Don’t let DeFi collapse on shaky foundations

What we’ve built so far can be compared to a collection of shiny skyscrapers, each project adrift on its own island of liquidity


Andrij Vatsyk/Shutterstock modified by Blockworks


DeFi needs to rethink its foundations before it’s too late.

The current market environment has been putting major DeFi protocols and infrastructure through a barrage of stress tests, ranging from stablecoin de-pegs and liquidations to hacks.
The free-flowing capital pouring into DeFi during the bull market encouraged fast build times, forks and protocol designs with unsustainable economic mechanics that could only work in an “up-only” market environment. 

During this last bull market, mechanism design was traded for quick returns. But these same designs have now created an inefficient and dangerous environment for users — who keep finding themselves at the forefront of black swan scenarios across DeFi. 

As DeFi keeps growing — like with new innovations like tokenized t-bills in combination with more efficient lending markets — we can’t ignore the foundation on which these protocols are built, and the basic data systems that make it all run.

Where DeFi summer led us astray

The use case for lending has caught the attention of users since the beginning of DeFi summer brought us access to on-chain leverage, self-repaying loans and exotic asset lending markets

However, looking at the current state of DeFi lending, what we’ve built so far can be compared to a collection of shiny skyscrapers, each project adrift on its own island of liquidity. 

Each lending protocol is a separate smart contract infrastructure. Existing lending protocols operate in a silo, with the oracle price and loan-to-value ratio as their only reference point for collateral health — both of which are usually preset and adjusted by governance vote. 

These lending protocols have no way to quickly and accurately assess changes in liquidity, depth or collateral utilization to properly adjust loan-to-value parameters or borrow APY. 

With the recent events that occurred with CRV as collateral on Aave v2, it was clear that each lending market was not accounting for liquidity depth for clearing liquidations or global supply and borrowing against a single collateral asset across markets. Ultimately, this affects the health of collateral assets, making it hard to see how well a platform is really doing — considering factors like how much supply is available and how much debt is tied to specific assets.

During the CRV situation, the total liquidatable supply was in excess of 10x of the available on-chain liquidity depth in a single lending market. 

The absence of a shared foundation of interconnected data obstructs the visibility of critical cracks and concerns in these protocols. Without a comprehensive view, addressing these issues becomes a daunting task, with issues often only made clear when it’s already too late.

Read more from our opinion section: NFTs are stuck in Web2

Ignoring proper asset health checks serves as a way for protocols to look like they’re doing well on paper, with high global total value. A more transparent, multichain relationship would require a real evaluation of the state of assets across lending platforms and pools. In part, tackling the task of transparent data also addresses issues like a focus on greed and short-term gains that DeFi has been known for.

With these risks highlighted, it seems that the high APY, leverage and increased risk appetite caused users to miss that these lending protocols were built on isolated, shaky foundations. Much like real buildings, it’s just a matter of time before this becomes a catastrophic problem.

The time for visibility and permissionless data is now

The lack of visibility isn’t an accident. The existing centralized and isolated paths are highly profitable and guarantee a choke point for the monetization of data by popular oracles. These middleware solutions hold ultimate control of user funds, making them a weak point that could be exploited by attackers and increases the chance of collusion between parties. 

Considering the ultimate goal of DeFi is to eat finance and ownership, getting to the first milestone of $1 trillion in value on-chain will require permissionless infrastructure that fully removes dependence on centralized parties and eliminates choke points.

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