Chain Street (Part 2) - The Challenges

Part 2 of a five-part series unpacking the challenges and nuances of investing in DeFi protocols. Blockchains transform counterparty risk into technical risk, swapping the threat of intermediary default for the threat of immutable smart contract bugs. As a percentage of TVL, exploit losses have trended down, and most 2025 losses came from centralised exchange breaches and social engineering rather than DeFi smart contracts. Hyper competition is the next dragon, since open source code, composability, and permissionless deployment mean any protocol can be forked in an afternoon, yet network effects around liquidity still let Uniswap hold 40%+ of Ethereum DEX volume and Aave 50%+ of active loans. The most distorted dynamic has been the split between equity holders and token holders, where the Gensler-era SEC pushed teams to siphon value to labs and starve token holders of cash flow claims, a pattern now being unwound by proposals like Uniswap’s UNIfication and ongoing Aave governance fights. The deeper bottleneck is no longer technology but assets, since DeFi needs tokenised equities, bonds, and real estate to become global always-on financial infrastructure rather than a venue for zero-sum speculation. Privacy and identity round out the challenges, with zero-knowledge proofs maturing toward Ethereum mainnet in 2026 and onchain identity offering a path to bring 1.3 billion unbanked adults into borderless lending, trading, insurance, and remittances.