What’s DeFi? Blockchain-based decentralized finance risks explained

Want to invest in crypto, understanding the risks? CNBC Make It explains what you need to know about cryptocurrency-based DeFi.

Despite their wider access to resources, even billionaire investors aren’t immune to risks when it comes to decentralized finance (DeFi).

That includes the case of Mark Cuban, who revealed on Wednesday that a DeFi token from Iron Finance called TITAN crashed to zero in one day. That experience is a good reminder of how volatile and risky investing in crypto and DeFi can be.

According to CipherTrace, from January to April, $156 million was stolen in DeFi-related hacks. DeFi fraudsters stole $83.4 million more. And though the completely crash is rare for tokens, like TITAN,  it’s still possible, so investors should be aware.

Despite DeFi has become buzzy lately, and you may have a fear of miss on investment opportunities, it’s important to study and understand the risks firstly.

Here’s what you should know, according to CNBC Make It experts.

What is DeFi?

Decentralized finance (DeFi) applications point to rebuild traditional financial systems, such as banks and exchanges, with crypto technologies. It mostly runs on the Ethereum blockchain.

According to John Wu, president of Ava Labs, a team supporting development of DeFi applications on the Avalanche blockchain, the difference is that DeFi apps operate “without a central service exercising control over the entire system.”

By DeFi lending, users can lend out cryptocurrency, as a traditional bank does with fiat currency, and earn interest as a lender, avoiding a bank as a middle man. Borrowing and lending are among the most common use cases for DeFi applications, but there are many more increasingly complex options too, such as becoming a liquidity provider to a decentralized exchange.

Usually, interest rates in DeFi are more attractive than with traditional banks, and the barrier to entry to borrow is low compared with that of a traditional finance system. Mostly, the only requirement to take out a DeFi loan is the ability to grant collateral with other crypto assets. Sometimes, users can offer their NFTs (nonfungible tokens) as collateral, for example, depending on the DeFi protocol used.

These factors also expose why DeFi is much riskier than a traditional bank.

How risky is such an investment?

It is important to understand that investing in DeFi carries serious risks.

Meltem Demirors, CoinShares chief strategy officer, said to CNBC Make It: “I think every DeFi protocol and every DeFi project has a different level of risk and a different level of reward.” But, he added, “it’s important to understand the reason the reward is high is because the risk is higher. The reason we see high yield is there is risk here.”

According to Demirors, there are three major types of risk to consider.

1. Technology risk

Smart contracts, or code protocols that carry out a set of instructions on the blockchain, are essential to run DeFi applications. But if there is a glitch appeared in a developer’s code, then there could be potential weaknesses within a DeFi protocol.

“At the end of the day, the software is only as good as the coding that was done, and sometimes, there are unknown errors in the code that governs these protocols,” Demirors said.

2. Asset risk

Borrowing on a DeFi application, you typically offer other crypto assets as collateral. For example, DeFi protocol Maker requires borrowers to collateralize their loan 150% of the loan value at a minimum.

But since cryptocurrencies are volatile, their value frequently fluctuates. If there is a market plunge, the crypto assets used as collateral may significantly lose their value, and some may even be liquidated. That’s why some use stablecoins, which are supposed to be pegged to fiat and be less volatile.

3. Product risk

“Typically, less mature pools or newer protocols will have higher yields because they’re untested,” told Demirors. “There’s a significant amount of risk related to how the yield you’re earning is being generated.”

Also please note, that there is no regulation or insurance on your funds when you use DeFi, unlike with traditional banks. Though DeFi loans are collateralized with other crypto assets, borrowers using DeFi protocols cannot be held accountable otherwise if they are unable to effectively pay back a loan.

Because of these risk factors, experts warn you to invest only what you can afford to lose and recommend conducting thorough research before investing.

What should beginners know?

As Wu said, if you decide to invest in any DeFi application, the first thing you should do is verify the applications you’re exploring to make sure they’re well-audited and secure.

When choosing an underlying network, such as blockchain, protocol, or exchange, Wu advises you to look for one that isn’t controlled by a small group of users, is capable of handling mass user demand, and has affordable transaction fees.

Wu warned that a few “big red flags” include “applications that don’t share their code or ignore concerns in their forums and social feeds about security.”

“Some of the best projects are led by anonymous or pseudo-anonymous founders who protect their privacy, so I don’t write a project off for that, but I do expect transparency on the application.”

And if something seems not okay, it likely is.

“DeFi is growing so fast and the yields are so high that opportunities can feel too good to be true. When in doubt, trust your gut or look for more objective members of the community with the technical expertise to thoroughly review the code,” Wu recommended.

What’s next for DeFi?

Demirors predicts that DeFi applications will continue to replicate financial structures that “we already know and love in the traditional finance world,” such as high-yield savings accounts.

Also, Demirors foresees that there will be new decentralized financial products and services built unlike any of the traditional ones that already exist, including brand new ways for creators to be paid for online content. “We really, truly are in the era of the financialization of everything,” she claimed.

Source: https://www.cnbc.com/2021/06/18/whats-defi-crypto-based-decentralized-finance-explained.html