The crypto market is experiencing severe depression, with the value of most top tokens having fallen far below their all-time highs. More worrying though is that the all-important decentralized finance sector, whose growth propelled crypto through one of its strongest bull runs throughout 2021, is showing signs of collapsing under the strain.
The crypto winter is wreaking havoc on DeFi, a rising segment of the blockchain industry that promises to deliver an alternative to the traditional financial system that anyone can access. Since 2020, DeFi has grown to become one of the fastest-growing and most important sectors of the crypto economy.
From the beginning of January 2020 until the end of the year, the total value locked in all DeFi protocols rose from just $601 million to an incredible $18.6 billion. But DeFi didn’t let up there, as 2021 saw its TVL locked rise to a whopping $235 billion by the end of the year.
DeFi rocketed all the way to the moon in 2021 but since then it has endured an epic and tumultuous crash back down to Earth. By the end of August 2022, the TVL in all DeFi protocols sank to just over $62 billion, according to DappRadar’s latest figures, down more than 70% from its all-time high.
So what are the main reasons for DeFi’s sudden fall from grace, and what challenges must it solve to bounce back?
DeFi Left In The Dust
One of the most crippling problems is the overall global economy, which has ground to a halt in 2022 due to a combination of the lingering effects of the COVID-19 pandemic, supply chain challenges, rising inflation and interest rates, the war in Ukraine and other factors. Bearish trends in the wider economy have had a disastrous impact on the cryptocurrency markets, with major tokens like Bitcoin and Ethereum losing more than 70% of their value this year.
Even though DeFi protocols provide much better rates of return than most traditional financial services, the crypto market crash has taken its toll on the DeFi sector. As the major tokens lost value, DeFi investors’ rewards have dropped significantly, at least in fiat terms. Adding to the turmoil was the widely publicized crash of the Terra USD stablecoin and its sister cryptocurrency LUNA, as well as the liquidity crisis that afflicted popular DeFi protocols like Celsius Finance and others.
Then there’s the seemingly never-ending stream of hacks and cyberattacks in the industry. DeFi just can’t catch a break, it seems, with a recent report by Chainalaysis showing that the sector lost a record amount of value to hack attacks and scams in the first quarter of the year. DeFi protocols accounted for 97% of the total $1.3 billion that were stolen from crypto services over that period. In contrast, DeFi investors lost ‘only’ $2.3 billion in the whole of 2021. Along with hacks, DeFi investors have lost money to a number of fraudulent schemes that include rug pulls and pumps and dumps.
When we combine all of these problems with the fact that DeFi remains largely unregulated, it's easy to see why so many investors have decided to flee for safer havens. They also explain why new investors are so hesitant to put their capital into the space, no matter how big the promised rewards might be.
How The Blockchain Trilemma Hinders DeFi
The question now is whether or not these problems signal the end of DeFi. Was it merely a promising experiment that, sadly, fell on its feet, or does it still have a future? While there will always be naysayers, there are reasons to believe DeFi will eventually bounce back.
However, most observers agree that the DeFi sector will need to address some major challenges before it can regain its lost TVL, including the lack of investor safeguards. Most importantly though, DeFi needs to find an answer to the so-called “blockchain trilemma”, a term first coined by Ethereum co-founder Vitalik Buterin to describe the delicate balancing act of the three pillars of cryptocurrency - namely, security, decentralization and scalability.
The blockchain trilemma is similar in some ways to the constant struggle that most humans have - the need to balance a social life, work and sleep. It refers to the idea that blockchain networks must be decentralized, secure and scalable, with the problem being that we can only have two of these “pillars”, at the expense of the third.
A key pillar of blockchain is its decentralized nature. This describes how control, or governance, of the network is moved away from a centralized entity, such as a bank, and instead shared equally by its users. This is what makes blockchain so appealing - it’s the users themselves who get to make decisions on things that affect the network.
Blockchains are inherently secure by design, but they’re not completely immune to being hacked. If a malicious actor is able to gain control of 51% of the network, they would be able to alter the blockchain and manipulate things to steal funds. The more nodes there are in a blockchain, the harder it becomes to attain 51% control, meaning the more immune it is to hacking.
As for scalability, this refers to the network’s ability to grow while maintaining fast transaction speeds and output. Blockchains need to be able to scale if DeFi is going to become a true alternative to traditional finance.
The blockchain trilemma is this: When we have decentralization and scalability, it comes at the expense of security. Meanwhile, storing security means less decentralization or less ability to scale. As a result, most blockchains try to maintain a delicate balancing act between all three concerns.
For the vast majority of users, decentralization of the blockchain cannot be compromised. Decentralized networks mean that control is handed over to its users, giving them direct access to their money without relying on a third party. With traditional finance, the user has to entrust their funds with the bank, which could withhold access any time it wants to.
Because of its decentralization, blockchain provides an alternative to centralized financial systems by eliminating the need for a middle man. The network maintains its security because each transaction must be validated by at least 51% of its nodes. Remember, the more nodes there are, the more decentralized the network is, meaning that it’s harder for any one entity to control and hack.
The problem then becomes scalability. The easiest way to imagine the problem is to say that each information on the blockchain carries “weight”. As we add more information to the blockchain, the data becomes heavier and moves around more slowly. Yet each node must be kept up to date in order to streamline the constant flow of transactions being made and funds being moved around.
To do this, we can limit the distribution of the blockchain - but by doing so, it means fewer nodes, making it easier for attackers to gain control of the network. In other words, adding scalability to the network comes at a heavy price of less decentralization and lower security.
It’s a major headache that blockchain, and DeFi especially, needs to solve. It’s similar to a traffic jam on many city streets. Traffic jams occur because the city planners never imagined that so many cars would be using the roads. It’s the same with blockchains - as they grow there’s a need to handle more transactions than they’re capable of processing. Like sitting in traffic, a user has to wait for their transaction to be processed. The problem can be summarized as too much traffic on an unscalable network, meaning transactions become unsustainably slow.
The Atomic Composability Problem
Unfortunately, while progress on solving the blockchain trilemma has been made by projects such as Ethereum 2.0, Polkadot, Avalanche and Algorand, for example, a fourth problem has since become apparent.
The above projects all use a variation of sharding, which refers to a process where transactions are offloaded from the main blockchain onto a kind of sidechain, where many can be processed at once, before finally being settled on the main chain.
However, this has created a problem with regards to atomic composability, which refers to the ability to bundle multiple transactions into a single action. Those who’re familiar with Ethereum understand how its smart contracts can be combined in order to facilitate multiple transactions at once. So a smart contract for taking out a crypto loan can be combined with a second smart contract that uses the proceeds of that loan, to buy another token, for example. In such a case, we are tying together two transactions, or “composing” them into more complex building blocks.
But should the second transaction fail, the user may well wish that they didn’t perform the first action either (i.e. getting the loan in the first place). What they want is for all of the transactions to happen, or for none of them to occur. So if they can’t use the proceeds of the loan to buy their desired token, they don’t want the loan at all.
This is what we refer to as “atomic composability”, and it’s a key enabler for DeFi because it allows for greater innovation - it becomes possible to compose functionality with other’s creations, creating more complex and useful decentralized applications for DeFi.
Such innovation will be critical for DeFi to emerge as an alternative to traditional finance. Take flash loans for example, which are not available with TradFi. Using flash loans, it becomes possible for traders to spot an arbitrage opportunity, borrow the assets to take advantage of it, profit off the difference in the price of that asset on different marketplaces, and then repay the loan, all in a single transaction. If this can’t be done in a single transaction, it becomes much riskier for investors, who could be left stuck with their loaned assets if the second transaction fails.
If atomic composability is not present, the network will have to process rollbacks and coordinate its actions, creating additional network traffic and increasing its inefficiencies. Therefore, atomic composability becomes a must-have for DeFi to scale.
Fixing The Quadrilemma
Solving this quadrilemma is a demanding challenge but already an interesting solution exists with the innovative architecture of Radix, a unique layer-1 blockchain protocol that’s designed specifically for DeFi.
The foundation of Radix is the Radix Engine, which is an asset-oriented smart contract environment that drops the message-oriented approach to smart contracts followed by Ethereum and other blockchains. Radix Engine is focused on the creation of assets, analysis of substrates and efficient sharding in order to enable “parallel processing” of transactions, resulting in almost infinite linear scaling. At the same time, it also provides atomic composability, ensuring that all of these pieces can work together seamlessly.
Key to this is the Radix Engine’s unique Cerberus consensus algorithm, which ensures scalability by delivering unlimited parallelism - in other words, being able to process multiple transactions at the same time, without slowing down the network.
Cerberus provides unlimited parallelism by creating a practically infinite number of shards that can reach consensus independently, yet in parallel with others. At the same time, atomic consensus can be reached across any set of shards for each transaction. In addition, it allows for UTXO-like substrates to be assigned arbitrarily to individual shards.
Cerberus requires two things to enable scalability through parallelism - the ability to define the meaning and rules of each substrate, and the ability for each transaction to define which substrates must be included in consensus.
To provide this, Radix Engine treats tokens such as cryptocurrencies and NFTs as global objects at the platform level, allowing the movement of assets to be parallelized as much as possible. In addition, every Radix transaction is unique and based on “intent”, enabling higher throughput for dApps without conflicts. Finally, each smart contract - known as a “component” in Radix - is assigned to a single shard. This ensures that each component can process as many transactions as required at any moment.
By combining the capabilities of Radix Engine and Cerberus, we arrive at a unique platform that’s able to scale dramatically to the level that global DeFi will require. One that’s capable of supporting potentially thousands of DeFi apps, and millions of transactions, via massive parallelism.
The advantages of Radix Engine and Cerberus are that resources can be transacted in parallel without bottlenecks. Components also run in parallel, at maximum speed and without conflicts. In this way, each independent dApp can be parallelized to support greater throughput using multiple, logically unrelated components. Moreover, the efficiency of this parallelism will be maximized because each transaction will only ever need to pull together the resources and components it needs at the time of processing.
What’s more, Radix Engine does all of this while ensuring atomic composability. This is because Cerberus is able to conduct cross-shard transactions, as necessary, in an atomic and efficient manner.
Fulfilling DeFi’s Promise
While few people are aware of the concept of the “quadrilemma”, the problems it causes are widely known, with slow transaction speeds, insecurity and failed transactions all being very common complaints among DeFi users. For this reason, the unrivaled parallelism offered by Radix through its tight integration with Cerberus could well prove to be critical if DeFi is going to be able to scale to the same degree as traditional finance.
If Radix can successfully tick all four boxes - decentralization, security, scalability and atomic composability - without sacrificing any one of those elements, we may finally have the highly scalable and future-proofed blockchain that DeFi needs to grow to the next level. If so, then Radix can provide the foundation required for a DeFi ecosystem that's finally able to live up to the promise. Namely, one that’s able to provide a genuine alternative to the slow, centralized and inherently unfair financial systems most people are stuck with today.
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