The Risks of Investing in DeFi

Josiah Nang-Bayi, MD
11 Min Read

Decentralized finance, or DeFi, has exploded in popularity over the past couple of years. By removing financial intermediaries and allowing peer-to-peer transactions through smart contracts, DeFi offers significant advantages over traditional finance including greater transparency, accessibility, efficiency and innovation. However, like with any new technology, DeFi comes with its fair share of risks that investors need to be aware of. In this post, we’ll explore some of the key risks associated with investing in decentralized finance.

Top 8 Dangers or Risks In DEFi Investing

Smart Contract Risks

One of the foundational components of DeFi are smart contracts – self-executing lines of code that facilitate agreements and transactions between parties. While smart contracts can automate many processes, they are still prone to bugs, exploits and hacks just like any other software. Several major DeFi hacks and losses have occurred due to vulnerabilities in smart contract code.

For example, the first ever DeFi hack occurred against a DAO (decentralized autonomous organization) called The DAO in 2016, leading to millions of dollars in losses. More recently in 2021, a bug in smart contract code led to over $600 million being drained from the Poly Network. Smart contract risks pose a significant threat to DeFi investors as flaws in the code can lead to loss of funds with almost no recourse.

Proper auditing and testing of smart contracts prior to launch is critical to limiting this risk. Investors should also avoid interacting with brand new contracts that are unproven. Checking sites like CryptoSec can provide more information on known contract risks and vulnerabilities.

Centralization Risks

While DeFi is meant to be decentralized, many platforms and applications still have centralized components and governance. Centralized features like how platforms are initially developed and launched, the role of administrators, and oversight through governance councils/committees create risk.

If a platform is deemed to have too much centralization, regulatory agencies could impose restrictions or requirements around custody, capital reserves, reporting, and more that may limit the application’s utility. Governments could even force platforms to blacklist certain addresses or freeze funds – essentially negating the core value propositions of decentralization.

Investors need to assess how decentralized a DeFi application truly is before investing. Opting for platforms with a high degree of decentralization in both technical architecture and governance is key to minimizing centralization risk.

Liquidity Risks

Liquidity refers to the ability to easily buy and sell an asset without dramatically impacting its price. Many DeFi lending/borrowing protocols rely on liquidity pools where users provide capital that is drawn upon for loans. If these pools are not sufficiently large, borrowers may struggle to secure loans or liquidity providers could face significant losses if withdrawals exceed reserves.

Poor liquidity also leads to high slippage on trades, excessive price volatility, and cascading liquidations across lending protocols. Investors could find themselves unable to exit positions or end up with significant impairment losses. Evaluating the depth of liquidity pools and current liquidity conditions is important for mitigating this risk. Choosing more established platforms with deeper liquidity tends to be safer.

Oracle Risks

Oracles are data sources that provide external information like asset prices to DeFi platforms. They serve as key inputs that influence smart contract execution. If Oracle data is manipulated or corrupted, it could lead to faulty transactions and big losses.

The risk stemming from centralized oracle sources has been demonstrated in exploits like the bZx flash loan attacks in 2020 where price manipulation through a single oracle source resulted in millions lost. While decentralized oracle networks like Chainlink improve security, oracle risks persist and remain difficult for individual investors to assess. Avoiding overexposure to protocols heavily reliant on oracles can help mitigate this systemic risk.

Regulatory Risks

The regulatory environment for cryptocurrencies and decentralized finance remains highly uncertain and varies widely across different geographies. Some governments have outright banned crypto investing while others have imposed strict rules. Regulatory changes can heavily influence the value and viability of DeFi platforms.

Investors face risks such as taxes being levied on previously tax-free protocols, certain asset classes being prohibited, and loss of access to DeFi platforms/features depending on jurisdiction. Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations may also compromise decentralization. While regulation can help legitimize DeFi, it also creates significant uncertainty and risk, especially for non-compliant platforms operating in legal gray areas.

Volatility and Market Risks

DeFi platforms are closely tied to the overall crypto markets and economy. The instruments and tokens used on DeFi platforms tend to be extremely volatile, as demonstrated by the boom and bust cycles in cryptocurrencies over the years. High volatility amplifies other risks like liquidity shortages and black swan events.

Market crashes and prolonged bear markets lead to declining revenue and asset value along with liquidity issues. Interest and collateralization rates must be carefully managed to prevent cascading liquidations during periods of extreme volatility. Investors should brace for volatility and be cautious of aggressive interest rates or overleveraging. Hedging strategies and proper position sizing are key to mitigating market risks.

Technical Risks

Like any software, DeFi platforms carry technology risks including bugs, glitches, hacks, and outages. The immutable nature of transactions on decentralized ledgers also gives hackers a lucrative target, as stolen funds cannot be recovered. Attack vectors like flash loan exploits, front running and sandwich attacks can lead to quick losses.

Man-in-the-middle attacks, denial-of-service attacks, and network congestion also pose risks to accessibility and transaction speeds. With no centralized support, users typically have no recourse against technical issues and losses. Rigorously audited code, decentralized oracle feeds, and usage of multi-sig wallets can help curb technical risks. But technological risks remain an unavoidable facet of DeFi.

Financial Risks

DeFi introduces new financial risks that investors must evaluate carefully. For example, impermanent loss occurs when liquidity providers suffer opportunity cost losses due to diverging asset prices. Investors also face risks from excessive borrowing, inefficient collateralization, high-interest rates, and unpredictable money market dynamics.

Platform “bank runs” are another risk that occurs when a market downturn spurs a surge of liquidity withdrawals. Without adequate reserves, such scenarios can lead to collapsed lending platforms and contagion across protocols. Margin trade positions that are highly leveraged pose further financial risks. DeFi inheritably has more financial complexity than traditional products. Understanding these risks is key for investors.

How to Mitigate DeFi Risks

While DeFi investing carries no shortage of risk, there are ways to manage the hazards:

Research platforms thoroughly – Read whitepapers, audit smart contracts, evaluate centralization, check governance policies and assess technology risks before investing.

Use reputable platforms – Opt for established platforms that have passed the test of time and demonstrated resilience. Avoid unproven platforms with low developer activity and community traction.

Start small – Limit position sizes and use small tests before increasing exposure. Don’t invest more than you can afford to lose.

Diversify across platforms – Allocate capital broadly rather than concentrating investments, so that underperformance or failure of a single platform doesn’t wipe out your portfolio.

Implement stop losses – Use stop losses to contain downside, especially for volatile assets. Laddered stop losses can protect profits while giving room for growth.

Master risk management strategies – Employ hedging strategies to mitigate risks like using stablecoins and futures contracts to hedge against volatility. Understand liquidation procedures.

Monitor closely – Stay on top of governance changes, new proposals, technical upgrades, and market conditions related to your investments so you can take proactive action if needed.

Use decentralized infrastructure when possible – Opt for decentralized oracle feeds, leverage decentralized exchanges, and use non-custodial wallets you control to reduce centralization risks.

The Future of DeFi Risks

As the DeFi space matures, certain risks like smart contract bugs and hacks should decline as auditing practices improve and lessons are learned from past exploits. However, other risks like regulatory uncertainty, market volatility, and centralization will persist. Managing risks is simply the price of admission for accessing DeFi’s numerous benefits.

While the risks involved with decentralized finance may seem daunting, the risks that accompany traditional finance are also substantial. As with any new technology, embracing DeFi requires adopting prudent strategies around risk management and portfolio construction. Those who take the time to properly understand and mitigate the array of risks stand to reap sizable rewards from the most promising innovation in finance since the invention of blockchain itself.

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Josiah Nang-Bayi, MD is a medical doctor by profession, an author, a financial literacy and digital assets enthusiast, an entrepreneur and a growing philanthropist.
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