Status Quo: DeFi 1.0
The Decentralised Finance (DeFi) space has seen phenomenal growth during the last 2 years, with TVL now exceeding $220 billion, with more than 3.5 million users across various DeFi protocols as of mid-October 2021.
Notably, when considering the DeFi lending and borrowing space, the majority of market share is concentrated among current sector leaders - Aave and Compound - together represent more than $28.8 Billion in TVL alone. Each of these sector leaders played an instrumental role in developing the DeFi ecosystem and so have been significant enablers of its widespread adoption.
However, the value capture mechanisms in these protocols benefit select participants and result in a misalignment of user incentives. As for any digital platform, if value capture distribution amongst various user profiles becomes disproportionate, it results in the delivery of sub-optimal network effects. This in turn deprives the ecosystem of benefitting from optimum value creation. In short, sub-optimal model design means sub-optimal value is created and distributed back to users overall.

Current limitations

Liquidity Mining Architecture
With regards to lending protocols, liquidity mining refers to the mechanism whereby participants are rewarded with native tokens in return for providing liquidity (lending) and borrowing assets from the protocol’s various token markets. Liquidity mining is widely considered fundamental to the success of any lending protocol given it is now a constituent element in users determining their total APY.
The value of liquidity mining is dependent on two factors:
  • the quantity of native tokens issued.
  • the ongoing value of these native tokens.
Lending protocols currently exhibit little to no correlation between the amount of liquidity lent and borrowed and the value of the native token, despite both being key metrics of protocol performance. This means current models exhibit significant dilution in the value of liquidity mining with increasing liquidity growth, as the same quantity of native token emission must be shared by an increasing pool of users. Importantly this type of dilutionary event also results in a reduction of total APY for protocol users.
Such an architecture leaves lending protocols solely reliant on traditional marketplace network effects in order to compete, which very simplistically means substantive supply of liquidity equates to user convenience and trust.
External Liquidators
External liquidators are third-party actors that earn fees for undertaking the buy-out of under-collateralized borrowers at discounts to market rates. The participation of external liquidators helps maintain the overall solvency of underlying asset markets.
In such models, the economic viability of liquidation events has to be substantial enough to attract liquidators to seek out under-collateralized loans. This has resulted in circumstances where the minimum proportion of borrower collateral sold off in liquidation events can be higher than that required to return the account to solvency, and is often punishingly high; a 50% minimum is not uncommon.
While the external liquidator model is arguably effective, it comes at a very high price. DeFi liquidation fees, now measured in hundreds of millions of dollars, represent significant value being extracted from the protocols which could instead be captured for the benefit of all users, rather than a select few (liquidators).
Risk Analysis Data
Assessing risk liability in DeFi lending portfolios requires a significant degree of user sophistication to accurately assess and manage effectively, especially with token assets that are subject to volatility and varying price correlation like WBTC and ETH. Understanding risk liability is essential, however most users do not have easy access to the resources or specialised know-how required in order to do so.
Existing DeFi protocols do not provide users with the high value analysis tools needed to enable them to simply and effectively manage portfolio risk. This results in an unnecessarily high number of liquidation events than otherwise would be the case, and as has been mentioned previously, often with punishingly significant impacts on borrowers.
Gas Costs
Ethereum gas fees remain a significant barrier to participation, especially for smaller participants not managing high-value token asset portfolios. Currently, the average gas fees on Ethereum can range between $30 to $50 per DeFi transaction, depending on network congestion at the time.
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