Does DeFi still have a chance to deliver on its promises?

DeFi is currently at a fork in the road. Whether it can deliver on its promise to build a better financial system depends on which of the two different paths it chooses to take.

Decentralized finance (DeFi) as a movement that promises to revolutionize the global financial system is underpinned by a simple yet powerful premise – to provide better solutions through peer-to-peer asset transfers and smart contract-driven autonomy.

Since 2015, multiple sub-sectors such as lending, trading, and automated market making have risen rapidly, reaching $175 billion in total value locked (TVL) in just a few years. As in other areas of Web3, DeFi is growing very fast in innovation and adoption.

Very fast, but very limited.

The recent faster decline aside, DeFi protocols still have limited influence outside of their homegrown early adopters due to frequent security hacks, lack of risk disclosure, poor user experience, and limited regulatory compliance.

Today, we are witnessing regulators stepping up their enforcement of DeFi on an almost daily basis, further narrowing its reach, while established traditional finance (TradFi) players are leveraging decentralized technologies to further diminish their unique value.

Needless to say, today’s DeFi protocols are standing at a fork in the road of existence.

By examining the dynamics of system change, system theory provides us with a framework and a potential roadmap to help us think about the two different paths facing DeFi.

Two forks in the road

In short, systems theory states that to change a system, we need to first understand its constituent variables and the relationships between them and the variables of other systems. In this way, we can modify the correct variables that are related to each other or add new variables to create a new set of relationships and outcomes, and create a new system over time.

However, the system is not linear, but rather a dynamic neural organism. Each change in the relationship between two variables creates a domino effect on the other variables.

Going back to DeFi and the question above, systems theory gives us a roadmap of two possible outcomes.

Road 1: Trad****Fi wins

Choosing to go the first route, DeFi does not employ the minimum rules or variables required by the macro system TradFi, such as Know Your Customer (KYC), Anti-Money Laundering (AML), disclosure of required information, security controls, and data protection. Instead, DeFi operates as a parallel and independent microsystem, but each of its variables has a direct impact on the benefits of the broader macrosystem.

This effect is initially thought to be relatively benign, but its scale will increase over time. TradFi regulators and established players with considerable power over the macro system are starting to see DeFi as a potential long-term threat.

They strictly enforce the rules, adopt key DeFi features that benefit their interests, such as liquidity and smart contract settlements, and make any variable that is not in their interests illegal, thus engaging in crime.

The result is that TradFi incorporates elements of decentralized functionality, but remains a TradFi system. The reach of DeFi is limited to marginal communities outside of the macro system and carries considerable legal and financial risks. If this path sounds familiar, it’s because it’s a continuation of the path DeFi has taken.

Road 2: Consumers win

Along the second path, DeFi becomes a legitimate alternative to traditional TradFi participants by employing minimally required rules or variables to protect consumers and operating in a broader macro system to solve real problems with better solutions than established players.

Here, DeFi incorporates elements of centralized functionality, but remains largely a decentralized product, offering on-chain transparency, access to solutions traditionally reserved for institutions and ultra-high-net-worth individuals, liquidity of illiquid assets, transaction speeds that bypass multiple intermediaries, and self-custody and ownership of individual assets. Financial assets owned.

Playing with TradFi players always leads to tension and sometimes direct conflict, with everyone outsmarting each other with the next innovation, justified or not, or shouting out. In this competitive arena, some DeFi players have failed, while others have succeeded. The same goes for TradFi. But the real winners are the consumers.

Two different paths lie ahead of us, and finally to answer the question, if by DeFi promise we mean DeFi replacing TradFi, then the answer is no.

If, on the other hand, what we mean is that by adopting a few variables while remaining decentralized in its core product, DeFi thrives in the broader macro system and ultimately fulfills its promise of wider access and better value for consumers, then the answer is a resounding “yes.”