Monero has long been celebrated for its potent privacy mechanisms, operating commonly on centralized exchanges and in the peer-to-peer format. Given the rise of decentralized finance (DeFi) carrying out transactions at incredible frequencies and speeds, being able to operate within such ecosystems would be a great boon for the asset. Yet those seeking confidentiality and functionality are currently finding themselves having to choose just one or the other.

Today, we are going to investigate what the reasons for that are and Monero’s prospects of being incorporated into DeFi in the future.

What is Decentralized Finance (DeFi)?

This is a decentralized, permissionless, open financial ecosystem, as opposed to how you would exchange BTC to XMR. It relies on public blockchains using smart contracts to facilitate transactions and services without the need for a centralized authority. These smart contracts are self-executing using terms directly written into code, ensuring that they’re automated, transparent, and trustless.

DeFi encompasses a wide range of financial services including:

• Lending
• Borrowing
• Trading
• insurance
• Asset management
• in-app purchases

DeFi protocols entail users interacting with these platforms by connecting their digital wallets, allowing them to borrow assets, earn interest, trade tokens, and more. Examples of such protocols include:

• Uniswap
• Aave, a lending platform
• MakerDAO, a stablecoin system

dApps allow for coins to be exchanged within a game or other useful app in addition to customization features, which can be purchased instantly.

Benefits of Accessing dApps and DEX

Monero currently primarily operates using peer-to-peer transactions. Here are the reasons why the efficiency of DEXs is superior:

• Automated smart contracts: this reduces the need for intermediaries and ensures trustless execution of agreements
• The P2P format does not allow users to participate in broadly distributed financial services
• Liquidity: in dApps, users can trade or swap assets within a larger pool of participants
• Customizable financial agreements: users are able to create more complex financial products, such as derivatives, synthetic assets, and automated portfolio management
• Tokenized collateral and staking: coins can be used as collateral and staked to earn rewards
• Users can earn rewards for providing liquidity, participating in governance, or engaging in staking and yield farming
• Cross-chain interoperability: assets from different blockchains can be used together
• Increased user participation leads to better pricing and more opportunities

Oxford Academic recently broke down why Decentralized Finance is the future.

Monero’s Obstacles

Monero has long been heralded for its privacy features which set it apart from other cryptocurrencies operated on DEXs like Ethereum and Solana. Despite that, Monero is currently the 5th most popular cryptocoin, it faces serious technical challenges hindering its ability to fully integrate into dApps brought on by its privacy-first approach.

Lack Of Native Smart Contract Support

Lacking the core components of DeFi, such as liquidity pools, lending, and decentralized autonomous organizations, renders Monero unable to interact with dApps directly.

Privacy and Interoperability

Many DeFi protocols are built on open-source Ethereum-based standards, such as ERC-20 tokens and the Ethereum Virtual Machine. 

By contrast, Monero consists of an unorthodox system:

• Ring signatures: these add the sender to a group of at least 12 people, of whom the rest of the people serve as decoys to hide who the actual sender is
• Stealth addresses: a one-time public address is issued to hide where the transaction is going
• Ring Confidential Transactions (RingCTs) are designed to obfuscate the amount of the transaction, only verifying a minimum of details in the process to approve the transaction.

This poses a substantial challenge, as it would require innovative new technologies to combine the benefits of both worlds.

Comparing Monero’s Privacy With Other Cryptocurrencies

Sadly, Bitcoin and most other altcoins did not succeed in achieving complete anonymity, which was one of its major goals. Monero has reigned supreme in that regard. Monero has privacy enabled in each transaction by default. 

Every Bitcoin transaction is completely transparent, as is the primary decentralized currency Ethereum. Despite the use of pseudonyms, anyone with access to the wallet can trace the movement of funds and analyze the network for patterns. Advanced blockchain technologies can be used to easily trace transactions in public accounts and link them to individuals or entities, especially if the user has interacted with exchanges that require verification.

There have been some privacy solutions built on top of Ethereum. Layer-2 protocols like zk0SNARKS (zero-knowledge succinct non-interactive arguments of knowledge) and privacy-enhancing solutions like Aztec Protocol offer mechanisms like masking transaction details or utilizing privacy-focused zk-rollups. However, these solutions are not natively integrated into Ethereum and require additional layers or smart contracts.

Potential Solutions

Though there are serious walls to integrating Monero into the DeFI ecosystem, there are several potential solutions that could enable its integration in the future. 

Wrapping Monero

This allows users to transfer assets while maintaining total security to platforms like Ethereum, Binance Smart Chain, or Polkadot. Monero could be locked in a smart contract on the Monero blockchain and receive a representation of that Monero on another blockchain. This “wrapped” version of Monero could then be used in Ethereum-based DeFi protocols just like any other Ethereum-based ERC-20 token. Throughout this, there must be a rigorous approach to maintaining privacy throughout all of this.

A Monero-compatible DeFi platform would need to adapt Monero’s privacy-centric architecture. This could involve developing privacy-centric smart contracts in decentralized protocols that ensure users’ transaction details are kept confidential. Platforms could incorporate RingCT into their functions. Needless to say, this would require significant collaboration between the developers.

The same services DeFi is known for can be enhanced to cater to those seeking total privacy, which is what crypto originally intended to achieve, such as private versions of:

• Lending and borrowing
• Stablecoins
• Dexs
• Yield farming 
• Liquidity mining
• Insurance contracts

It would also be a godsend in other areas in which people have privacy concerns, such as 

• Gaming
• Social media accounts where people often suffer reputational damage
• Instant messaging platforms
• Marketplaces
• Healthcare apps
• Voting platforms
• Subscription services

The Growing Demand For Privacy In DeFi

The open nature of public blockchains allows anyone to access transaction data. This transparency, while beneficial for trust and auditing purposes, is not always desirable for users who value confidentiality. Users are often exposed to having their financial activities traced. For example, suppose a user interacts with a decentralized exchange or participates in a lending protocol, which can reveal their trading habits, the identity of the counterparties, and sensitive financial information. 

Users desire the same level of anonymity and confidentiality as they have come to expect from private financial transactions in traditional systems. Monero is uniquely positioned to play a role in addressing this need.