When blockchain technology began to expand beyond Bitcoin (BTC)
and into more general-purpose applications, many within the industry
saw an opportunity to remake key financial infrastructure using this
technology. They soon came to realize that this novel technology with
game-changing potential lacked the reliability and performance that
would allow it to compete with industry stalwarts, such as the Society
for Worldwide Interbank Financial Telecommunication, or SWIFT. The potential was there, but it was still a little too early.


Fast
forward a couple of years, and this larger trend to remake core
financial functions on open networks has given rise to a whole new world
of blockchain-native financial services. Open finance, also known as decentralized finance,
has grown from a few applications experimenting with financial services
on public blockchain networks into a dominant sub-sector, with more
than $1 billion locked up in under two years.


When the COVID-19
pandemic started spreading and creating economic chaos, the DeFi sector
experienced its first true test as part of the global liquidity crunch
that hit financial markets. The cautious reopening of economies around
the world offers an opportunity to reflect on how DeFi might transcend
beyond its current limitations to become an integral component of the
global financial system.


Searching through history for lessons



History rhymes, or so they say. Investors old enough to remember “Black Monday”
recall watching the Dow Jones Industrial Average tank by 22.8% on Oct.
19, 1987, marking its largest single-day drop in history. Many observers
felt that automated trading software, which was just beginning to
spread across Wall Street, was responsible
for the crash. Furthermore, large fund transfers were delayed, as both
the Fedwire and the NYSE DOT systems for passing financial messages
clogged due to high activity.


On March 12, 2020, a day known
as “Black Thursday,” the protocols carrying financial transactions on
blockchains would once again become clogged up with tremendous volume.
An initial drop in the markets was amplified by a combination of
financial automation (bots and other tools) gone bad and congested
networks, with catastrophic results.


DeFi, and decentralized apps
in particular, felt the heat of the Black Thursday catastrophe. While
innovation and interest in the DeFi space have continued to grow, the
events of Black Thursday shook investor confidence in the reliability of
these novel financial protocols.


Clogged up public
networks and every made transaction significantly more expensive,
financial services that relied on these networks froze. Investors lost
millions of dollars due to both security malfunctions and the
depreciation of their digital assets.


After the 1987
crash, soul searching among industry leaders led the financial markets
to adopt fail-safe measures, such as “circuit breakers,” which would
halt trading momentarily in the event of significant losses. During the
dot-com bubble in 2000, the global financial crisis of 2008, and the
recent COVID-19 Black Thursday crash, these circuit breakers shut down
trading at crucial moments to prevent the market from taking an even
bigger hit.


DeFi has yet to fully recover its lost
deposits from March 12. The growing DeFi ecosystem has an opportunity to
become more resilient by learning from Black Thursday and to shift
gears and enter the mainstream, just as the equity markets became more
robust after 1987’s Black Monday.


Re-instilling confidence in the potential of DeFi



DeFi’s
main challenge is to expand beyond its current cohort of early adopters
and attract millions of mainstream users. A prerequisite to onboarding
the masses is having these financial services run in a stable and
reliable fashion, regardless of the prevailing market conditions. The
architectural design of these services, however, makes this difficult. 


Public
blockchains tend to congest sporadically, making transactions
prohibitively expensive to send and leading to network-wide “freezes.”
DeFi applications must interact with these networks every time a user
wishes to send payments, take out loans or even update the current price
of assets. Speed, reliability and availability are cornerstones of
modern finance, and unless decentralized finance can provide a similar
experience, high-value users have little incentive to switch over.
Successful companies cannot allow malfunctions in their communications
systems, let alone the financial services that underpin value transfers.


Recognizing
these limitations early on, developers set off on an industry-wide
effort to build scaling solutions that can enable high-throughput,
real-time gross settlement, or RTGS,
for DeFi protocols. Most of the leading solutions have been employing
variations of a similar approach called second-layer scaling. These
solutions, such as optimistic rollups, sharding and LiquidChains,
generally involve offloading a bulk of DeFi activity from public
networks and onto application-specific blockchains that offer more
bandwidth, more throughput and are more cost-effective, while retaining
the same level of auditability that is characteristic of
blockchain-based applications. DeFi applications utilizing second-layer
scaling can still maintain a connection with a public network, which
acts as both a transparent ledger and a liquidity hub.


Another
ambitious scaling solution that could enable orders of magnitude more
transaction volume is sharding. This technique shares similar principles
to second-layer scaling solutions, in that it involves splitting up, or
“sharding,” a single network into smaller shards, each of which
processes its own transactions and stores its own data while still
retaining its connection to a “main chain,” known as the “Beacon chain” in the case of Ethereum.


Less is more when it comes to public blockchains



Whether
it’s in the Ethereum ecosystem or elsewhere in the industry, teams have
embraced the notion that a single chain will struggle to support the
throughput demands of global payment rails that could catapult DeFi into
prime time. Teams have realized that for blockchains to scale, they
must do the minimum amount of work required in order to guarantee the
validity of transactions, while the high-volume activity takes place on a
series of gas-reduced side chains or shards.


These
scaling solutions, such as second-layer scaling and sharding, could
bring DeFi closer to a stage whereby users interact with these financial
services without being exposed to the backend complexities — as it
should be. By running most of the heavy lifting on these custom
second-layer solutions, public blockchain networks will be free to serve
their true purpose — as liquidity hubs and global ledgers for public
proofs only. Doing less, not more, on public networks could allow DeFi
to scale exponentially, enabling a much quicker, smoother user
experience that consumers have come to expect from financial services
technology, without sacrificing any of the auditability, for which
blockchains are so well-known.


The
views, thoughts and opinions expressed here are the author’s alone and
do not necessarily reflect or represent the views and opinions of
Cointelegraph.



Beni Hakak
is the CEO and co-founder of LiquidApps and LiquidEOS. He was formerly
the director of operations at Bancor and a strategic consultant manager
at Ernst & Young. Prior to that, Beni had served in an elite
technology unit of the Israeli Defense Forces and graduated from
Israel’s top technology institute, Technion, in industrial engineering
and management. Beni discovered blockchain technology four years ago and
has been creating, advising and working for companies in the space ever
since.