FinTech

Why Privacy and Interoperability Will Fuel Exponential Growth in DeFi

By Ryan Nguyen. Ryan is the founder of Lightening Cash, the first privacy protection asset transfer protocol on Binance Smart Chain. He is also the Co-Founder of HC Capital & HC Ventures.

Cryptocurrencies are currently in their biggest bull market in history. Although it’s not the first time digital assets have seen huge price hikes, most sources seem to agree that the circumstances are quite different from the 2017 rally. For the most part, the differences are down to the more advanced state of maturity in the markets and the inflow of institutional funds. In recent weeks, BNY Mellon, Deutsche Bank, and Goldman Sachs have all put their weight behind crypto, indicating a more sustainable growth than we saw in the boom-and-bust pattern of 2017 and 2018. 

There are parallels to be drawn between the current rapid expansion of decentralized finance, and the evolution of the cryptocurrency markets. DeFi has been growing at a breakneck pace for over a year now. In February 2020, it broke through the $1 billion in total value locked barrier, only to sail past $40 billion in February 2021. However, like the 2017 bull run, the growth has been fueled by mostly individual retail investors rather than institutions or professional traders. 

Barriers to Growth

Big money will ultimately find its way to DeFi just as it found its way to cryptocurrency. But several critical challenges need to be overcome before that can happen – privacy. As things stand, DeFi is highly dependent on the Ethereum platform, and it comes with inherent flaws. 

Aside from the often-discussed lack of scalability and high transaction fees, DeFi transactions on Ethereum aren’t private. Once you know someone’s public address, it’s possible to trace every single transaction they carry out, including the parties involved, amounts, and any trends in their usage habits. Bad actors can then share that information publicly, which is a risk many institutions and professional traders are likely to be unwilling to take. 

While many institutions, such as MicroStrategy, have been transparent about their cryptocurrency holdings, confidentiality is critical in trading, given that companies act on behalf of clients. Given the sums involved, it would be too easy for anyone to analyze movements and figure out who is behind them. 

However, the lack of privacy also creates other issues that bring an unacceptable level of risk. Because all transactions are visible to everyone, front-running has become rife on Ethereum-based DeFi. For the benefit of the uninitiated, front-running on Ethereum involves exploiting the mempool, which is a kind of queue where unconfirmed transactions wait to be included in blocks. Miners have the flexibility to choose which transactions they put into a block and will often choose those with the highest transaction fees. 

Front-running bots continually scan the mempool for potentially profitable transactions and then seek to replicate them with a bid for higher transaction costs. The higher fees mean that the miners are more likely to pick the front-runner’s transaction for inclusion in a block first, and so the trade becomes unprofitable for the first, honest trader. 

Growing But Fragmented Liquidity

Given the challenges with Ethereum, it’s hardly surprising that developers are now looking to other platforms to build their DeFi applications. However, this also comes with an unfortunate side-effect, in that liquidity becomes diluted across many different DeFi ecosystems. Therefore, interoperability is another critical challenge to solve, as high-rolling traders seek out markets with deep liquidity. By developing protocols that are interoperable across different blockchain platforms, funds can flow freely, generating more liquidity. 

Zero-Knowledge Proofs - An Compelling Privacy Solution

How can these issues be solved? There is hope on the horizon. For the privacy challenge, zero-knowledge proofs offer an attractive solution for enterprises and institutions. Zero-knowledge proofs effectively provide an additional layer of privacy by cloaking the transaction details. Validators or miners on a blockchain network receive a proof that allows them to validate the transaction, but without knowing the details of it or posting them publicly. 

Zero-knowledge proofs solve a critical trade-off that presents when attempting to introduce privacy into blockchain transactions. Although they allow the user to transact with complete privacy, there is still a trail that will enable the user to verify the transaction in case of an audit request or similar. In this respect, they allow an organization to demonstrate compliance when required. 

Zero-knowledge proofs have been around for several years now, used in privacy coins such as Zcash. However, partly in response to the demand for private transactions, they’re now becoming more widely deployed. 

Inroads into Interoperability

There are also significant strides being made in interoperability. Whereas legacy Ethereum competitors such as EOS, Tezos, or Tron operate as “walled gardens,” newer platforms such as the Binance Smart Chain (BSC) and Polkadot are built with interoperability in mind. BSC is compatible with the Ethereum Virtual Machine, and Polkadot’s bridge parachains can theoretically connect into any other blockchain. 

Both are becoming magnets for DeFi developers, with BSC-based PancakeSwap recently becoming the second-biggest decentralized exchange by volume, second only to Ethereum’s Uniswap. 

With solutions to the challenges of privacy and interoperability, the DeFi markets will be primed to undergo the kind of epic exponential growth that we’re currently seeing in the cryptocurrency markets. Within the coming years, DeFi will achieve the same trillion-dollar status that Bitcoin recently managed, fueled by professional investors with a desire to capture the value in this burgeoning sector. 

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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