Over the past few years, DeFi (Decentralized Finance) has been booming in the news headlines. Due to the widespread mentions in the media, they have become attractive to investors. Their interest is also warmed up by incredibly high profitability and an endless stream of new protocols.
Nonetheless, the experts from Yahoo! Finance, and CoinDesk claim about the inefficiency of DeFi. Let’s analyze the cause-and-effect relationships with altynex.io.
To begin with, you may have a question regarding what DeFi is. Answering the query:
“DeFi (Decentralized Finance) is an ecosystem of decentralized blockchain applications that provide financial services without a centralized management organization.”
To have a basic understanding of what is DeFi and how it works, check the mini-clip below:
Decentralized finance is relevant to the global economy and is not limited to the crypto world. Generally speaking, a bank is a responsible organization for the safety of funds. In DeFi, this function is performed by smart contracts. Due to blockchain technologies and the Internet, that system is considered more profitable for investment.
However, the US analysts identify and highlight six factors that make DeFi ineffective:
1. Mass information inequality (asymmetry)
Nothing causes tremendous inefficiency in the financial market more than asymmetry or unequal distribution of information between insiders and investors.
In the case of DeFi, people close to the protocol projects have vaster access to information than investors in the same position. Early access to information, exampled by new liquidity pools, can lead to significant advantages in the DeFi market.
Here is an example of an automated market maker (AMM) protocol that is about to launch a handful of new pools to increase liquidity for an n-th token. Since insiders have access to information, they are ready to provide liquidity right after the pool is launched, thereby receiving most rewards.
2. Growing protocol ecosystem
Traditional capital markets operate within the infrastructure framework that has been forming for decades. Meanwhile, DeFi is being built based on an ever-changing landscape.
New financial primitives are launched in the form of DeFi protocols every week. During the growth phase, these protocols will be initially inefficient, and these inefficiencies will cascade into other areas of the DeFi space.
For example, a new algorithmic stable coin (Tether) may regularly deviate from its arbitrage opportunities.
For your information,
Arbitrage (econ.) is a few logically connected transactions aimed at making a profit.
Stablecoin is a cryptocurrency that minimizes price volatility.
3. Governance changes
Governance proposals regularly change the behavior of DeFi protocols, which leads to market inefficiency. These dynamics are unique to DeFi and don’t have an equivalent in traditional markets.
From changes in compensation mechanisms to more radical ones (in the behavior of a particular protocol), the DeFi governance system is a source of constant inefficiency in the market.
For example, a governance system proposal that changes the length and weight of different liquidity pools in AMM leads to higher yields that pools produce: the higher the indicator, the better the compensation.
4. Hacker attacks on the protocol
Ironically, but nowadays, it’s impossible to imagine the functioning of DeFi without ecosystem hacks or other side effects.
New protocols are regularly exploited, creating liquidity gaps in the market that can be utilized in various transactions. From this point of view, hacker attacks are a source of inefficiency of DeFi, which has no analogs in other financial markets.
5. The influence of CeFi (Centralized Finance)
The “battle” between CeFi and DeFi is one of the most riveting dynamics to watch in the crypto world. Regardless, it can be also seen as a source of market inefficiency.
Skipping the details: a classic example here is a trading activity increase in the DeFi governance token on centralized venues. It may lead to higher prices and better rewards in the corresponding DeFi protocol.
6. A fragmented ecosystem
The fragmentation of DeFi is hard to reduce, given their volume with a large number of different protocols. The variety of crypto assets traded under numerous but not integrated protocols can lead to price inconsistencies and intermittent arbitrage opportunities between these protocols.
As DeFi continues to grow, this level of fragmentation is also likely to increase, which will lead to increased inefficiency of the market before its consolidation (strengthening of positions).
Despite the shortcomings, DeFi has a chance to become a relatively efficient market. We should expect consolidation of protocols and blockchain, reduction of profitability, and liquidity mining programs alongside information transparency in the ecosystem. However, some of the factors discussed in the previous section may worsen the success journey. DeFi is still a relatively new market that hasn’t received acclaim from investors.
Speaking about the forecast for the near future, analysts will still consider it an “inefficient ecosystem.” However, in the current crypto world, a lot can change in one click, in the heat of the moment.
To add a finishing touch to our article, let’s dive into the interview with John Quinn, CIO and general partner of Decentral Park Capital. He’s talking about his version of the future of DeFi.
The information contained in this article is provided for educational purposes and does not constitute investment advice. Remember that every action related to crypto investments is worth the risks.