Privacy lending will unlock trillions of dollars in potential for the Decentralized Finance market.

Author: Jason Delabays Source: cointelegraph Translation: Shan Ouba, Golden Finance

Fully Homomorphic Encryption (FHE) technology can unlock trillions of dollars in capital from traditional finance for DeFi by enabling privacy lending, encrypted credit scoring, and confidential transactions.

Although decentralized finance (DeFi) has recently shown signs of recovery, most of the capital in traditional finance still has difficulty entering this field. Many people attribute the reasons to "insufficient scalability," "regulatory restrictions," or "poor user experience," but the real core obstacle is more fundamental—lack of confidentiality. Once this issue is resolved, trillions of dollars in capital will be activated.

In December 2021, when the total value locked in DeFi reached its peak, it set an astonishing figure of 260 billion USD. However, when we broaden our perspective, this number is actually insignificant — it's important to realize that the daily flow of funds in the global financial system is measured in "trillions of dollars": the daily trading volume in the foreign exchange market alone exceeds 7.5 trillion USD, and the total size of the global bond market has surpassed 130 trillion USD.

Since the industry crash in 2022-2023, DeFi has gradually recovered: lending protocols have demonstrated strong survival capabilities, and the total locked value has also rebounded. Nevertheless, the exploration of global capital by DeFi remains just the "tip of the iceberg"—the reason lies not in "insufficient scalability," but rather in the absence of key elements that traditional finance relies on for survival.

Cryptography is dismantling the highest barriers

For most financial institutions and high-net-worth investors, "confidentiality" is a non-negotiable bottom line. However, on public blockchains, every deposit, loan, and withdrawal record is fully open and transparent. This level of transparency may excite crypto purists, but for most "heavyweight capital", it is an unacceptable fatal flaw.

This is precisely why the "frictionless, open, institutional-grade financial services" promised by DeFi still seem out of reach for many. However, recent technological breakthroughs—especially advancements in fully homomorphic encryption (FHE)—indicate that the realization of this vision may be closer than it appears.

Today, fully homomorphic encryption has gained more mainstream attention and is no longer just a theory in academia.

This type of "privacy protection technology" can process data without decrypting it: sensitive information remains encrypted even during use. This means that financial institutions can enter the DeFi ecosystem while ensuring that their transaction and holding information is not disclosed.

Unsecured Lending and More Possibilities

Taking "unsecured lending" as an example - this is undoubtedly one of the clearest application scenarios of FHE in the DeFi field, and it aligns with the operational model of most credit businesses in traditional finance. Traditional finance rarely relies on the "over-collateralization" mechanism, but DeFi uses it as a core method of risk management, with a large amount of assets locked up, severely limiting its coverage.

Fully homomorphic encryption technology has completely changed this situation, and its operational logic can be summarized as:

1. Users submit encrypted credit data or KYC (Know Your Customer) information to the protocol;
2. Smart contracts verify this data using FHE technology (for example, determining whether "the user's credit score is above 700 points"), and the entire process does not require decrypting the data;
3. If the verification is successful, users can obtain loans without the need to provide collateral, and all information will remain confidential;
4. If the user defaults, the lender may gain access to decrypt specific data, thereby pursuing legal action off-chain.

Regardless of the outcome, financial institutions responsible for risk assessment and credit issuance can finally enter the on-chain financial world without disclosing positions or leaking customer data.

This "privacy-protecting lending" makes DeFi more flexible and inclusive, and closer to the operational logic of traditional finance. And unsecured lending is just the beginning — with the help of FHE technology, we can even reconstruct the underlying foundation of DeFi lending.

Imagine reconstructing the current mainstream lending protocols with "confidential ERC-20 tokens" as the core; adding features such as encrypted credit scoring to hide loan amounts and MEV protection, etc. — this is not just a simple function upgrade, but a brand new technological primitive designed for the lending space.

For institutions, this means that "private collateral pools" can be established, allowing them to conduct credit-based lending while keeping their positions confidential; for retail users, loans can be obtained without collateral, avoiding the interference of "frontrunning" and MEV bots; for lending protocols, this provides an evolutionary path centered on "confidentiality", ultimately achieving a breakthrough of "trillion-level scale" without sacrificing the core characteristic of "trustlessness."

In terms of openness and interoperability, public chains have always been superior to private chains; however, traditionally, private chains have had an advantage in confidentiality, making them more attractive to organizations that require data privacy protection. With the help of FHE technology, public chains can achieve confidentiality comparable to that of private chains while retaining their core advantages.

Challenges still need to be addressed, but there's no need to give up

Although the above vision is beautiful, if DeFi wants to truly achieve scalable development and activate the trillions of dollars of capital trapped in traditional finance, relying solely on "private credit scoring" and "confidential lending pools" is far from enough— we need to build a completely new underlying system. Before that, we must overcome several design challenges, such as the "liquidation mechanism": encrypted values complicate the conditions for triggering liquidation. Although FHE supports numerical comparisons, notifying the liquidators discreetly may require the use of encrypted events or off-chain relay mechanisms.

The credit system is another complex area: building encrypted KYC and default recovery mechanisms requires the integration of law and technology — the core challenge lies in balancing confidentiality and accountability.

MEV protection needs further improvement: hiding transaction amounts is just the first step. To achieve comprehensive protection, it may also be necessary to combine "encrypted amounts" with "batch transactions" or "time locks" to further obscure trading patterns.

Liquidity will also be affected: for example, cWETH and WETH will create a divide, but this gap is expected to be bridged through yield incentives or seamless wrapping tools. From the user experience perspective, the decryption tool needs to be wallet-level simple to lower the usage threshold.

Finally, the oracle presents a unique challenge: public prices may hint at the true value of crypto assets, but oracles compatible with FHE technology in the future may be able to solve this problem.

These challenges are not "fatal obstacles," but rather problems that need to be solved. Only by overcoming these challenges can DeFi unleash its full potential. If every operation is completely transparent, institutions will never enter the market; retail users should not be forced to give up privacy or accept excessive collateral in order to obtain credit. With the rapid development of FHE technology, perhaps in the near future, we will be able to achieve the integration of "on-chain DeFi efficiency, Swiss bank-level confidentiality, and real-world credit services."