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Managing risk in DeFi – the decentralized way

by the Crystal analytics team

October 15, 2021

 How can transparency and regulatory compliance be brought to DeFi without compromising on the industry’s decentralized ethos?

New trends are continually emerging in the crypto world – and some use cases have greater staying power than others.

One application for blockchains and digital currencies that seemingly exploded out of nowhere in 2020 is decentralized finance. Often referred to as DeFi for short, this is an umbrella term that’s used to describe an array of financial services. The projects in this space are attempting to take on big banks – cutting out middlemen to ensure that transactions are cheaper, faster and automated thanks to smart contracts.

Data from DeFi Pulse shows that approximately $8.5 billion was locked up in DeFi protocols at the start of 2020. Fast forward to the beginning October 2021, and this figure stands at $200+ billion – a powerful illustration of the astronomical growth this burgeoning sector has enjoyed.

And a number of analysts firmly believe that DeFi is still at a nascent stage. Renowned crypto investor Matthew Roszak recently told Markets Insider that he expects the industry to “add a zero” in the coming 12 months…

But when you peel away the palpable excitement of what DeFi could achieve, and how it could transform the way we all interact with money, you begin to see big challenges that need to be resolved. Placing funds in one of these protocols is riskier because a centralized structure isn’t in place. Whereas you can get a new PIN code for your debit card if you forget it, similar safeguards aren’t available in the world of DeFi. And as the debate over regulation begins to intensify across central banks and governments worldwide, these protocols need compliance solutions to ensure they remain relevant for years to come.

What is DeFi and the decentralized economy?

Let’s rewind for a moment – and refresh ourselves about what DeFi actually offers.

Most decentralized applications are based on the Ethereum blockchain, where smart contracts first made their debut.

Here’s a common analogy used to describe this technology. In an old-fashioned world, buying a can of Coke would involve going into the shop, picking it off the shelf, going to the shopkeeper, and handing over the money. Smart contracts are like vending machines because they eliminate the need for an intermediary – in this case, the shopkeeper. As long as a thirsty customer has the right cash, they can get the drink they want in a permissionless way.

DeFi now enables crypto investors to borrow and lend digital assets – and oftentimes, savers can end up receiving more generous interest rates than what a fiat-focused bank can provide. Loans are also easier to access if cryptocurrencies are provided as collateral. Given how many financial institutions have opaque requirements when deciding which applications to accept, this can provide a lifeline to people outside of the banking system – or those who have been turned down because they are self-employed and their earnings vary from month to month.

The applications don’t end here. DeFi protocols can also be used to swap one crypto token for another – instantaneously and trustlessly. Staking is also proving popular, and this is where digital assets are locked up for a predetermined period of time, with users earning additional tokens in exchange for providing this liquidity.

As promising as all of this sounds, there are downsides. Reliance on smart contracts means there’s a real risk of funds being lost if mistakes are made in the code. Indeed, in October 2021, tens of millions of dollars were drained from the Compound protocol because a = sign was missing from a protocol upgrade. The stakes really are that high.

Opportunistic fraudsters actively look for vulnerabilities so they can swoop in and steal cryptocurrencies. And in some cases, the founders of DeFi protocols can also act dishonestly – performing “exit scams” where they run off with their customers’ funds. Oracles, which are responsible for providing up-to-date information on asset prices, can also suffer failures. Such bugs can make it seem like Ether costs $10 when everywhere else is trading them for $3,000, and they can be exploited for financial gain.

How centralized and decentralized exchanges differ

The rise of DeFi has transformed the role of the humble crypto exchange. In this industry’s early days – where only bitcoin and a small handful of coins existed – most trading platforms were centralized.

But now, decentralized exchanges (DEXes) have exploded in popularity. Most do away with Know Your Customer checks, meaning that investors can buy and sell their coins without having to reveal their true identity. In some cases, users don’t even need to register for an account with a DEX – instead, they can just connect a crypto wallet.

A common complaint often centres on the fact that some decentralized exchanges are more difficult to use than their centralized counterparts. To compound the problem, they can also suffer from lower liquidity – and this can make it harder to purchase or offload digital assets quickly at the current market rate.

Perhaps the most appealing thing about a DEX concerns how users always remain in full control of their funds. That’s opposed to a CEX (centralized exchange), where there’s a danger funds could be lost forever if the trading platform collapses. “Not your keys, not your coins” is a common saying in crypto circles.

Data from Crystal Blockchain suggests that, as of August 2021, trading volumes on centralized exchanges stood at about $90 billion. By comparison, their decentralized rivals are creeping up on them – with DEX volumes of $77 billion over the same period.

Centralized or not, every exchange needs to offer transparency and risk management – but a different approach needs to be taken with decentralized platforms.

The problem with centralized gatekeepers

Given how DeFi is built on cutting out middlemen, introducing centralized solutions for these protocols is a non-starter – and something that goes against the very ethos of decentralization.

Nonetheless, something needs to be done. At present, there are limited anti-money laundering checks in place across the decentralized finance and non-fungible token sectors, and users have little protection from hackers and other malicious actors. Worse still, this lack of compliance also has the potential to stymy further growth – as of right now, institutions are unable to inject their capital into the space.

To this end, a radical new approach is needed. Many DeFi protocols rely on unique governance structures that allow everyone in an ecosystem to have their say on a project’s future direction, and they could benefit from intelligence that prevents their communities from being hurt or damaged.

Clarity Protocol offers a multi-chain, accessible, decentralized protocol that supports democratic risk management and due diligence for the tokenized economy – bringing blockchain analytics to DeFi. While configurable entities allow communities to customize risk profiles, decision oracles provide executable summaries. The activities of bad actors – including exploits, hacks and other forms of undesirable behaviour – can be detected quickly, smart contracts can be rated, and crowdsourced data that is both cleaned and verified is available at the tap of a button.

Everyone from data providers to data consumers can benefit from Clarity Protocol – and decision oracles will have the freedom to convert raw datasets into actions, making the process of community governance easier than ever before.

Crystal Blockchain becomes Clarity’s first community member

Clarity Protocol is an offshoot project of Crystal Blockchain, which identified the need for a decentralized approach to be taken in tackling the risks associated with DeFi.

To maintain Clarity’s decentralized ethos, Crystal isn’t a majority stakeholder or shareholder in this project – instead, it simply serves as a key data provider, delivering verified information that can be used by communities everywhere to make transparent decisions.

To find out more about the Crystal for DeFi solution for decentralized transparency get in touch at [email protected]

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