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

Although decentralized finance (DeFi) has recently shown signs of recovery, a significant portion of capital from traditional finance still struggles to enter this space. Most people attribute the reasons to "insufficient scalability," "regulatory constraints," or "poor user experience," but the true core barrier is more fundamental – a lack of confidentiality. Solving this issue could activate trillions of dollars in capital.

When the total value locked (TVL) in DeFi peaked in December 2021, it reached an astonishing $260 billion. However, zooming out reveals that this figure is actually minuscule – consider that the global financial system moves "trillions of dollars" daily: the foreign exchange market alone sees over $7.5 trillion in daily trading volume, and the global bond market totals more than $130 trillion.

Since the industry crash of 2022-2023, DeFi has gradually recovered: lending protocols have demonstrated strong resilience, and TVL has risen again. Even so, DeFi's tapping of global capital remains just the "tip of the iceberg" – the reason is not "insufficient scalability," but the absence of key elements essential to traditional finance.

Encryption Technology is Removing the Highest Barrier
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 completely transparent. While this transparency might excite crypto purists, for most "heavyweight capital," it's an unacceptable fatal flaw.

This is precisely why, for many, DeFi's promise of "frictionless, open, institutional-grade financial services" still seems out of reach. But recent technological breakthroughs – especially progress in the field of Fully Homomorphic Encryption (FHE) – suggest that realizing this vision might be closer than it appears.

Today, FHE is gaining more mainstream attention and is no longer just an academic theory.

This type of "privacy-preserving technology" can process data without decrypting it: sensitive information remains encrypted even during computation. This means financial institutions can participate in the DeFi ecosystem while ensuring their transactions and portfolio information remain confidential.

Uncollateralized Lending and More Possibilities
Take "uncollateralized lending" as an example – this is undoubtedly one of the clearest use cases for FHE in DeFi and aligns with how most credit operations work in traditional finance. Traditional finance rarely relies on "over-collateralization" mechanisms, but DeFi uses it as a core risk management tool, locking up vast amounts of assets and significantly limiting its reach.

FHE technology fundamentally changes this dynamic. Its operational logic can be summarized as follows:

1. Users submit encrypted credit data or KYC information to the protocol.

2. Smart contracts use FHE to verify this data (e.g., determining if a "user's credit score is above 700") without ever decrypting it.

3. If verification passes, users can obtain loans without providing collateral, and all information remains confidential.

4. If a user defaults, the lender can gain permission to decrypt specific data to pursue recovery through off-chain legal channels.

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

This "privacy-preserving lending" makes DeFi more flexible, inclusive, and closer to the operational logic of traditional finance. And uncollateralized lending is just the beginning – leveraging FHE, we can even reconstruct the foundational layers of DeFi lending.

Imagine rebuilding current mainstream lending protocols around "confidential ERC-20 tokens," combined with features like encrypted credit scores hiding loan amounts and MEV protection – this isn't merely a functional upgrade but a completely new technical primitive for the lending space.

For institutions, this means being able to establish "private collateral pools" to conduct credit-based lending while keeping positions confidential. For retail users, it means accessing loans without collateral while avoiding front-running and MEV bots. For lending protocols, this provides an evolutionary path centered on "confidentiality," ultimately achieving "trillion-dollar scale" breakthroughs without sacrificing core "trustless" properties.

In terms of openness and interoperability, public chains have historically been superior to private chains. Traditionally, however, private chains held the advantage in confidentiality, making them more attractive to institutions needing data privacy. With FHE, public chains can match the confidentiality of private chains while retaining their core strengths.

Challenges Remain But Need Not Hinder Progress
While the vision is promising, for DeFi to truly achieve scale and activate the trillions of dollars dormant in traditional finance, "private credit scores" and "confidential lending pools" alone are not enough – we need to build an entirely new underlying system. Before that, several design challenges must be overcome, such as the "liquidation mechanism": encrypted values complicate triggering liquidation conditions. Although FHE supports numerical comparison, secretly notifying liquidators might require encrypted events or off-chain relay mechanisms.

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

MEV protection also needs refinement: hiding transaction amounts is just the first step; comprehensive protection might require combining "encrypted amounts" with "batch transactions" or "timelocks" to further conceal transaction patterns.

Liquidity will also be affected: for instance, cWETH and WETH might fragment markets, but this gap could be bridged through yield incentives or seamless wrapping tools. From a user experience perspective, decryption tools need to be wallet-simple to lower the barrier to entry.

Finally, oracles present a unique challenge: public prices might hint at the true value of encrypted assets, but future FHE-compatible oracles might solve this problem.

These challenges are not "fatal obstacles" but rather puzzles that need solving. Only by overcoming them can DeFi unlock its full potential. Institutions will not participate if every move is completely public; retail users should not be forced to sacrifice privacy or accept over-collateralization to access 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."