Investing in DeFi is seriously risky, but maybe it doesn’t have to be
In the last two years, a whole new industry has emerged within the blockchain and cryptocurrency universe, that of decentralized finance (or DeFi for short).
Built predominantly on the Ethereum blockchain, DeFi is the crystallization of ambitions held by the architects of cryptocurrencies, to build a fully fledged financial system controlled by no single entity.
The arrival of crypto allowed us to send and receive money with no intervention from an intermediary (e.g. a bank), but the rise of DeFi allows us to borrow, lend, save, speculate and more under the same conditions.
For example, with DeFi lending protocols such as Compound, anyone can take out a cryptocurrency loan backed by collateral or gain interest by lending out their own crypto, irrespective of their identity and financial history.
Decentralized exchanges (DEXs), meanwhile, facilitate peer-to-peer transactions without the need for an intermediary that holds custody of the funds. Unlike on traditional crypto exchanges, users can also trade any Ethereum-compatible token for any other, provided there is supply and demand.
As explained by Michael Beck, Project Lead at DeFi risk management firm UNION, “DeFi apps are built on smart contracts, like traditional DApps, but they strive to decentralize the role of governance and the custodial role of the application.”
“That’s favorable from the perspective of DeFi because people are putting a lot of value into smart contracts, so they want to know there’s no single person who can pull the rug out from under them.”
And Beck is right to suggest that money is flooding into decentralized finance. According to data from DeFi Pulse, almost $25 billion is currently locked up in DeFi smart contracts, up from just $15 billion at the start of the month and less than $1 billion a year ago.
However, while there is clearly significant value to be found in this burgeoning new financial ecosystem, there is also considerable risk, especially for the unwitting investor.
DeFi risk and reward
The earliest adopters of new technologies are always positioned to gain the most in the event the product or service enters the mainstream. If someone had purchased Bitcoin five years ago, for example, their investment would be worth 100x its original value today.
The benefits of early adoption, however, are only realized if the investor manages to back the right horse. And the same can be said of the numerous DeFi projects emerging today.
Yield farming is a DeFi practice whereby users lend their own cryptocurrency to a project, earning interest in exchange for providing liquidity. In some cases, stakers are also compensated with a governance token, which gives them a “vote” on the future of the project and can also be exchanged via a DEX.
To optimize the return on their investment, yield farmers often transfer funds between different protocols, in search of the greatest annual percentage yield (APY). This is the driving force behind the growth of DeFi right now.
However, risks associated with yield farming are great, especially for retail investors. High transaction fees, market volatility and security incidents linked with vulnerabilities in smart contracts can all result in the value of an investment falling through the floor.
“We all make a trade when we move from centralized to decentralized products,” says Beck, who casts the conundrum as a question of reliability versus innovation.
“Centralized products have a strong brand reputation and pedigree, and operate in ways that have been tried and true for years. When you move over to decentralization, you find a little more innovation, but there’s a commensurate level of risk.”
Comparisons could be drawn between the current state of DeFi and the ICO boom of 2017-18, during which period investors pumped billions of dollars into new crypto projects in the hope the associated coins (akin to shares) would appreciate in value. Many of these projects were rotten, however, and a large number of people lost much if not all of their investment.
Given the esoteric nature of blockchain and the complexity of the various lending and borrowing mechanisms at play in the DeFi ecosystem, it will be challenging for the average investor to distinguish between DeFi projects with real value and those that are riding the hype.
“For someone with only a few tokens in their pocket, DeFi is incredibly risky, expensive and complex. We look at those factors as barriers to participation,” Beck told TechRadar Pro.
“If you think about the aspiration for blockchain and cryptocurrency to ultimately provide self-sovereign democratization of finance, it’s hard to see how DeFi can succeed as things stand.”
According to Beck, however, there is a way to open up access to this thriving new financial ecosystem without exposing investors to dangerous levels of risk.
Insuring against disaster
Set to launch imminently, the UNION protocol is designed to address barriers to entry for retail investors by insuring against eventualities that might result in the loss of funds.
It does so through so-called umbrella tokens, which Beck explains can be compared to policies taken out with a traditional insurer, that bestow certain benefits on the holder.
“These products provide flexible tooling, so people don’t necessarily have the exposure that they would in an uncovered DeFi market,” he said.
The protocol itself allows for various different types of composable benefit structures, which can be shared across multiple policies. This means UNION can underwrite occurrences that could threaten the value of investments, such as collateral optimization issues, fluctuations in transaction fees and smart contract failures.
Whereas comparable DeFi insurance platforms, such as NexisMutual, might insure against the failure of a specific smart contract, UNION hopes to set itself apart with policies that cover a broader range of risks at once.
Unlike other insurance protocols, UNION is also able to sidestep certain know your customer (KYC) requirements, because the bearer of an umbrella token does not profit from it directly. This means anyone is able to take out a policy without having to hand over personal information.
This combination of qualities, Beck hopes, will address risk-related barriers to entry, while also catering to participants for whom privacy and decentralization is the number one concern.
While projects such as UNION may go some way to offsetting the risks associated with investing in DeFi, peril can never be eliminated entirely and may also take on new forms as the ecosystem evolves.
An attribute known as composability means that new DeFi projects can build upon and connect up to existing applications and infrastructure, creating something new entirely. But this may also pose problems for investors, Beck claims.
“The more projects there are, the more unexpected interactions between them.”