Fully Homomorphic Encryption (FHE) could pave the way for trillions in traditional finance entering decentralized finance (DeFi) markets by facilitating private lending, encrypted credit scores, and confidential transactions.
At its highest point in December 2021, DeFi’s total value peaked at an astounding $260 billion. However, when compared to the trillions traded daily in the global financial system, this figure appears minor. For instance, the foreign exchange market alone experiences over $7.5 trillion in daily trades.
DeFi has shown resilience since the downturn in 2022-2023, with lending protocols demonstrating longevity and a rebound in total value locked (TVL). Yet, DeFi still touches only a fraction of global capital due to the absence of crucial elements found in traditional finance.
The Encryption Technology’s Role in Overcoming Obstacles
Confidentiality is essential for institutions and high-net-worth individuals; however, all transactions on public blockchains are visible. This level of transparency may excite crypto enthusiasts but deters substantial capital investment.
The solution lies in advancing technologies like Fully Homomorphic Encryption (FHE), which enables data processing without decrypting it. This means sensitive data remains secure while being utilized, allowing institutions to engage in DeFi without revealing their trades or sensitive information.
Revisiting Uncollateralized Lending in DeFi
An illustration of FHE’s application in DeFi is uncollateralized lending, resembling traditional credit systems. Unlike conventional finance, which generally does not require overcollateralization, DeFi practices this to mitigate risk, thereby limiting its reach.
FHE alters this paradigm. Users can share encrypted credit or Know Your Customer (KYC) data with protocols. By employing FHE, a smart contract can affirm aspects like credit scores without exposing information. Approved users could borrow funds without collateral, and lenders may have the option to decrypt specific data if defaults occur, thus allowing legal recourse off-chain.
This privacy-centric approach in lending enhances DeFi’s flexibility and inclusiveness and aligns it more closely with traditional financial structures. Uncollateralized lending represents just the initial step, paving the way for more comprehensive uses of FHE in DeFi.
Moving forward, leading lending protocols can be restructured around confidential ERC-20s, incorporating encrypted credit assessments and protected loan details. This could transform DeFi lending fundamentally, not merely updating features but establishing new foundational practices.
For institutions, this means having the ability to build private collateral pools while maintaining confidentiality and providing credit-based lending options. Retail borrowers could obtain loans without collateral, safeguarded from adverse effects like front-running.
Public blockchains are typically favored over private ones regarding openness and interoperability, yet private chains offer enhanced confidentiality, making them preferable for data-sensitive institutions. With the integration of FHE, public blockchains may achieve comparable confidentiality levels without sacrificing their inherent advantages.
Addressing Challenges for DeFi Expansion
While the prospects for FHE are promising, for DeFi to truly expand and tap into the trillions remaining in traditional finance, it requires more than just private lending mechanisms and credit scores. A new foundational design is essential, addressing issues linked to liquidations and ensuring encrypted values do not complicate necessary actions.
Systems for credit management represent another layer of complexity, needing an intersection of legal and technical solutions to safeguard confidentiality without forsaking accountability. Moreover, protection against maximal extractable value (MEV) also needs further focus, ensuring methods are in place to obscure transaction patterns adequately.
Although these challenges pose hurdles, they aren’t unattainable. Resolving these issues is critical to realizing DeFi’s full capabilities, encouraging institutions to engage without publicizing every transaction and allowing retail clients to maintain their privacy while obtaining credit. As advances in FHE proceed rapidly, the merger of DeFi functionality with confidentiality akin to Swiss banking practices may soon be a reality.
