DeFi’s original purpose was to create a fair financial system for all, making it more inclusive. However, some argue that DeFi’s protocols are contrary to this, as DeFi incumbents rely on their protocol’s solvency being dependent on a small group of sophisticated users known as liquidators. Liquidators act in a predatory fashion, buying out under-collateralised loans at steep discounts and extracting value from the protocol for their own benefit at the cost of the general community. High gas fees disincentivise smaller investors from participating on Ethereum-based protocols. When they do, fees limit the frequency of their participation. Finally, along with opaque liquidation models and complex user interfaces, these issues have culminated in a market which now significantly benefits a small, elite group of well-heeled investors above everyone else.
Josh Rogers is CEO and Founder of Minterest. Minterest came out of stealth in August 2021 with $6.5million from top-tier investors. Minterest is a cross-chain decentralised money market lending protocol built on Polkadot. Its unique design attracts and rewards long term liquidity with Minterest distributing value captured by the protocol to MNT token holders who actively participate in its governance.
Here, Rogers explains how DeFi must change in order to get back on track to its original purpose – being inclusive and accessible to all:
The emergence and subsequent warp speed growth of DeFi has taken even the staunchest of crypto supporters by surprise, marking a significant new phase in the digital asset arena. Crypto owners can now put their assets to work without having to sell their holdings. Given that the market cap of crypto is around $2.3trillion, the potential scale of the DeFi market is enormous. Currently, $224billion worth of crypto assets are locked in DeFi protocols, allowing their owners to earn yields that are significantly more attractive than traditional lending markets. While this is an impressive achievement for an industry still in its nascent stage, this only accounts for 10% of total crypto assets globally.
Early DeFi trailblazers laid the ground for a truly innovative ecosystem. For example, while huge leaps forward have been made in protocol design, current models still need significant refinement. DeFi architecture in crypto is unique in how value is captured and distributed, however this is not reflected in DeFi lending and borrowing protocols today. Liquidity mining in Defi has various nuances but in essence, it’s about users receiving native tokens and any associated governance rights, in return for participating in ways that add value to the protocol.
The pervasive issue in existing lending protocols is that the more effective their liquidity mining is at attracting liquidity, the more the value experienced by users is undermined. This is because as liquidity and borrowing increases, the number of native tokens issued by protocols is distributed amongst a greater number of users, who each receive a declining proportion of the overall total.
Why this occurs is because the price of native tokens in these protocols is not correlated to their supply of liquidity and borrowing, yet still, they are key measures of performance. The architectural rationale is what is known as marketplace network effects, which in essence means as more users enter the platform, the greater liquidity created by them equals more convenience and trust, which then attracts more users. When this process kicks in, it drives growth, and so compensates for lost value in liquidity mining.
Most protocols rely on external liquidators who scan the protocol for under-collateralised borrowers, whose position they then buy out at significant discounts to market rates. The ability for liquidators to buy the borrower’s tokens at a discount acts essentially as their fee. This model in DeFi’s early stages worked and made sense for numerous reasons, including technical simplicity. What has since changed, however, is the sheer scale of total fees now extracted by liquidators, which can be measured across the sector annually in hundreds of millions of dollars.
New innovations are turning this conventional model on its head. The technology now exists to allow for auto-liquidation mechanisms, which are fairer in how they minimise user collateral being liquidated in such events. New buyback designs capture all fees associated with liquidation activity, which as stated earlier, are not insignificant, plus the protocol captures interest and flash loan fee income. This is then used to buy-back native tokens on market, which are then distributed to its users for participating in governance. This change in architecture should address some of the shortcomings in DeFi architecture.
Another hurdle to overcome is that many DeFi lending projects offer highly complex user interfaces which results in their inability to assess risk and evaluate their positions. An individual who holds crypto but has little experience or knowledge of liquidation processes, is vulnerable to market forces, and this lack of transparency may discourage them from staking. So, innovation in this space is key if the industry is to gain the confidence of users going forward.
The purpose of this new iteration of DeFi protocol technology, other than giving users the highest possible long-term yields, is to create certainty for DeFi’s future relevance and longevity. If the original premise of DeFi – a fairer and more inclusive financial system for all – is the end game, then innovation must continue to put the user at its core.