What is DeFi?
Decentralized Finance (DeFi) refers to a collection of financial products and services that are built on top of blockchain networks. It is a brand-new monetary system that is considered as an alternate to the current traditional banking system. DeFi is an open-source, permissionless, decentralized financial system that can make financial services accessible to everyone and eliminates the role of a central authority.
DeFi does not rely on central financial intermediaries like brokerages, exchanges, or banks. Instead, Defi Decentralized Apps (DApps) use smart contracts to execute all transactions. These smart contracts are also what connect all these DeFi DApps or protocols to a DApp platform.
An interesting aspect of DeFi is the ability to stack DApps together to maximize returns. DeFi protocols are modular, which means it opens up the possibility for protocols or DApps to be mixed and matched to unlock unique combos. Anyone can create, adapt, mix, link or build on an existing DeFi product without permission.
The unique modular approach along with other innovative concepts has attracted a large number of investors to DeFi. The insane returns from these DApps have only accelerated the adoption. But as the returns and the number of investors increased, so did the risks associated with it. Some of the potential use cases in the DeFi sector include borrowing and lending money, trading tokens and cryptocurrencies in Decentralized Exchanges (DEX), earning returns through yield farming and liquidity mining, issuance of stablecoins, mortgages and insurance.
Risks of Investing in DeFi
All investment opportunities entail some degree of risk. Even the most popular investments run the risk of fluctuations, losses and even market failure. But investing in DeFi involves higher risk as it is a budding sector that is still evolving to the needs of investors and developers.
1. Infrastructure risks
The countless DeFi protocols that exist, have to rely on the infrastructure of DApp platforms like Ethereum, Cardano, and Polkadot. Therefore, if there is a critical bug in the platform, all DeFi protocols that rely on the platform would fail as well. However, this type of failure is highly unlikely. Nevertheless, it is important to note that a failure in DeFi’s underlying technology could affect any financial services in the space.
2. Coding risks
Within DeFi, various protocols exist enabling investors to access a number of financial services. All these protocols deploy smart contracts to enable their services. But, as with any software, these smart contracts that power DeFi protocols are vulnerable to significant amounts of risk. Any issue with the developer’s code could potentially expose the DeFi protocol to hacks and exploits. To mitigate such risks a lot of developers have started to opt for smart contract security auditing which would help them correct design issues, errors in code and other security vulnerabilities.
3. Asset risk
Just like every lending market, there is a risk that the borrower defaults on the loan. This risk is mitigated in the form of collateral which provides coverage for the invested funds. But since cryptocurrencies are volatile, their value frequently fluctuates. If there is a downturn, the crypto assets used as collateral may sharply decline in value, resulting in positions being liquidated. Though DeFi loans are collateralized with other crypto assets, borrowers using DeFi protocols cannot be held accountable otherwise if they are unable to pay back the loan.
4. Product risk
DeFi is a still maturing sector and new protocols are popping up everywhere and everyday. But since a lot of these concepts are radically new and innovative, a lot of developers are in unchartered territories. There’s a significant amount of risk related to how these new concepts are designed and implemented. Also, it may often be hard to foresee the threats and vulnerabilities that may come up in the future when something new is entering the market. Therefore, some of the newer protocols pose a lot of risks as they are more susceptible to exploits from hackers and sometimes developers themselves. But despite this, the high returns offered often succeed in attracting a lot of interest from investors.
5. Financial risk
Investors typically use historical data and benchmarks to evaluate investment opportunities and risks. But the high volatility and lack of historical data and benchmarks make it difficult to evaluate the risks of investing in DeFi in the traditional sense. The lack of regulation and insurance poses additional risks to the funds that are invested in DeFi.
6. Regulatory risks
Currently, DeFi operates largely out of the realms of government and regulatory control which has raised concerns about illegal access to financial services and lack of consumer protection. But the rapid growth of DeFi has been attracting greater regulatory attention. While the increased regulation can help in protecting the rights of consumers, it could also stifle innovation in the DeFi sector. It is unclear about the kind of regulations that may be imposed on the DeFi sector in the coming years. But policymakers and regulators that develop regulations to oversee DeFi markets are tasked with the job of balancing the innovation in the DeFi with the need to protect consumers.
7. Lack of insurance
Unlike banks where the funds are insured, the funds in DeFi are not insured and investors stand the chance to lose all their funds. The increased market volatility, higher chances of fraud and lack of regulation only add to the risk that the investors are exposed to. Despite the increased risks, most of the funds remain uninsured. Therefore, the need of insurance is much more pronounced in the DeFi sector.
8. Impermanent loss
Impermanent loss is when the price of assets locked up in a liquidity pool changes after being deposited and creates an unrealized loss versus if the assets were simply held in a crypto wallet. The bigger the change is, the more the investor is exposed to impermanent loss. But liquidity pools like UniSwap reward liquidity providers with trading fees in order to counteract the loss. Investors have to be careful while depositing funds into an Automated Market Maker (AMM) as some liquidity pools are much more exposed to impermanent loss than others.
The DeFi sector is crawling with persons and entities of dubious intentions. There are numerous scams and schemes that try to dupe unsuspecting investors of their money. It is important for new investors to be aware of such threats and avoid them. As well as being aware of common attack vectors, users also need to watch out for certain scams that can take place even on well-known DeFi platforms. Some of the examples of scams include exit scams, pump and dump schemes, fake airdrops and rewards, and rug pulls.
10. Hidden fees
Something that often catches a new DeFi investor by surprise is the fees that are associated with different transactions. The fee structure is not always transparent and a lot of times new investors incur several unexpected fees. Apart from the number of hidden fees, the fees itself are sometimes astronomically high that the fees can eat up all the profit from the trade. The account conversion fees and fluctuations in the price of the cryptocurrency should also be taken into consideration. Ethereum, one of the most popular smart contract platforms, is suffering from high transaction costs.
11. Inexperienced investors
The hype around cryptocurrencies and DeFi have attracted a large number of retail investors. Most of these investors are inexperienced and often get caught up in the frenzy around the latest trends. Such investors are more likely to make investment decisions before doing thorough research. As the DeFi sector is unregulated and littered with scams, a new investor that is not careful may end up making losses or even lose their entire funds.
The DeFi sector suffers from massive volatility due to the speculative nature of the sector. The market is also going through a period of price discovery as new DeFi protocols enter the market. There is a lot of room for innovation in the sector and as new applications and use cases of these technologies are identified, the prices are bound to move even further. The rewards from these protocols are also volatile. One example of this is how yield farming protocols started rewarding yield farmers governance tokens, introducing a new concept called liquidity mining.
The recent surge in popularity of DeFi has introduced a lot of investors to the world of DeFi. But a lot of investors make their investment decisions based on emotion rather than sound reasoning and logic. Fear of missing out (FOMO) has motivated a lot of them to keep throwing money at every new trend without assessing the risks. Some critics point out the wild market is creating a bubble and leaving the retail investors vulnerable to a market crash.