While tradfi APYs have trended towards zero (some banks even now provide negative interest on savings), Defi offers double or even triple-digit percentage returns.
The attraction is obvious: who wouldn’t want to double their money in a year simply through locking it into a decentralised finance protocol and letting time take care of the rest?
Not only that, the huge interest in Defi has seen the value of the underlying tokens users earn for staking increase massively in value, with new protocols launching all the time adding extra dimensions to the Farming landscape.
There is of course a trade-off. Due to their novelty and highly experimental nature, Defi protocols come with a number of unique risks that you need to be aware of.
Smart Contract Vulnerability
Smart Contracts are coded instructions. Incorrectly coded instructions, with weak logic can enable hackers to exploit the contract and steal the funds. Do a quick Google and you’ll see how prevalent the issue is.
Smart Contract Costs
Defi needs to interact with a blockchain to execute Smart Contracts which incurs a fee. Those Ethereum based Defi projects have seen Gas fees reach extraordinary levels. Not all projects rely on Ethereum, so shop around. There are an increasing number of cheaper Smart Chain alternatives, listed below.
You Are Fully Responsible
Defi is a double-edged sword. You can be staking and farming in no time, but you are fully responsible. There is no recourse should you lose the private key controlling access to your Defi wallet or incorrectly allocate funds.
Broadly speaking, the more established Defi protocols, with a higher total value of assets locked into them (also known as TVL), are safer. This is because their code has been extensively audited and “battle-tested” in a live environment.
They’re also maintained by teams of highly accomplished developers. That doesn’t make them entirely safe, however: hacks and exploits still occasionally occur.
Newer protocols will offer higher APY in order to build up liquidity, and their tokens will start from a lower base value, but their reputation hasn’t been established.
While the temptation is to lock your assets into the protocol that promises the highest APY, it’s prudent to perform due diligence into the project before you start staking your precious crypto.
- Has the code been professionally audited?
- How long has the project been operational?
- What is the total value locked into the protocol? (A higher number generally implies greater legitimacy.)
The risks of yield-bearing crypto projects were illustrated in March 2020, when a cascade of forced liquidations led to huge losses on the decentralized finance (Defi) lending platform Maker.
The plummeting value of Ether (ETH), which acts as the platform’s base collateral, caused Collateralized Debt Positions (CDPs) to fall below the ETH:DAO collateralization ratio and trigger losses of $6.65 million.
Another platform, Cred, was forced to suspend inflows and outflows of funds relating to its Earn program after filing for bankruptcy. It is worth remembering that there’s no Lender of Last Resort in the crypto industry.
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