Over the last year, the total value locked (TVL) in decentralised finance (DeFi) projects has risen from $62.23 billion to $213.13 billion, according to Defi Llama data. That represents a 242.5 percent growth in just one year.

TVL is the sum of all deposits made in cryptocurrency in DeFi services like staking, lending, and borrowing, liquidity pools, etc. The numbers indicate an exploding interest in the segment from users and organisations alike.

However, one of the largest investment banks in the world, Morgan Stanley, doesn’t believe that the growth will continue in the future and that the DeFi industry will remain “fairly small”. It published a report stating that regulation and excessive collateralisation are the two factors weighing the DeFi space down.

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According to analysts from Morgan Stanley, DeFi only benefits protocol providers and not the end-users themselves. Also, since decentralisation promotes autonomy in transactions, DeFi systems are vulnerable to cyberattacks and hacks. The analysts, therefore, believe that traditional financial systems are still more efficient than the new decentralised systems.

"Rather, DeFi protocols often seem to us as a way to attract cash flow to enrich the protocol operators,” the report read. “DeFi is hack-prone and at risk of financial crime given anonymity is a key feature”, it went on to say.

With regards to regulation, most nations are already delving deep into the working of DeFi systems, and those that are uncomfortable with cryptocurrencies are doing away with them altogether.

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Moreover, stringent Anti-Money Laundering (AML) and KYC laws are still not in place for the crypto industry. According to Morgan Stanley, this is one of the major barriers to the institutional adoption of DeFi services. And the introduction of these KYC and AML norms will "force DeFi to be more centralised," it said. Of course, that would defeat the entire purpose of DeFi systems that are meant to be decentralised in nature.

Another problem with crypto loans is collateralisation. Unlike conventional loans, borrowers in the DeFi space must pledge enough collateral in crypto assets to match the loan value. Crypto markets are quite volatile, and the value of the pledged assets could, therefore, either appreciate substantially or plummet. If the value nosedives, the borrower must attach additional crypto assets to back his (her) loan, thus exacerbating the problem. Without a governing authority or body, this cannot be controlled. Therefore, Morgan Stanley expects DeFi to remain small in the upcoming years.

"Overcollateralization in lending/borrowing means Defi lending doesn’t expand the money supply (for the same cryptocurrency), which means, without centralisation, it will be harder for DeFi to be seen as an alternative to the current fractional reserve banking approach,” the bank report said.

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Currently, the top three DeFi lending protocols are Anchor (on the Terra blockchain), AAVE, and Compound (both Ethereum-backed), with a total of $33.12 billion of TVL in the lending space, according to Defi Llama.

(Edited by : Jomy Jos Pullokaran)

First Published:Mar 23, 2022 3:37 PM IST