Decentralized Finance (DeFi) is a new financial system powered by blockchain technology, the same tech which powers Bitcoin and Ethereum.
DeFi is the technology which powers NFTs and Decentralised Exchanges such Fantom, Australian based DEX. The DeFi market is really booming right now, we recently saw DeFi Tokens Generated $252 Million In Revenue For April 2021.
Let’s take a look at the most common risks of using DeFi.
10 Risks Of DeFi Investing
1. Financial Risk
Because DeFi is a new technology, it comes with sizeable financial risk. We have seen people that have lost millions, and also those that have made millions. The financial risk of DeFi could be considered high risk, high reward, depending on a number of factors, mentioned below.
2. Counterparty Risk
Some of DeFi is completely decentralised and some is “semi-decentralised”. For example, using Uniswap to facilitate on-chain peer-to-peer crypto transactions would be considered completed decentralised, as it transacts directly using the Ethereum blockchain. And on the other hand, an example of a semi-decentralised platform would be Binance Smart Chain (BSC), a clone of Ethereum, is controlled by Binance.
3. Software Risk / Smart Contract Bugs
A bug is what allowed hackers to drain 6.3 million ETH from the Dao back in 2016; the first major project to resemble what we now call DeFi today. Reputable DeFi platforms attempt to mitigate the risks of bugs by hiring strong teams of developers and by submitting their code to auditing teams. However time after time we have seen both audited and unaudited code fail a DeFi community, leading to loses in the millions of dollars. This has seen the arrival of DeFi insurance; offered by companies such as Nexus Mutual and Swissborg.
4. Storage Risk / Phishing
Crypto stored in non-custodial wallets risk the loss of funds through phishing. This is where a user is tricked into giving out their seed phrase, or entering it into a fake website. It is a very sure fire way to lose everything in your wallet. The lesson: Never Ever enter your seed phrase to an unknown source or store it in a digital file on your phone or computer, where you could get hacked.
5. Platform Risk / Oracle Failure
Oracle failure has been a major vector of attack in DeFi in 2020. Where bad actors use a Flash Loan to buy or sell an asset, which manipulates the price of that asset just long enough for them to arbitrage the difference and exploit a protocol for millions. This is why projects such as Chainlink are so highly revered, because they solve a massive challenge in DeFi adoption.
6. Security Risk / Admin Key
When you hear of “Rug Pulls” it’s usually because of an admin key. We always have to be on the look out for centralised admin controls that allow a developer or team to lock or move funds deposited into the DeFi app. The most reputable teams in DeFi such as Compound will firstly put in a timelock that prevents changes to code from happening without approval from a Dao governing upgrades and proposals. Secondly they will add a time delay so a community will be warned if a potentially unfavourable or controversial change is coming to the protocol.
7. Liquidity Crisis
Liquidity crisis refers to a lock up of funds and a lack of liquidity. For example: if you lend Dai to Aave, all the Dai is then subsequently borrowed and the app indicates that 100% of Dai is utilised, then you can’t your Dai out until some borrowers return the funds. This can become a real risk particularly due to the use of over collateralised loans that dominate DeFi.
8. Protocol Risk / Governance Failure
Governence failure is another factor interwoven into DeFi protocols. There are debates over whales exerting their massive influence to their own best interest and hurting the smaller fish in the wider community. Others argue that whales wouldn’t self-sabotage a protocol where their money is invested. There are also ongoing debates over deep-pocketed CFi now exerting their influence on DeFi governance and protecting the interests of the larger exchanges.
Pegged assests or Stable Coins risk the chances of de-pegging. This can cause many issues, like an AMM liquidity pool going to zero.
While there are still many problems and risks associated with DeFi, they are being addressed as the cryptocurrency space evolves. DeFi is still very new but as it matures and improves, we will likely see more and more users moving to DeFi in the near future.
10. Compound Risk
All of the risks together form a compound risk for the entire DeFi application. Over time, as this new technology starts to mature, and go through testing and fixing phases, we will see fewer critical edge case risks and lower compound risk.
Caitlin Carey – Crypto News Guest Author
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