The Three "U"s of DeFi Ubiquity
0xcde3
June 14th, 2021

Mapping out the hurdles DeFi will face in its quest for mainstream adoption 🗺

Decentralised Finance, DeFi, is thought by many to be the future of the financial services industry and is expected to completely change the way people think about money and the systems and institutions they entrust to look after their money. The space has you covered for anything ranging from peer-to-protocol lending protocols to insurance policies that protect users from loss of funds due to protocol bugs. Derivative protocols like Synthetix have you covered for any investments in non ETH-based assets, and you need look no further than Opyn for all your cash-settled options trading needs.

The space is quickly starting to resemble a fully functional financial system, with all the applications and systems needed for standard retail investor transactions established and regularly audited, but also the most niche structured products thriving and innovating further with every passing day.

However, the most striking difference is that DeFi is trying to do what TradFi (Traditional Finance) did over the past 2,000 years in just a couple of years. This pace of innovation is in large part aided by the true and native composability of DeFi which allows projects to seamlessly integrate with each other like Lego and create mind-blowing synergies. DeFi is well on its way to catching up to TradFi in terms of functionality and has its eyes set on surpassing it as soon as the mainstream is ready.

The future is bright for DeFi, and the space is always vibrant and full of energy, no matter the state of the overall crypto market. We are still a while away from widespread adoption of DeFi, and as many people often say, we are still early. Metamask, the most popular chrome extension based wallet used to interact with DeFi, only recently reached 5 million monthly active users. Mainstream adoption too soon would potentially come at the wrong time for DeFi as the applications may not be properly optimised to support the large and sudden influx of users, but I have had a lot of time to think about this problem lately and have come to some conclusions about what I believe are the main hurdles DeFi needs to surpass before it is truly ready for the mainnet to hit the mainstream.

I call these hurdles the Three "U"s of DeFi Ubiquity.

Usability

The first, and arguably most important of these hurdles to ubiquity, is usability. Many of the most successful DeFi protocols are advanced, regularly audited and professionally run but have user interfaces that are unapproachable to all but the most sophisticated investors. In reality, the underlying service these protocols are offering is groundbreaking in the quest for the democratisation of many of the world's most powerful financial instruments which were previously unavailable to most retail investors. Consequently it is important that the people set to benefit the most from this democratisation are also able to understand and use these tools without having to resort to financial advisors.

The key to this issue is going to be knowing which parts of the UI to hide, and which to display prominently. Uniswap is one of the market leaders in keeping its UI simple yet powerful. Still, there will eventually be a divergence of the consumer level interfaces and pro-level interfaces using the same backend, a bit like Coinbase vs Coinbase Pro to really drive this point home. Metamask does not focus greatly on UI refinement at the moment, but it will take a beginner-friendly browser wallet that has a good fiat on-ramp and perhaps doesn't even refer to itself as a wallet but more as a key to Web3 to really help push DApps into the mainstream.

Increasingly we will start to see startups cropping up worldwide in various industries focusing on leveraging DeFi technologies to verticalise and fine-tune the experience for different audiences with different financial preferences. The technology behind many of the most popular DeFi protocols is optimised for scale, performance and reliability, so there is a wide-open opportunity for startups to come into specific geographies such as developing economies, where debt financing for small businesses is harder to come by, and build a straightforward front end. This front end could then automatically tap into the sea of open-source protocols and liquidity that is readily available. It could then focus on making it accessible to non-crypto-native audiences with seamless on-ramps for Fiat which, in the future, could allow someone in Venezuela to take out a loan using stablecoins on AAVE using an L2 solution like Polygon without ever noticing that they have done all of this on a trustless and decentralised back end.

Ideally, customers would eventually be aware of the fact that they are interacting with DeFi, but in order to reach a truly mainstream audience there will be a transitionary period where perhaps these front ends do not lean too heavily into the crypto angle. This movement comes straight out of the playbook of new Fintech startups like Monzo and Revolut that have spent the past decade taking complex financial systems, reducing their complexity and making them accessible to retail investors. These startups often build on top of TradFi and reduce friction for retail users by bending the rules or by bundling transactions together. DeFi could use the same approach and reduce friction even further by abstracting away the complexities of the Ethereum blockchain and presenting a seamless solution to the end-user. It is unlikely that this simplified DeFi front end innovation will come from the existing Fintech incumbents because the way they are used to working is so different to the way DeFi works. TradFi Fintech startups are used to pushing up against and fighting the traditional systems to try and squeeze them into a user experience that is pleasant to use. The DeFi space is flexible by design so the approach taken by these verticalised DeFi gateways will be simple, and even encouraged by the protocols themselves, contrary to the struggles faced by TradFi Fintech startups where in this case the incumbent banks are constantly trying to play catch-up with the challenger Fintech startups .

While there will be many independent startups fulfilling this function and maybe even getting funded through the protocols' own grants DAOs, many of these usability improvements will also come from the protocols' own core teams, especially on the institutional side. Institutional TradFi, at least in the short term, tends to prefer interacting directly with the people that built the technology they are going to be leveraging. AAVE has actually started experimenting with permissioned pools for institutional investors because institutional investors previously found it tough to use the protocol due to lack of KYC and AML compliance, and this has allowed banks and other institutional clients using AAVE to know that the other parties in the network are compliant and vetted not to be on an OFAC sanctions list. This is just another example of DeFi slightly adapting to TradFi without compromising on their core principles as an almost intermediate stage to mainstream adoption. Whether that be through making it feel like Fiat through stable-coins, or increasing KYC for institutions to help them to feel more at ease about the protocols they are transacting with, these measures all go a long way towards lowering hurdles to mass adoption.

It is also likely that whilst at this early stage the protocol teams themselves are working on the UI and UX as well as the underlying infrastructure, they may slowly start to shift their focus away from the consumer side and specialise more on the protocol itself. This would likely manifest itself in protocols keeping their existing UIs more as a reference with the aim of slowly phasing them out in the very long-term. Platforms like Zapper and Zerion, which are focused almost exclusively on usability and accessibility, will then step in to focus on the front ends and leave the protocol teams free to optimise their platforms.

The runway is wide open, and the tech is ready. These protocols exist and are being built and tested by thousands of users every day. The best part is that anyone can come in and make them more useful to any specific demographic. Look no further than projects like Ribbon to see this in action. Ribbon has made some sophisticated covered call strategies available to anyone with a Metamask wallet by building directly on Opyn's cash-settled ETH options protocol, all while making it feel as simple as an, admittedly high-risk, savings account to the end-user.

Undercolateralisation

The second hurdle is the issue of overcolateralisation in DeFi lending protocols. When you put the whole DeFi stack together, what you are left with is essentially a fully decentralised crypto bank that runs itself in the most traditional sense of the word. DeFi, just like a bank, allows you to convert between currencies, deposit money and receive interest in return for providing liquidity to the bank to then allow them to loan it back out. On the other side of the equation, anyone can then go to the bank, take out a loan and then pay it back at a rate most suited to their risk profile and time horizon. In TradFi some loans are unsecured, but many are secured in that they have some form of collateral backing the loan. If you fail to pay back said loan, the traditional bank has the legal authority to repossess that asset and liquidate it in exchange for cash. The percentage of the total loan required as collateral often depends on a credit score and past successful repayment of loans. Some traditional bank loans are overcollateralised when the asset is highly illiquid to make sure that enough cash can be recouped in the event of a loan default. Conversely in most DeFi lending protocols, you need to provide significantly more crypto as collateral than the stable-coins you are borrowing, sometimes as much as 700%.

It can be hard to understand why someone would ever want to take out a loan worth less than the amount they are putting down as collateral, and whilst there are some valid reasons for this such as delaying a taxable event or increasing leverage on positions through complex financial gymnastics, the vast majority of the world is unwilling or, more importantly, unable to borrow money in this way.

The main reason people borrow money is precisely because they do not have the spare capital available at that time. People take out mortgages to buy houses, or take out loans to start a small business in their hometown. Sometimes a mortgage may even start highly collateralised but later turn undercollateralised if the value of the house goes down, however due to the credit history of the borrower the loan is still able to remain a performing loan. The downside of undercollateralisation is of course that if the loan were to default, the collateral would not be able to cover the principal. In this case, the borrower would step in to cover the difference if they are in fact creditworthy and have some reputational skin in the game not to run off with the money with no consequence.

To cater properly to these kinds of users it is important that DeFi eventually gets to a point where loans can be undercollateralised in some way. The difficulty is that DeFi is by its very nature anonymous and trustless, which means that the concept of social proof and credit scores becomes very difficult to handle and potentially even ideologically problematic. A potential solution could be a quasi-anonymous loan passport solution in which the user is anonymous on one dimension but not on another, i.e. their wallet address is public, but the owner of the wallet is not. One could, in theory, understand someone's creditworthiness through their DeFi loans history, which is of course publicly visible on Web3 or even decrease the user's collateral requirement for their next loan by a certain percentage every time they repay successfully. Another alternative is allowing user loans to be secured and guaranteed by other individuals they know in real life that trust the borrower enough to guarantee their loan and delegate their credit.

Perhaps we could even see some CeFi institutions step in to perform credit checks on DeFi users on a per address basis. This solution would, of course, introduce some centralisation as it would involve real-identity based KYC, but may be a necessary interim solution for users that prioritise a low collateral ratio over absolute anonymity as lending protocols could eventually introduce pools of loans where a trusted third party has verified creditworthiness in advance. This CeFi verification could also be a Zero Knowledge Proof, in that the verifying party would know that the borrower is creditworthy but would essentially allow the borrowers to prove their creditworthiness to another party without having to reveal their identity. When the borrower proves their creditworthiness with zero knowledge, they would display the fact that the CeFi institution has deemed them creditworthy as a boolean value in their wallet, perhaps as a non-transferrable NFT.

There are already some great projects being built in this space like teller.finance which is taking a similar approach to the aforementioned CeFi integration by connecting to your bank account through Plaid and then offering risk-assessed DeFi loans on their platform without the need for collateral. Although we are still a while away from a foolproof creditworthiness checker solution in DeFi there are many different approaches one can take and I believe a combination of these approaches will play a large part in solving the issue of collateralisation in the quest for widespread adoption.

Aside from lending protocols, there is also a significant level of overcollateralisation across the whole DeFi universe which was initially there for the sake of simplicity including in options protocols. There has been some great research done into improving the collateral efficiency of these protocols to allow for partial collateralisation without having to worry about creditworthiness through strategic liquidations with a "shock buffer" of a size large enough to withstand a Black Thursday event.

Understandability

The final hurdle that, depending on how you look at things could be the hardest or easiest of these to solve, is the difficulty around understandability and education. This hurdle may ultimately solve itself if the first two issues are solved and DeFi starts to resemble the way in which users are used to dealing with and thinking about finances. However, it is still important to acknowledge that for non-technical people, the DeFi space can be very opaque and consequently more difficult to trust.

Fiat money and the way centralised traditional financial systems work is deeply ingrained in our culture and is a little easier to properly comprehend because many parts of the system rely on trust and simple written agreements which come together to form financial systems. Understanding the way these systems work in DeFi is a lot less straightforward. While in TradFi it is relatively straightforward to explain the basics of how a bank works, in that one can deposit money, and in return the bank lends that money out and pays interest for that privilege. There are very few parts of that process that are opaque because, ultimately, it just involves numbers moving from one spreadsheet to another.

The difference with DeFi is that you first have to feel comfortable with the concept of decentralisation, anonymity, trustless systems, distributed ledgers, and then you have to try and explain how all of this functions automatically through smart-contracts. There are many parts of DeFi that have to be hand-waved away and perhaps this could become a hindrance to trust.

One could also, of course, argue that many people implicitly trust the banking system because enough other trusted people do and not because they understand every part of the process. The same could eventually be true when enough knowledgeable people trust DeFi and understand a good enough percentage of the current information gaps.

There are some great resources out there like Finematics and Bankless doing amazing things in the education space and teaching newcomers about all things DeFi. This will be crucial in making sure people are comfortable enough with the technology to use it, especially when currently decentralisation slightly goes against the grain and users may be met with scepticism from friends and family.

It should, however, be noted that the younger digital-native generation finds the concept of digital money extremely intuitive as they have grown up interacting with various in-game currencies, and the youngest among them have potentially never even used physical cash in their lives. This will undoubtedly make the proliferation of DeFi a more natural process as Gen-Z is starting to trust the digital world more than physical and may even start to learn about finance through DeFi in context rather than adapting antiquated financial concepts to fit the DeFi world as in the current status-quo.

Overall the space is going in all the right directions. It will take a while for these ideas to materialise fully, but this is the part that interests me the most about the DeFi space. There is so much mind-blowing R&D going on every day, and people are experimenting, taking risks and breaking boundaries. I'm very passionate about making sure as many people as possible have access to these tools and can take part in the revolution. Understanding the pieces of the puzzle left to fill will become increasingly important as the protocols we rely on are built out and refined and start to look towards the next steps.

Thank you for taking the time to read this piece 💙

If you enjoyed the piece and are interested in receiving more of my content or keeping up to date with anything else I get up to a follow on Twitter would be great... or if you're more of an email person that works too - subscribe to my infrequent mailing list via the link below.

Arweave TX
ykaPYVsbiP0NwLn9Y7JSGsR_CoYrhHjQIMSAx9hLhpo
Ethereum Address
0xcde3725B25D6d9bC78CF0941cC15Fd9710c764b9
Content Digest
klQF-dVD9TOVI288YuTObvBVY5_GsrmBGDunRoWpYt8