Defi is a wonderful invention that many people believe to be the future of finance. Like any new technology, though, decentralised finance comes with risks, both systemic and external.
Systemic risk includes the potential for a vulnerability in the smart contract. If the Defi protocol hasn’t been thoroughly tested for bugs, it could be exploited by a hacker who could steal funds. If this happens, there is little recourse for compensation: Defi removes human organisations from the equation, remember, so if you lose funds, there is no helpline to call or claims form to file.
Smart Contract Vulnerability
Unfortunately, the increasing popularity of DEFI and a huge influx of new DEFI applications has inevitably seen a big increase in the exploiting of smart contracts to drain funds.
Generally speaking, Defi primitives like those we mentioned earlier are among the safest protocols to use, since they have been extensively audited – though they still carry a degree of risk. The newer and more experimental the Defi service, the likelier the possibility that it will contain a vulnerability.
Market Correction
Much of the interest in DEFI stems from the exceptional rates of return that you can earn on your crypto assets in comparison to traditional finance. With interest rates at record lows, the ability to earn double, and in some cases triple digit returns, is extremely appealing.
Much of this is possible because – as of 2021 – we are in a bull market, where the overall sentiment in the market is high. This means that there is :
- a huge demand for the leverage mentioned above, which drives up the rates of return available
- a huge amount of DEX trading activity, generating fees for the liquidity providers
- the perception that all new coins have the potential to rapidly increase in value, regardless of a unique use case, driving demand for DEFI services rewarding users with their native token
All of the above are susceptible to a prolonged market correction, as has been seen several times through crypto’s history. A bear market would crash demand for leverage, reducing interest rates, see the trading on DEXs plummet, and thus rewards for providing liquidity and the perceived value of tokens earned would fall through the floor.
As the saying goes, ‘when the tide goes, we’ll see who’s been swimming naked’
User Error
There is also the risk of user error. While Defi design is improving all the time, it’s still not as user-friendly as traditional financial apps for banking and saving. It thus helps to have a degree of technical knowledge, to understand what is happening when you interact with these protocols, and the steps you should take to prevent loss of funds.
Don’t interact with Defi until you know what you’re doing, and as with all things in crypto, don’t invest with more money than you can afford to lose.
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