Technology Challenges and Knowledge Gaps in DeFi: Partnering for Success

As financial institutions begin exploring the DeFi landscape, many are realizing that their legacy systems and existing workflows are not compatible with blockchain technology. Interacting with decentralized protocols and automated market mechanisms can feel like an entirely new world – one where the rules of traditional finance (TradFi) don’t apply.

Technology challenges: Interoperability and Irreversibility

Financial institutions are accustomed to working with highly customized legacy systems designed to operate within the parameters of traditional, centralized finance. DeFi, by contrast, is decentralized, with no intermediaries to broker trades, maintain order books, or manage custodial services. This creates a significant interoperability issue – getting legacy systems to communicate with blockchain protocols is complicated.   

For example, while transaction data is available on chain, parsing that data into institutional-grade reports, audit trails, and compliance documents requires sophisticated tools and expertise. This can be a headache for investment advisors that must routinely provide clients with detailed account statements and portfolio breakdowns from custodians. Without the right technology, it is difficult to generate a unified report that captures assets stored on chain across multiple wallets and protocols. 

Another challenge inherent in DeFi technology is the irreversibility of transactions, which can make mistakes both costly and permanent. In TradFi, by contrast, there is often a centralized intermediary to contact to help parties unwind transaction errors. If a transaction is mistakenly submitted to a DeFi protocol, there is nobody to call to reverse it. 

Knowledge gaps: Understanding the Idiosyncracies of DeFi 

In addition to technological hurdles, many institutions may lack knowledge about how DeFi operates. This can cause operational challenges, such as failing to understand why a trade on a certain digital asset failed. For example, in DeFi, assets can be upgraded or updated, with ticker symbols and contract addresses changing in ways unfamiliar to those used to CeFi. So a simple mistake, like attempting to trade a “dead coin”, may lead to errors and confusion.

Failing to understand Miner/Maximum Extractable Value (MEV) risk is another example of an area where a lack of knowledge can result in significant slippage on transactions. MEV  is a set of strategies employed by arbitrageurs to maximize their profits by reordering or censoring transactions in a blockchain network. This is possible because pending smart contract transactions are held in the network’s publicly visible waiting area, or mempool, where they sit until a miner or validator confirms the next block in the network chain. If institutions are unaware of MEV risk, they may unknowingly be allowing arbitrageurs to front-run their transactions.

Addressing the technology challenges and knowledge gaps

The good news is that solutions to these challenges exist. By partnering with the right technology provider, institutions can gain access to tools that help them perform validation checks pre-trade – reducing the risk of a mistaken trade becoming permanently enshrined on the blockchain. Institutions should look for a technology provider that can also help to aggregate DeFi liquidity, manage trades, automate reporting and provide other information needed to operate their business in DeFi. 

With the right platform, institutions can manage all of their DeFi transactions in one place, avoiding the need to piece together information from multiple blockchains and protocols. The result is a more streamlined, efficient workflow that reduces operational friction and allows institutions to focus on strategy rather than technology.

Lastly, the right partner will have deep knowledge of both CeFi and the unique nuances of DeFi, helping institutions to bridge the gap between the two worlds. A good provider will help clients understand the mechanics of DeFi: how to interact with decentralized exchanges, manage liquidity pools and avoid common pitfalls. 

Conclusion

DeFi is on the cutting edge of both finance and technology, offering institutions unprecedented opportunities for innovation and growth. However, as with any frontier, it comes with a novel set of challenges, particularly for institutions dependent on legacy systems and traditional methods of operation.

A key to success in DeFi is partnering with the right technology provider, one who can bridge both the technology and knowledge gaps. 

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Talos has helped numerous institutions navigate DeFi’s complexities. Contact us to explore how we can support your institution in overcoming these challenges to unlock the potential of DeFi.

Click below to read the previou chapters:

1. The AML/KYC Challenge in DeFi: Risk Mitigation Techniques
2. Cybersecurity Challenges in DeFi: Addressing the Risks
3. Custody Challenges in DeFi: Navigating Compliance

^{Disclaimer: Talos offers software-as-a-service products that provide connectivity tools for institutional clients. Talos does not provide clients with any pre-negotiated arrangements with liquidity providers or other parties. Clients are required to independently negotiate arrangements with liquidity providers and other parties bilaterally. Talos is not party to any of these arrangements. Services and venues may not be available in all jurisdictions. For information about which services are available in your jurisdiction, please reach out to your sales representative.}