Despite the benefits the decentralized finance market offers, it’s important that investors tread carefully when looking to venture into this space. Read on to learn about the most pressing DeFi risks that crypto investors need to be aware of.
What Is DeFi?
Decentralized finance (DeFi) offers Internet-native financial services powered by smart contracts and running on public blockchains.
The growing DeFi market reduces the control banks and other financial institutions have on financial services by offering autonomous financial protocols that anyone with an Internet connection and a crypto wallet can access.
From borrowing and lending to trading, hedging, and investing, there is already a broad range of traditional financial services that the DeFi market has replicated for digital asset holders.
However, while there’s no arguing that the benefits of DeFi are attractive, it’s not void of risks. So, what are some of the DeFi risks that new and experienced investors need to be wary of? Let’s take a look.
Decentralized finance is attractive to consumers for various reasons.
First, it eradicates the fees that banks and other financial institutions charge users for using their services. Secondly, users have more control over their funds as they can hold their money in secure digital wallets instead of using banks. Thirdly, anyone with access to an internet connection can not only access their funds but carry out transactions in minutes.
However, while there’s no arguing that the benefits of DeFi are attractive, it goes without saying that just like most of these ‘newer’ technologies, it’s not void of risks. So, what are some of the DeFi risks that new and experienced investors need to be wary of?
DeFi Risks: What Investors Need to Know
Read on to discover five DeFi risks investors in the decentralized finance markets need to know.
Decentralized finance protocols are software applications that operate on the internet, usually with very little to no human oversight. Still, the applications act as a conduit that allows for millions or even billions of dollars to flow through them. And just like it is with any software, these applications are prone to bugs (coding errors), and hackers who can identify a code’s vulnerability can exploit it to siphon funds from the protocol.
Over the years, there have been several cases of coding errors that have made waves. Software risk poses a threat to both investors and the DeFi company. For instance, investors can lose their funds in the event the application is hacked, while the company can either be destabilized by the attacks or forced to close up shop.
While some DeFi protocols take it upon themselves to refund investors their money in the event of a security vulnerability, which is never immediate, it’s imperative to assume that if you invest in a DeFi protocol and hackers gain access to it and steal money, your funds will be gone.
While there is no bulletproof method that investors can incorporate to avoid coding or software risk, there are ways that they can reduce it.
Arguably the best way to reduce code risk is to only deal with protocols that have been audited by third-party blockchain security firms. Additionally, investors can stick to DeFi applications that have been around for a long time. Why? Because such protocols have had a chance to discover and fix the issues with their software. Lastly, you can check if the DeFi protocol you are interested in has suffered any software risk, when it happened, and how the team behind it responded. You could also check the measures they’ve put in place to ensure there’s no repeat of the same in future.
Any loan agreement made inside or outside of the DeFi ecosystem entails counterparty risk. Counterparty risk can be described as the risk of loaning money to a person who won’t repay. To counter this, large DeFi lending protocols, such as Aave or Compound, usually require borrowers to over-collateralize their loans. That means if you are borrowing on any of the two applications, you will need to provide collateral that is worth more than 100% of the amount you are borrowing.
While DeFi lending protocols are able to reduce counterparty risk to a large extent as you are not dealing directly with counterparties but with smart contracts, elements of counterparty risk remain. For example, if oracles used in DeFi protocols stop working, financial losses can occur. Moreover, if you are dealing in non-collateralized stablecoins that lose their peg, you could also take a hit on your Defi position.
Impermanent Loss Risk
One of the common risks that liquidity providers in decentralized finance are prone to is Impermanent Loss (IL).
Impermanent Loss occurs when the liquidity provider experiences a temporary loss of funds caused by volatility in a trading pair that results in one asset dropping in value a lot more than the other. If the market doesn’t stabilize, the impermanent loss will become permanent once the liquidity provider withdraws funds from the trading pool.
While the wider crypto market is largely regulated and operates with some degree of regulatory oversight, the DeFi industry remains almost entirely unregulated. However, DeFi has been under scrutiny from various regulators who are trying to establish a regulatory framework for the sector with the claim to want to protect consumers.
But, even with the complexities of the technology, some regulators who have so far been tasked with developing regulatory frameworks around the crypto space aren’t pro the DeFi space. Additionally, should a regulatory framework be developed and become accepted across the board, it’s unclear how such laws will affect an investor’s DeFi investments. Harsh regulations could have a substantial negative effect on DeFi investments, especially DeFi tokens.
The digital asset markets are very volatile, and that includes the DeFi market. Yield can compress quickly, and prices in DeFi-related assets can crash as quickly as they rally. Market risk, therefore, poses one of the biggest risks for DeFi investors.
While using stablecoins in DeFi lending, for example, can alleviate the effects of market risk to a high degree, most DeFi investments are high-risk and can lead to substantial losses if risks are not managed adequately.
The bottom line is that no DeFi investment is risk-free. However, that doesn’t mean you shouldn’t invest in the decentralized finance space. Instead, being aware of the risks can help you evaluate how impactful any DeFi risk can affect your investment.
Can I Lose Money in DeFi Investing?
Yes. As an investor, you can lose money in DeFi investing, given that decentralized finance has a variety of risks that can affect the value of your portfolio.
How Can I Avoid DeFi Risks?
Unfortunately, there’s no guaranteed way of avoiding DeFi risks. However, you can do your own due diligence before participating in a DeFi protocol or application, and manage your risk accordingly in relation to the product you are deploying capital into.
Are There Any Regulations to Protect Investors Who Invest in DeFi?
No. Given the technological complexities, there aren’t any clearly spelled out laws or regulations in DeFi. However, certain jurisdictions might already have or are working to establish regulations around the DeFi and crypto space in general.
Is DeFi Secure?
No. The sheer amount of DeFi hacks we have seen in the last three years has taught us that today’s DeFi ecosystem is far from as secure as it needs to be for the average investor to feel comfortable enough to trust their money with a DeFi protocol.
While most of the leading DeFi platforms have not experienced hacks, operational errors also play a role in the DeFi system’s insecurity. However, as the industry matures, we can expect better and more robust protocols to establish themselves.