Serial entrepreneur Tim Delhaes, founder of Grindery, a Binance Labs S4 company, is a web3 enthusiast shaping the future of DeFi.
I see decentralized finance (DeFi) as a game changer for the finance sector. It represents the financial world’s equivalent of the Wild West where the rules are being written as we progress. It’s a place where the traditional banking system is being upended and power is being handed back to the people.
However, with great power comes great responsibility, and in the case of DeFi, that responsibility lies in security. Unfortunately, billions have been lost to hacks in the DeFi space over the last three years, indicating the urgent need for a radical rethink.
DeFi is a complex beast, constantly evolving and, with that evolution, comes risk. The more complex the system, the harder it is to secure. This is an unavoidable compounded risk inherent in any rapidly evolving system.
The Rise Of Automated Market Maker Protocols
At the heart of DeFi is the decentralized exchange (DEX), a platform that allows peer-to-peer transactions without the need for a middleman. These DEXs use automated market maker (AMM) protocols. AMMs are what triggered the DeFi revolution in 2017, often referred to as “the summer of DeFi.” The primary problem these AMMs solved was to enable anyone to release a token and provide liquidity for it. They originated on Ethereum, expanded to other blockchains, and now exist on every blockchain.
However, these AMMs were not originally designed to work cross-chain. In the last few years, dozens, if not hundreds, of blockchains have emerged—each with its own AMM. To secure liquidity, these blockchains and their protocols need to connect to major liquidity sources, primarily Ethereum.
The dominant solution that has emerged in recent years is to connect these AMMs using so-called cross-chain messaging protocols like LayerZero, MultiChain and Celer. Unfortunately, this has resulted in the DeFi patchwork we use every day. Security breaches in this patchwork have led to substantial financial losses, revealing the vulnerabilities inherent in this system. Surprisingly, these cross-chain losses account for nearly half of all DeFi-related hacks, despite cross-chain transactions making up only a small portion of total DeFi transactions.
Securing The System: Three Approaches
So, how do we secure a system that is constantly evolving?
1. Optimistic Protocols
One approach is the use of so-called optimistic protocols. These protocols do not rely on off-chain systems to provide security, which is a significant feat given that the weakest link in cross-chain systems has always been the off-chain component. I see companies like Connext, Nomad and Across as leading the way in this space.
2. Self-Contained Protocols
Another approach is the development of self-contained protocols. These protocols operate primitive systems without relying on external sources for data or interaction. By reducing reliance on external systems, these protocols can enhance security, increase robustness and provide users with greater control. Projects like Ajna and Blend are pioneering examples of this approach.
3. Trading Automation Systems
Lastly, there are trading automation systems. These systems create decentralized brokers that can substitute the need for algorithmic trading of AMMs. While they may not be as efficient as AMMs, they can potentially provide the necessary order-matching frequency. Companies like Hummingbot and Carbon are the ones I see at the forefront of this innovation.
While the past five years have been dominated by cross-chain messaging and AMMs for transferring values between chains, we are witnessing a slow change of tides. Traditional order books are making a comeback, pioneered yet again by Uniswap through Oku and soon Uniswap X.
As we strive for a more secure and efficient cross-chain DeFi ecosystem, the integration of optimistic and self-contained protocols with trading automation systems could potentially lay the groundwork for a new breed of P2P cross-chain DEXs. This innovative approach could merge the lower capital needs of order book trades with the high order matching frequency of AMMs, all while keeping security entirely on-chain.
While this solution may not replace the convenience of using major AMMs like Uniswap or Sushiswap for exchanges on specific chains, or replace bridges between stable, confined subsystems like ZK, Layer 2s offer a compelling proposition for those blockchains on the long tail.
Forefront Of Innovation
These are the chains that are at the forefront of innovation and pushing the boundaries of blockchain technology but currently suffer from a lack of liquidity and low user adoption. By providing a more secure, efficient and user-friendly alternative, this new approach could help these innovative chains overcome their current challenges and unlock their full potential.
In doing so, it could not only reshape the DeFi landscape but also pave the way for the widespread adoption of decentralized finance—all while mitigating the compounding security risk posed by the current approach of AMMs and messaging systems.
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