Imagine a shadow universe of dark pools, anonymous mixers, and private marketplaces. Like DeFi, this shadow realm is highly liquid, ultra-usable, and built on cutting-edge cryptography. The difference is, it’s off-grid, off-chain, and untraceable.
Inside this shadow realm, anonymous communities proliferate. Capital flows into dark pools, undetected. Mixers and bridges cross-pollinate, merging liquidity across networks. Safe from the blockchain eye of Sauron, financial freedom flourishes.
As the dust settles on DeFi’s most recent hype cycle, lack of privacy is emerging as one of the ecosystem’s biggest setbacks. And with a growing number of teams building to fix this, it seems that a privacy-enhanced DeFi is almost inevitable.
Currently, trading strategies on DeFi are single use only. Once you execute a sophisticated trade, that’s it- your strategy is out for the world to see, and so instantly loses its edge.
As DeFi grows, smaller traders are stalking whales as a strategy, and tools with which to do this are becoming more advanced. Startups like analytics platforms Nansen, Santiment and portfolio explorer DeBank offer an easy way for traders to watch wallets.
This impacts the biggest whales in the space, who are forced to split their holdings into multiple accounts, and go to extreme lengths to obscure their strategies.
Take crypto Twitter’s latest fascination with the movements of Sam Bankman-Fried, CEO of FTX and Alameda Research. According to on-chain data, $80 million in FTX’s native token FTT was deposited on Cream Finance by an account believed to belong to Bankman-Fried.
The account proceeded to borrow and short YFI by selling the token on Binance. YFI is down 68.5% in the past month, and traders blamed the short for the token’s continued descent.
At press time, FTT dominates over 50% of the total liquidity on Cream Finance. Cream governance last week voted to partially delist FTT from the platform, reducing its borrowing power, as a response.
Centralization debate aside, the Bankman-Fried scandal has sparked a conversation on privacy among top traders like Arthur Cheong, founder of DeFiance Capital, and co-founder of Three Arrows Capital Kyle Davies, who tweeted:
“Privacy today means sending coins to centralized exchanges and that is not a long-term solution. For DeFi to grow, we need censorship resistance through not only decentralization but also privacy.”
Beyond protecting large whales’ moves from prying eyes, if a large number of traders mirror the moves of major players it could have systemic effects on the market. According to Harry Halpin, CEO of privacy startup Nym Technologies, this might impair DeFi’s maturity.
“DeFi without privacy is bound to have a crisis in the same way the financial system is doomed to collapse. It’s simple,” he told The Defiant.
And there are security risks to non-private DeFi as well.
Emphasized by Howard Wu from private smart contract platform Aleo, DeFi is susceptible to miner front-running attacks. Because miners can see trades before they are finalized on the blockchain, they can bet on events before they happen.
This impacts any kind of on-chain liquidity, such as decentralized exchanges, derivatives, and prediction markets.
“The lack of privacy creates incentive misalignments,” Wu said, “As volume and participation grows, the incentives to exploit these flaws increases proportionally.”
Faced with this truth, countless new, next-generation DeFi products are emerging from the shadows.
Some of these are Ethereum-specific products, like Aztec, Stealth Swap, and Zk-Sync. While in different stages of production, these startups will ultimately offer private swaps and ERC-20s, while Aztec comes with its own private contract scripting language, Noir.
Other startups, such as Secret Network, Dune Network, Findora, and Aleo, take a different approach, moving away from Ethereum onto their own privacy-enhanced platforms. Yet while shifting away from Ethereum itself, these platforms are built with DeFi in mind.
Secret is focused on what Tor Bair, founder of the Secret Foundation, calls “programmable privacy”, or general-purpose, privacy-preserving computation. “Programmable privacy allows for privacy how you want, for anything you want, when you want it, and from whom you want it,” Bair said.
Advances in cryptography mean that DeFi favorites such lending and borrowing can still occur, but with smart contract logic entirely concealed from view.
With researchers at Cornell and Stanford University, and co-founded by cryptography heavyweight Benedict Bunz, Findora seeks to build a privacy-preserving, yet fully auditable financial infrastructure.
Aleo has launched a privacy-focused blockchain and tools that, among other things, allow coders to integrate zero-knowledge cryptography directly into web applications. “For DeFi users, Aleo enables dark pools, anonymous mixers, private marketplaces – you name it,” Wu said.
And then there are some outliers, which offer a more general-purpose, interoperable solution, such as Ren Project, and Haven Protocol.
Ren Project is foremost an interoperability solution, but also features a virtual machine that allows for privacy-preserving computation. This allows Ren to act as an anonymizing layer for transparent blockchain assets such as Bitcoin.
And several other projects are lurking in stealth. IOHK, the research lab behind $3.4 billion cryptocurrency Cardano, are moving to release private smart contracts next year. $1.7 billion blockchain Tezos is making similar moves.
Still, the task at hand is far from simple. In order to build privacy-enhanced DeFi, developers are challenging some of the deep-rooted design decisions of the DeFi space.
For one, while some startups are building tools on Ethereum, others are creating their own settlement layers, maintaining that the underlying blockchain needs to be private-by-default. In this future, anonymous DeFi rests on a network of blockchains, with liquidity flowing seamlessly between them.
Nym Technologies is preparing for such a future. A blockchain agnostic tool, Nym is positioning itself to provide network-level privacy for all of DeFi, irrespective of whether or not it is based on Ethereum.
Halpin said that building privacy-preserving tools like privacy-preserving smart contracts, without having a network that protects user information, is like “building your castle on foundations of sand.”
Other breaking changes are being considered. For example, next-generation DeFi may break away not just from Ethereum, but from the entire browser paradigm, as privacy and security concerns push DeFi onto the desktop.
Privacy tools could also make tokens and cryptocurrencies more fungible, as they are less likely to be blacklisted from centralized exchanges due to their transaction history.
The result of this innovation could have ramifications beyond the DeFi ecosystem as well.
“Private applications could play a role far larger than DeFi. They could come to fundamentally shape how we use the web,” Wu told the Defiant.
By bringing these products to market, DeFi could play a role in ushering in a privacy-enhanced paradigm. Increasingly, technology companies profit from the extraction and reselling of data. By focusing on privacy tooling, DeFi has the ability to challenge this basic economic fact.
The new privacy emphasis comes at a time where DeFi is reflecting on its shortcomings.
According to blockchain analytics firm Santiment, DeFi volume is down 55% in the past month. In order for DeFi to reach its next stage, investors and developers are turning toward the fundamentals and while “many of the other barriers to adoption and real-world problems have been solved now,” Loong Wan, the CTO of Ren, said, “Privacy is still somewhat outstanding in that regard.”.
According to Halpin from Nym, the increased desire for privacy is also coming at a time where people are spending more time online.
“We’ve seen interest in Nym skyrocket. We launched a testnet during COVID19 and after one month, we’re already one-tenth the size of Tor,” he said.
And that’s notable because, while the recent conversation of privacy in DeFi has centered around Bankman-Fried’s short selling, it’s not just whales who are vulnerable to surveillance.
Indeed, without necessarily having the means to employ anonymity techniques, small traders are disproportionately impacted by the lack of privacy.
According to Halpin, this poses a threat to DeFi’s core value proposition: making complex finance instruments available to normal people. And this next wave of adoption is necessary for DeFi to achieve its broader impact.
“Once DeFi hits the mass market, it will be unstoppable,” he said.