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Can Multi-Chain DeFi Protocols replace Legacy Finance?

May 4, 2022

Defi offers a secure method of building transparent and all-inclusive financial systems.

Due to the rapid development, innovation, and gradual adoption of the Defi protocols, discussions of whether they should be allowed for cross-chain interaction have started.

The developer’s choice of the Defi protocols’ design is crucial. They are used to ensure the development of Defi platforms that solve challenges experienced by legacy finances.

This also ensures that they avoid the issues suffered by isolated systems. However, most developers are not concerned with multi-chain communications in the Defi ecosystem.

This article will examine Defi systems’ challenges and why they may not replace traditional legacy finance.

Where the legacy finance fails

Most modern financial service providers fail because they rely on siloed systems. These are systems that do not interact with other applications or information systems.

They tend to rely on internal processes to solve problems. These kinds of systems are common within most departments in big enterprises.

In the digital era, the handling of transactions is different. Money transfers are easy as it involves transferring digital data from one account/address to another.

However, the framework adopted by financial institutions to fight legacy issues is rigid and limited. For instance, it requires more than six parties to perform typical inter-border transactions.

All of these activities are characterized by to and from verifications that make it impossible for fund transfers to happen in real-time.

New borderless financial solutions such as PayPal, Western Union, and MoneyGram, among the others, are finding it difficult to curb this challenge.

Reasons why existing Defi chains may not replace traditional finance

Defi seeks to resolve this issue since it is a distributed, open, and digitally connected network. It ensures that data transfers happen securely with no need for human interaction.

As Defi technologies grow, more innovations and activities are expected in the future. Their potentials are yet to be discovered.

Below are some of the reasons why Defi chains are not yet up to the projected future growth:

Immature technology

Defi technology is new, meaning it is not yet thoroughly tested for more extended periods to ascertain its resilience. There is a considerable possibility that there could be a high risk of losing funds on this platform.

A good example is Compound, a Defi platform that suffered a massive system glitch. It caused the system to mistakenly send a massive amount of cryptocurrency to its customers.

Lack of consumer protection

Defi has existed without the control of any legal rules or regulations, which would translate to its users having little or no protection whenever the system fails, or a technical glitch occurs.

There are no reimbursement schemes for the users and no laws that govern Defi service providers.

The threat of hackers

Hacking can also affect traditional finance. However, with Defi systems, the technology architecture is even more advanced, which exposes it to multiple points of potential failure hence the possibility of an attack from sophisticated hackers.

High collateral requirements

Most lending transactions in Defi require users to place high collateral amounts before accessing the loan on the platform caused of the Defi markets’ unpredictability, whose prices change abruptly.

The high collateral requirements significantly affect the users’ loan eligibility in Defi.

Private Key requirements

In Defi and cryptocurrencies, users must secure their wallets to store their digital assets there. Also, individual private and institutional investors must have multiple signatures for their wallets to store their cryptocurrency assets.

No one can access their wallets without providing private keys unique to each user. Private keys are typically long and unique codes with random characters, which makes them easier to lose or forget.

If investors lose access to their unique keys, they lose the funds stored in their wallets forever.

Challenges faced by Defi network

Decentralized markets have their benefits and their downsides too. Whereas Defi offers many advantages, the challenges it faces significantly affect its adoption.

Below are some of the severe challenges that affect the Defi ecosystem:

1. Smart contracts vulnerabilities

Smart contracts are coded algorithms that work the same way as the actual contracts. They handle the execution of contracts between various parties provided that the conditions have been met.

It is better to note that a bug in the smart contract code results in considerable losses to the users or investors in the platform.

Another issue with smart contracts is that if one party makes a mistake and sends funds to the wrong address, the transaction may be irreversible, leading to the loss of funds.

In addition, smart contracts can face the risk of DDOS attacks, resulting in loss of funds and financial data.

The challenge arises when a Defi network uses defective smart contracts. Its users tend to suffer severe loss of funds and trust issues with the Defi ecosystem.

User error is also associated with smart contracts since a simple mistake can lead to huge losses.

2. Defi market unpredictability

Users and investors are usually concerned about the uncertainty found in the Defi market. It leads to a massive loss of money once the prices change despite stable technology.

The market’s instability and unforeseeable changes have caused most users to disregard Defi as an alternative measure of value.

Since cryptocurrency’s value keeps changing, it becomes a problem for users to go with any currency for financial transactions. For this reason, Defi continually increases its market volatility, thus discouraging big investors.

3. Lack of regulations

Defi is not protected by regulations worldwide because governments or central banks have no access and control over the transactions, which has caused many people not to trust the platform.

Some foreign governments stopped the use of cryptocurrencies for no reason whatsoever.

Due to the lack of government or central bank regulations, there is a higher probability of criminal activities happening on the platform.

Since the system operates anonymously, users can transfer funds to and from without revealing their identities, which further encourages criminal activities.

4. Low liquidity

The cryptocurrency market comes with various digital currencies, which further creates additional problems when cashing out.

Low liquidity poses another challenge for exchanging digital assets meaning that users may fail to access their funds on time.

There is a belief that most cryptocurrencies are highly liquid. However, this only applies to a few digital assets. Due to this factor, users cannot exchange their cryptocurrencies freely, which cripples the entire financial platform.

5. Defi troubleshooting

Other factors affect the adoption of Defi systems. The first one is that the Defi platform is not entirely decentralized. This is because developers do not fully control it.

Only central providers of Defi solutions have full control. Therefore, its challenging to decentralize the system, hence making funding a challenge.

The future of cross-chain protocols

Cross-chain Defi protocols come with improved security, high processing speed, and a gateway to discover other benefits in the Defi space.

They also introduce different programming languages to the blockchain ecosystem, which supports continuous experiments and more Defi potentials.

From this analysis, we can conclude that each blockchain has its strengths and weak points. Therefore, no single blockchain can offer scalability, flexibility, usability, functionality, speed, and security.

However, as the blockchain infrastructure gradually improves, we will have a financial system that is open, transparent, and widely distributed.

For Defi services to be widely adopted, cross-chain functionality should be considered.

Conclusion

Cross-chain solutions were introduced due to the inadequacy of blockchains to cater to Defi platforms’ needs.

In the future, cross-chain solutions can utilize the power offered by Defi protocols which will improve the structural foundation required to build a robust and effective decentralized financial system.

Happy learning 🚀

Further reading


Peer Review Contributions by: Briana Nzivu