Author: Jason Delabays Source: Cointelegraph Translation: Shan Ouba, Golden Finance Fully homomorphic encryption (FHE) technology can unlock trillions of dollars in capital in traditional finance for DeFi by enabling private lending, encrypted credit scoring, and confidential transactions. Despite the recent resurgence of decentralized finance (DeFi), the majority of traditional finance capital remains resistant to entry. Many blame "lack of scalability," "regulatory restrictions," or "poor user experience," but the core obstacle is more fundamental: lack of confidentiality. Solving this problem could unlock trillions of dollars in capital. At its peak in December 2021, DeFi's total locked-in value reached a staggering $260 billion. But a broader perspective reveals that this figure is actually insignificant—consider the trillions of dollars flowing through the global financial system daily: the foreign exchange market alone accounts for over $7.5 trillion in daily trading volume, and the global bond market surpasses $130 trillion. Since the industry crash of 2022-2023, DeFi has gradually recovered: lending protocols have demonstrated strong viability, and total locked-in value has rebounded. Even so, DeFi's access to global capital remains at the tip of the iceberg—the reason isn't a lack of scalability, but rather a lack of key elements that traditional finance relies on to survive. Cryptography is removing the highest barriers to entry. For most financial institutions and high-net-worth investors, confidentiality is a non-negotiable bottom line. However, on a public blockchain, every deposit, loan, and withdrawal record is completely public and transparent. This transparency may excite crypto purists, but for most "heavyweights," it's a fatal flaw. This is why, for many, the promise of "frictionless, open, institutional-grade financial services" offered by DeFi still seems out of reach. However, recent technological breakthroughs—particularly in the field of fully homomorphic encryption (FHE)—suggest that this vision may be closer than it seems. FHE is now gaining mainstream attention, moving beyond the realm of academic theory. This "privacy-preserving technology" processes data without decrypting it: sensitive information remains encrypted, even while it's being used. This means financial institutions can enter the DeFi ecosystem while ensuring their transactions and holdings remain private. Uncollateralized lending and more possibilities. Take "uncollateralized lending" as an example. This is undoubtedly one of the clearest application scenarios for FHE in the DeFi field, and it is also consistent with the operating model of most credit businesses in traditional finance. Traditional finance rarely relies on the "overcollateralization" mechanism, but DeFi uses it as a core means of risk management, locking up a large amount of assets and greatly limiting its coverage.
Fully homomorphic encryption technology has completely changed this situation. Its operating logic can be summarized as follows:
Users submit encrypted credit data or KYC (customer identity verification) information to the protocol;
Smart contracts verify this data through FHE technology (for example, determining whether the user's credit score is higher than 700 points"), and the entire process does not require decryption of the data;
If the verification is passed, the user can obtain a loan without providing collateral, and all information remains confidential;
If the user defaults, the lender can obtain the right to decrypt specific data, thereby pursuing legal recourse through off-chain channels. Whatever the outcome, financial institutions responsible for risk assessment and credit issuance can finally enter the world of on-chain finance without disclosing their holdings or leaking client data. This "privacy-preserving lending" makes DeFi more flexible and inclusive, and more aligned with the operating 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 current mainstream lending protocols with "confidential ERC-20 tokens" at their core; adding features like encrypted credit scores to hide loan amounts and MEV protection—this is far more than a simple functional upgrade, but rather a completely new technical primitive for the lending sector. For institutions, this means establishing "private collateral pools" to conduct credit-based lending while maintaining confidentiality of holdings. For retail users, loans can be obtained without collateral, while also avoiding front-running and interference from MEV bots. For lending protocols, this provides a confidentiality-focused evolutionary path, ultimately enabling breakthroughs in "trillion-level scale" without sacrificing their core trustlessness. Public chains have historically outperformed private chains in terms of openness and interoperability. However, private chains have traditionally enjoyed a greater advantage in confidentiality, making them more attractive to institutions requiring data privacy. With FHE, public chains can rival private chains in confidentiality while retaining their core advantages. Challenges remain, but there's no need to give up. While the aforementioned vision is promising, if DeFi is to truly scale and mobilize the trillions of dollars of capital trapped in traditional finance, "private credit scores" and "confidential lending pools" alone are far from enough. We need to build a completely new underlying system, and before that, we must overcome several design challenges. For example, the "liquidation mechanism": encrypted values complicate the conditions for triggering liquidations. While FHE supports numerical comparisons, privately notifying liquidators may require the use of cryptographic events or off-chain relay mechanisms. The credit system is another complex area: building encrypted KYC and default recovery mechanisms requires the coordination of legal and technical approaches. The core challenge lies in balancing confidentiality and accountability. MEV protection also needs further improvement: hiding transaction amounts is only the first step. Comprehensive protection may require combining encrypted amounts with batching or time locks to further conceal transaction patterns. Liquidity will also be impacted: for example, there will be a disconnect between cWETH and WETH, but this gap could be bridged through yield incentives or seamless packaging tools. From a user experience perspective, decryption tools need to be wallet-level and simple to use. Finally, oracles pose unique challenges: public prices may imply the true value of cryptoassets, but future FHE-compatible oracles may address this issue. These challenges are not fatal obstacles, but rather thorny issues that need to be addressed. Only by overcoming these thorny issues can DeFi unleash its full potential. If every step is fully transparent, institutions will never enter the market; retail users should not be forced to give up privacy or accept over-collateralization in order to obtain credit. With the rapid development of FHE technology, perhaps in the near future, we can achieve the trifecta of "on-chain DeFi efficiency, Swiss bank-level confidentiality, and real-world credit services."
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