When blockchain technology began to expand beyond Bitcoin (BTC) and into more general-purpose applications, many within the industry saw an opportunity to remake key financial infrastructure using this technology. They soon came to realize that this novel technology with game-changing potential lacked the reliability and performance that would allow it to compete with industry stalwarts, such as the Society for Worldwide Interbank Financial Telecommunication, or SWIFT. The potential was there, but it was still a little too early.
Fast forward a couple of years, and this larger trend to remake core financial functions on open networks has given rise to a whole new world of blockchain-native financial services. Open finance, also known as decentralized finance, has grown from a few applications experimenting with financial services on public blockchain networks into a dominant sub-sector, with more than $1 billion locked up in under two years.
When the COVID-19 pandemic started spreading and creating economic chaos, the DeFi sector experienced its first true test as part of the global liquidity crunch that hit financial markets. The cautious reopening of economies around the world offers an opportunity to reflect on how DeFi might transcend beyond its current limitations to become an integral component of the global financial system.
Searching through history for lessons
History rhymes, or so they say. Investors old enough to remember “Black Monday” recall watching the Dow Jones Industrial Average tank by 22.8% on Oct. 19, 1987, marking its largest single-day drop in history. Many observers felt that automated trading software, which was just beginning to spread across Wall Street, was responsible for the crash. Furthermore, large fund transfers were delayed, as both the Fedwire and the NYSE DOT systems for passing financial messages clogged due to high activity.
On March 12, 2020, a day known as “Black Thursday,” the protocols carrying financial transactions on blockchains would once again become clogged up with tremendous volume. An initial drop in the markets was amplified by a combination of financial automation (bots and other tools) gone bad and congested networks, with catastrophic results.
DeFi, and decentralized apps in particular, felt the heat of the Black Thursday catastrophe. While innovation and interest in the DeFi space have continued to grow, the events of Black Thursday shook investor confidence in the reliability of these novel financial protocols.
Clogged up public networks and every made transaction significantly more expensive, financial services that relied on these networks froze. Investors lost millions of dollars due to both security malfunctions and the depreciation of their digital assets.
After the 1987 crash, soul searching among industry leaders led the financial markets to adopt fail-safe measures, such as “circuit breakers,” which would halt trading momentarily in the event of significant losses. During the dot-com bubble in 2000, the global financial crisis of 2008, and the recent COVID-19 Black Thursday crash, these circuit breakers shut down trading at crucial moments to prevent the market from taking an even bigger hit.
DeFi has yet to fully recover its lost deposits from March 12. The growing DeFi ecosystem has an opportunity to become more resilient by learning from Black Thursday and to shift gears and enter the mainstream, just as the equity markets became more robust after 1987’s Black Monday.
Re-instilling confidence in the potential of DeFi
DeFi’s main challenge is to expand beyond its current cohort of early adopters and attract millions of mainstream users. A prerequisite to onboarding the masses is having these financial services run in a stable and reliable fashion, regardless of the prevailing market conditions. The architectural design of these services, however, makes this difficult.
Public blockchains tend to congest sporadically, making transactions prohibitively expensive to send and leading to network-wide “freezes.” DeFi applications must interact with these networks every time a user wishes to send payments, take out loans or even update the current price of assets. Speed, reliability and availability are cornerstones of modern finance, and unless decentralized finance can provide a similar experience, high-value users have little incentive to switch over. Successful companies cannot allow malfunctions in their communications systems, let alone the financial services that underpin value transfers.
Recognizing these limitations early on, developers set off on an industry-wide effort to build scaling solutions that can enable high-throughput, real-time gross settlement, or RTGS, for DeFi protocols. Most of the leading solutions have been employing variations of a similar approach called second-layer scaling. These solutions, such as optimistic rollups, sharding and LiquidChains, generally involve offloading a bulk of DeFi activity from public networks and onto application-specific blockchains that offer more bandwidth, more throughput and are more cost-effective, while retaining the same level of auditability that is characteristic of blockchain-based applications. DeFi applications utilizing second-layer scaling can still maintain a connection with a public network, which acts as both a transparent ledger and a liquidity hub.
Another ambitious scaling solution that could enable orders of magnitude more transaction volume is sharding. This technique shares similar principles to second-layer scaling solutions, in that it involves splitting up, or “sharding,” a single network into smaller shards, each of which processes its own transactions and stores its own data while still retaining its connection to a “main chain,” known as the “Beacon chain” in the case of Ethereum.
Less is more when it comes to public blockchains
Whether it’s in the Ethereum ecosystem or elsewhere in the industry, teams have embraced the notion that a single chain will struggle to support the throughput demands of global payment rails that could catapult DeFi into prime time. Teams have realized that for blockchains to scale, they must do the minimum amount of work required in order to guarantee the validity of transactions, while the high-volume activity takes place on a series of gas-reduced side chains or shards.
These scaling solutions, such as second-layer scaling and sharding, could bring DeFi closer to a stage whereby users interact with these financial services without being exposed to the backend complexities — as it should be. By running most of the heavy lifting on these custom second-layer solutions, public blockchain networks will be free to serve their true purpose — as liquidity hubs and global ledgers for public proofs only. Doing less, not more, on public networks could allow DeFi to scale exponentially, enabling a much quicker, smoother user experience that consumers have come to expect from financial services technology, without sacrificing any of the auditability, for which blockchains are so well-known.