Decentralised Finance (DeFi) technology has revolutionised the financial world. DeFi has promised to provide automation, transparency and decentralisation of financial activities, which categorically challenges the traditional centralised financial markets.
However, like every new technology, it has its own risks and downsides. If you are planning on investing or trading in DeFi, you must know the risks that are associated with it. Let’s discuss this in detail.
What Are The Risks Of DeFi?
The risks of DeFi are as follows:
- Impermanent loss
One of the most common risks of DeFi investing is impermanent loss. This happens due to the volatile nature of cryptocurrencies.
During DeFi lending, you must lock your crypto in liquidity pools. If there is a change in the price of your assets after depositing them, it leads to impermanent loss.
This risk is present in DeFi lending protocols due to the Automated Market Maker System. DeFi lending pools maintain their asset ratio in the pools at a specific ratio with two tokens.
For example: The ratio of BTC and ETH can be fixed at 1:4.
Thus, if you want to deposit your assets in a DeFi liquidity pool, you have to put in both Bitcoin and Ethereum in the same ratio.
Now, DeFi lending pools depend on arbitrage traders to align the price of a token in the pool with their existing market price. These traders add tokens of higher value to the pool when there is a change in the value of these tokens.
Thus, if there is a fall in the price of Ethereum, these traders will deposit Bitcoin to remove ETH.
However, there is a catch. As the ratio of coins changes, the liquidity pool will increase the token's price in high supply, that is, Ethereum in this case, and reduce the price of Bitcoin. This will encourage the arbitrage traders to rebalance the pool.
After this rebalancing procedure takes place, you can face an impermanent loss as the price of your assets, after rebalancing, will be much less than the current market value of your assets.
However, DeFi platforms offset your impermanent losses by providing a share of the trading fees depending upon your stake volume in the pool.
Furthermore, you can minimise the risk of impermanent loss by investing in a liquidity pool that only operates with one cryptocurrency or dollar-pegged stablecoins.
- Governance risks
Decentralised finance platforms are, by nature, decentralised. However, when it comes to governance, you can observe that a few users control the outcome of any proposal on the network. This is because these users receive governance tokens for their active participation and alignment in the ecosystem. These token holders can vote on issues related to the platform.
The decisions of these token holders can change the liquidity composition of staking pools and thus affect investors. DeFi platforms are prone to governance attacks and can benefit from a more robust governance system.
- Software risks
DeFi protocols run on automated smart contracts requiring little human intervention. Like any other software application, it is bound to have some problems. The software risks that decentralised finance protocols have are:
- Errors in coding
These are errors in the smart contracts of DeFi protocols that cause the software to malfunction.
- Security vulnerabilities
Many DeFi protocols have risks that allow cybercriminals to steal funds from the platform.
A famous example of DeFi software risks is Ethereum’s DAO hack. When Ethereum started, there was a DAO that collected funds for the purpose of crowdfunding. Its wallet's smart contract had a major flaw that allowed hackers to drain millions from the fund.
However, Ethereum resolved this situation by implementing a hard fork to return the lost assets to their owners.
When searching for a DeFi platform, search for one with a long track record. They tend to have lesser software risks. These long-running DeFi protocols have had enough time to sort out any software issues that may come up and cause issues to its users.
- Rug pulls
Scams are very common in crypto projects. If you have been a part of the cryptocurrency world long enough, you might have heard of a scam called rug pull. It is an exit scam in which cybercriminals create a new cryptocurrency, build a liquidity pool, and pair it with a stablecoin. Then they market it in the crypto community to attract investors to add liquidity to the pool. Investors then get a portion of the transaction fees for their contribution to the liquidity process.
After this, the team behind the project simply dumps all their tokens in the pool and withdraws the stablecoins. They then transfer all the investors' money to their accounts and abandon the project. The users are left with a cryptocurrency of zero value.
To avoid such scams, you can check the token distribution of a crypto project before investing. Simply use a blockchain explorer like Etherscan (for Ethereum) and check the token distribution by clicking on the “Holders” tab. If only a few crypto wallets control the circulating supply of a token, you can consider it a massive red flag.
- Gas fees
Ethereum has the largest decentralised finance applications in the current market. Due to its limited scalability and an increasing number of users, transaction or gas fees on this blockchain can get pretty high.
It is particularly applicable if your DeFi investment needs more than one step to authenticate. Hence, before investing, always consider whether or not the gas fees may consume a considerable portion of your return on investment.
- Flash loan attacks
A flash loan is a type of unsecured loan that you can find on decentralised finance platforms. They do not need any collateral. Malicious users use such loans to manipulate the market in their favour while still abiding by blockchain rules.
For example: On May 2021, there was a flash loan attack on PancakeBunny. A malicious user borrowed many BNB tokens and manipulated the price of USDT/BNB and BUNNY/BNB in PancakeBunny’s staking pools. This allowed the user to steal a lot of BUNNY tokens. Later, the user dumped all in the crypto market, causing its price to crash.
The hacker stole almost $3 million in profits.
Decentralised finance has negated various risks from the money market by removing third parties and making the entire process automatic and corruption free. However, this technology has its own risks. Notably, the risk management of DeFi investment is a bit challenging as it doesn’t conform to conventional risk management of financial instruments.
Be aware of these possible risks for better trading results and experiences in DeFi.
