to community-driven research.

Another crucial risk management consideration is smart contract risks. With billions of USD locked into smart contracts, vulnerabilities in their code can be disastrous and result in severe losses to those interacting with applications supported by the contracts. Ensuring that contracts have been audited by well-respected, yet centralised firms, including Zokyo and CertiK are vital before locking funds in these contracts. However, this centralisation can lead to a concentration of power and potential conflicts of interest, especially when the auditing firms are also service providers to the clients they are auditing.

A decentralised alternative to traditional auditing methods is a highly valued alternative in the blockchain industry given it aligns with the decentralised ethos of blockchain technology. Decentralised auditing involves a network of independent auditors collaborating and verifying smart contracts and blockchain infrastructure. With the constant innovation taking place in the industry, decentralised auditing firms have been picking up steam as of late. Code4rena is a decentralised auditing solution that aims to provide a more secure, transparent and trustworthy platform for the blockchain industry. The platform uses a decentralised network of security experts who work together to verify the integrity of smart contracts and transactions. This reduces the risk of fraud and manipulation, as the network is audited by multiple parties.  Similarly, Hats.Finance is a decentralised bug bounty protocol that allows developers to securely and transparently reward security experts for finding vulnerabilities in their smart contracts. In addition, teams like DeFi Safety provide up-to-date protocol reviews that delve into smart contract risks that users should be aware of prior to making use of DApps. With these considered, DeFi can become safer by managing this type of smart contract risk.

Sophisticated Insurance Products

DeFi offers an exciting new way to access financial services without relying on traditional institutions. However, DeFi also comes with its own set of risks; this is where sophisticated insurance products come in – they help to mitigate these risks and make DeFi a safer ecosystem. These insurance products use cutting-edge technology to provide protection against potential losses, giving DeFi users peace of mind and the confidence to explore all that the decentralised industry has to offer.

Insurance plays a critical role in traditional finance as it protects individuals and businesses from financial loss in case of unexpected events such as death, illness, theft, or damage to property. The importance of insurance is evident in the fact that it provides financial security and peace of mind to policyholders, allowing them to plan for the future with confidence. In addition, insurance companies also provide financial stability to the economy by pooling funds from policyholders to invest in stocks, bonds, and real estate. These investments help to fuel economic growth and provide a source of income for insurance companies, which in turn can pay out claims to policyholders. 

Decentralised insurance is a new and innovative way of providing insurance coverage. Instead of relying on traditional insurance companies, decentralised insurance operates on a peer-to-peer network, where members can pool their funds to offer coverage for specific risks. This type of insurance leverages the power of blockchain technology, allowing for a more secure, transparent, and efficient system. One of the key players in the decentralised insurance industry is InsurAce, a company that provides coverage for deposits into yield-generating DeFi protocols, as well as Stablecoin depeg events. The claims process uses blockchain technology for fast, transparent claim handling and payouts.  

Decentralised insurance can cover a wide range of risks that are not limited to the existing web3 ecosystem, including property damage, liability, health, and life insurance. The underwriting process is done through smart contracts, which are self-executing contracts that automatically trigger payments based on predefined conditions. This eliminates the need for intermediaries and subsequently reduces the cost of insurance. According to a recent report, the global decentralised insurance market is expected to grow to $20 billion by 2025, with a compound annual growth rate of over 40%. With its potential to disrupt the traditional insurance industry and offer a more transparent and efficient system, decentralised insurance is poised to play a major role in the future of the DeFi ecosystem.

DeFi insurance is a relatively new concept in the financial world and has been gaining popularity in recent years. Despite its potential to revolutionise the insurance industry, there are still several limitations that need to be addressed to reach its full potential. One of the biggest limitations is capacity issues. Currently, the DeFi insurance market has a limited capacity to handle large amounts of insurance needs. For example, the total available insurance capacity in DeFi is less than US$ 1 billion, while the total TVL of DeFi far exceeds US$50 billion. Another limitation is adoption, as DeFi insurance is still in its early stages and has not yet been fully embraced by the mainstream population.

Regulation is also a challenge for DeFi insurance, as the regulatory landscape for DeFi is still unclear and in flux, leading to uncertainty for consumers and businesses. Lastly, the cost of insurance in DeFi can be high compared to available yields in DeFi protocols, limiting its widespread adoption. For example, a typical yield on a DeFi borrowing and lending platform may only be around 5-7% during a bear market (as opposed to 30-40% in a bull run), and therefore with a cost of 2-3% the relative cost of insurance is quite high during quieter markets. Despite these limitations, the potential benefits of DeFi insurance make it an exciting area of growth and development in the financial world.

To address the limitations of DeFi insurance, several solutions have been proposed and are currently being implemented. Firstly, to overcome the capacity issues, DeFi insurance providers are exploring ways to increase the available capacity without the need to rely on staked capital. This could include deals with traditional finance for reinsurance, or DeFi-native reinsurance too. Additionally, the development of new and more advanced decentralised ecosystems, such as Arbitrum, Optimism and Polkadot, can provide a more scalable infrastructure for DeFi insurance. Secondly, to increase adoption, DeFi insurance providers are partnering with traditional insurance companies and incorporating their products into existing financial systems. This can help to bridge the gap between DeFi and traditional finance and make it easier for consumers and businesses to understand and use DeFi insurance. Web3 integrations are also being implemented, and new products are being released each month to offer wider coverage to investors. 

To address the regulatory challenges, DeFi insurance providers are working closely with government agencies to clarify the regulatory landscape for decentralised insurance. This can provide greater certainty for consumers and businesses and increase the overall trust in insurance platforms like InsurAce. Finally, to reduce the cost of insurance, DeFi insurance providers are exploring alternative pricing models to increase their efficiency and incorporate the latest data. Additionally, the development of new, more efficient DeFi insurance products can help to lower the cost of coverage and make it more accessible to a wider audience. 

No-Code Transaction Tracking

As many in the industry proclaim, the cryptocurrency space is plagued by UX shortcomings. However, though most in the community focus on the difficulty of understanding how web3 wallets work and interacting with DApps, one ignored area is the confusing nature of transactions. From the perspective of most blockchains with the smart contract functionality to support DApps, submitted transactions first are sent to the memory pool (mempool) where they remain until a validator includes them in a proposed block. In order to be executed, a transaction must go through consensus and then validity checks. First, other validators in the network will provide attestations, indicating that they are in consensus about the existence of the block being added to the chain. Subsequently, the block is examined for any invalid transactions.

At this point, although it may have been executed after progressing through both obstacles, the transaction might not yet have reached finality, whereby it cannot be reversed, for an additional period of time. An example of this is Ethereum – only after 2 lots of 32 blocks, known as an epoch, have been added to the longest chain, has the initial block reached finality; with a block being proposed every 12 seconds, this means that finality is only reached after 12.8 minutes.

This is difficult to understand for new users of blockchains and actually makes transacting on-chain less safe given the high possibility of an exploit in the situation that a user is unaware of what is truly happening. Subsequently, to make DeFi safer, transaction mapping must become significantly more gamified such that individuals can easily understand the internal workings that take place between the submission of a transaction and when it reaches finality. Such a process should not require the user to read any code. No-code transaction tracking could manifest in transaction simulators where prior to a user being able to sign off on a transaction with their private key, they first receive a visual representation of what is financially occurring based on the smart contracts they are interacting with. 

Making Crypto Infrastructure More Decentralised

It is an issue for web3 and DeFi that the current Web3 infrastructure is heavily reliant on centralised aspects such as web servers, browsers, and social media or social graphs. This creates significant security and privacy risks, and can compromise the integrity of the entire system. Web servers such as Amazon Web Services (AWS), for example, are centralised servers that store vast amounts of user data and information. The reliance on these servers means that users have limited control over their data, and that it can be easily accessed and used by third parties. This also creates a risk of data breaches, which can result in sensitive information being compromised. 

Web browsers are another centralised aspect of the Web3 infrastructure. These browsers control the information that users see and access, and they often collect and store data on users’ browsing habits. This information can be used by third parties for advertising or other purposes, which can compromise user privacy. Furthermore, social graphs, which are graphical representations of social networks and connections, are also centralised in nature. This means that users’ relationships and connections are controlled by a single entity and that users have limited control over the information that is shared. This creates severe privacy risks, and can also result in the spread of false or misleading information.

To address these concerns, the Web3 infrastructure needs to become more decentralised. This would involve moving away from reliance on centralised servers, browsers, and social graphs, and instead, creating a system where users have more control over their data and information. Decentralised systems can be more secure and private, as they are not controlled by a single entity and are less vulnerable to data breaches and other security risks. Some new projects are already working towards solving these issues. IPFS has created a decentralised file storage solution, Brave is a blockchain-based browser, and Lens Protocol has developed a new web3 social graph. 

Improved On-Ramp and Off-Ramp Solutions

As previously explained, many users in the crypto industry, particularly those who are new to the space, decide to leverage centralised exchanges (CEXs) when undertaking a multitude of actions. CEXs typically have an aesthetically pleasing UX and are extremely easy to use given that blockchains are not being used to execute and settle transactions. These features eclipse the risk that users are carrying when making use of these platforms. However, with CEXs being drastically less transparent than distributed ledgers, the counterparty risk is high.

Irrespective of the uncertainty of giving up access to one’s cryptocurrency by using CEXs, many users, both experienced and newcomers, rely on these exchanges as a fiat-crypto on-ramp and off-ramp. This issue comes as a direct result of the existing decentralised solutions for migrating tokens into fiat and vice versa – or a lack thereof. In order to increase the usability of DeFi without initially taking on the risks of using CEXs, further innovations must come for fiat on-ramps and off-ramps. Through the passage of time, it is possible that these decentralised solutions have been refined such that users can, for example, directly interact with DApps with fiat, paying a small fee to the on-ramp. 

Liquidity

As a direct result of refined on-ramp and off-ramp solutions, more liquidity will move on-chain instead of remaining on CEXs. This is highly important to continue the growth of the DeFi space, with respect to its safety, size and usability. Liquidity is often the key impetus behind the burgeoning of financial markets given it is extremely relevant in determining the efficiency and stability of the market. In economics, liquidity refers to the ease with which an asset can be bought or sold without affecting the asset’s price. Subsequently, the greater the liquidity of a market, the more readily an asset can be traded at its fair market value.

However, additional liquidity to benefit the DeFi markets will not purely arise from users who previously relied on CEXs; institutions, banks and exchanges will be required to contribute to the liquidity in DApps in order for the space to be safer. In the absence of these levels of liquidity, large trades will substantially move the market, resulting in services and offerings failing to hold their true value based on efficient markets as well as supply and demand dynamics. With institutional liquidity in the decentralised market, there will be more depth in exchanges and less slippage when trades are being made. Under the widely held macroeconomic assumption that liquidity is the driving force of markets, the DeFi space can only mature and evolve with more liquidity. 

Notwithstanding, liquidity must be ubiquitous throughout the DeFi ecosystem as opposed to being situated in one or a small group of protocols. In the TradFi markets, including CEXs, market makers have the role of ensuring liquidity on different trading platforms. Whilst centralised parties can similarly perform this role with respect to DeFi protocols, the resulting issue is, once again, counterparty risk. As such, decentralised market-making solutions must be improved and refined to ensure that liquidity can be spread across the entire blockchain. 

Already, there are decentralised market-making platforms that utilise algorithms to make trades that provide depth to decentralise exchanges (DEXs). Such protocols rely on users of other DeFi applications depositing their cryptocurrencies into a smart contract that is capable of making markets. These users are incentivised by the arbitrage profits captured by the decentralised market maker. Yet, as it stands, centralised market makers are noticeably superior to their decentralised alternatives. Nonetheless, fundamentally, decentralised market makers represent a positive stride that contributes to the overall safety of the DeFi ecosystem. 

Decentralised Payment Solutions

Bitcoin revolutionised finance and payments with its groundbreaking concept of a public ledger system that is accessible to anyone and immutable, creating a world where trust in intermediaries is no longer necessary. Despite the promise of a trustless financial system, the reality has been harsh for millions of individuals who have lost their assets due to the fallacies of human nature rather than the limitations of technology.

The loss of trust in centralised web3 entities has fueled a wave of innovation and growth in the DeFi space. DEXs, where users have custody of their own funds instead of relying on a central authority, have experienced tremendous growth. dYdX, the leading DEX in terms of volume, saw daily volumes of US$100k to US$3 million in October 2021 and now boasts over US$1 billion in volume traded each day. In comparison, Coinbase, the second largest centralised exchange by volume, saw daily volumes of US$5 billion to US$1 billion in October 2021 but now has a similar daily volume to that of dYdX as of February 2023.

The DApp ecosystem is growing as more users become their own custodians, but there is still a way to go in creating user-friendly experiences similar to centralised exchanges and payment systems. The current process of withdrawing crypto to a centralised exchange, converting it to fiat, and transferring it to a bank incurs high fees and spreads, hindering global adoption. Centralised crypto debit and credit cards are not fully decentralised, as they are still linked to centralised companies that require custody of funds. Moreover, they do not address the fundamental systemic issues in accessing credit to begin with. The infrastructure needed for people in emerging markets to use crypto as a payment method is still lacking. Irrespective of the increasing demand for stablecoins in these markets as native fiat currencies lose value, the seamless conversion of self-custodied crypto to fiat and a mechanism for spending it is not yet widely available.

The growth of web3 organisations, which operate and make payments using cryptocurrencies, is driving demand for solutions that allow these businesses to effectively bridge the gap between the crypto and fiat worlds. DAOs, for example, typically hold their funds in crypto but face the challenge of being unable to make payments in fiat because of the limited infrastructure available for plugging into the traditional financial system. The significance of this problem cannot be overemphasised, especially given the projected exponential growth of the Web 3.0 blockchain market. According to the “Web 3.0 Blockchain Market Size, Share & Trends Analysis Report,” the global Web 3.0 blockchain market size was USD$1.73 billion in 2022, and it is expected to grow at a compound annual growth rate (CAGR) of 47.1% from 2023 to 2030. With businesses scaling faster than ever, it’s crucial to address the need for effective payment solutions that support this rapidly evolving sector.

The task of integrating a non-custodial and decentralised back-end with traditional financial infrastructure is only the beginning of the limitless potential of decentralised payments. Tokens offer a rich opportunity for entrepreneurs to bring value and utility to the forefront of this new payment paradigm. Utilising DeFi primitives, existing financial instruments such as APY yield platforms, loans, insurance, and more can be transformed and made accessible to non-crypto native users. Platform-native tokens can power ecosystems that incentivize and reward users for leveraging decentralised payment methods, leading to new, recurring utility and innovative token economics. The future of decentralised payments is brimming with untapped potential, waiting to be unlocked.

Conclusion

In conclusion, the DeFi space has seen significant growth due to the loss of trust in centralised web3 entities. Similarly, DEXs have seen tremendous growth, with dYdX leading in terms of volume traded each day. The DApp ecosystem is growing as more individuals become their own custodians of funds, however, there is still a long way to go in creating user-friendly experiences. The imprudent perspective that risk management strategies have evolved from the traditional finance industry is one vertical fettering the impact of DeFi on financial inclusion. The integration of non-custodial and decentralised back-end systems with traditional financial infrastructure is crucial for the growth of web3 organisations and businesses. The use of tokens in decentralised payments offers a rich opportunity for entrepreneurs to bring value and utility to the new payment paradigm. Likewise, DAOs must learn to effectively monetise and manage their treasuries to ensure that their runway is not pegged to the overall cryptocurrency market capitalisation.

Making strides in the development of all verticals necessary to make DeFi safer will have a profound impact on the financial sector. Iterating on what works to render it more effective is crucial for increasing liquidity levels in the DeFi industry, catalysing the growth of its relevant markets. Furthermore, by continuing to innovate and mature DeFi protocols, the DApp ecosystem will be able to provide financial inclusion to a wider portion of individuals without them being exposed to vulnerabilities in the space. By striving to evolve DeFi through innovating in the verticals discussed in this article, the ecosystem can continue to burgeon and pick up more relevance outside of crypto-native circles.

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FAQs

What is the role of treasury management in DeFi safety?

Treasury management is crucial in DeFi safety as it provides a source of funds to support the application’s development and finance crucial initiatives. However, the current issues with token treasuries include lack of monetization and high correlation with the wider market. Effective monetization of token treasuries is fundamentally important to the growth and development of the DeFi space.

How can counterparty risk and smart contract audits improve DeFi safety?

Counterparty risk and smart contract audits are vital in risk management. A uniform method of evaluating counterparty risk is needed, and smart contract risks should be mitigated by ensuring that contracts have been audited by well-respected firms. Decentralised auditing, which involves a network of independent auditors verifying smart contracts and blockchain infrastructure, is a highly valued alternative in the blockchain industry.

What is the role of sophisticated insurance products in DeFi safety?

Sophisticated insurance products help to mitigate risks in DeFi and make the ecosystem safer. These products use cutting-edge technology to provide protection against potential losses, giving DeFi users peace of mind and the confidence to explore the decentralised industry. Decentralised insurance operates on a peer-to-peer network, where members can pool their funds to offer coverage for specific risks.

How can no-code transaction tracking contribute to DeFi safety?

No-code transaction tracking can make DeFi safer by making transactions more understandable for users. This could manifest in transaction simulators where users receive a visual representation of what is financially occurring based on the smart contracts they are interacting with, without the need to read any code.

Why is liquidity important for the safety of DeFi?

Liquidity is often the key impetus behind the burgeoning of financial markets as it determines the efficiency and stability of the market. More liquidity will move on-chain instead of remaining on centralised exchanges (CEXs), contributing to the growth of the DeFi space in terms of safety, size, and usability. Decentralised market-making platforms that utilise algorithms to make trades can provide depth to decentralised exchanges (DEXs) and spread liquidity across the entire blockchain.