Decentralised finance has slowly become one of the cryptocurrency world’s top trends, experiencing a visceral bull run in 2020.
In the digital asset industry trends change fast. However, new opportunities that allow you to capitalise on cryptocurrencies can begin to be overused. Therefore, the decentralised finance sector has become the new black of crypto. Unlike the ICO bubble infamous period, it didn’t happen in a blink of an eye - the way to acceptance was slow: it took almost one and a half years to rise from zero to first billion in capitalisation. In summer 2020, it really gained momentum and market caps increased every week by a billion!
We saw what we’d call a so-called “stealth bull trend” in this niche, and it has expanded into something mainstream in today’s market due to the significant interest rate arbitrage available that drives the speed of this segment development. The DeFi p2p lending market grew over seven times in 2019.
However, by early Autumn 2020, the DeFi frenzy began to get out of control. The crypto community likes to experiment, and support of the thriving trend was strong. Since the potential risks of involvement have risen drastically, it’s an excellent time to review the potential pitfalls of the DeFi area more closely.
Trust is a thing that is earned the hard way, and the desire to get rich fast has led many decentralised finance investors to financial losses. The ongoing frenzy regarding DeFi and its tokens surely reminds of the ICO fever back in 2017. However, DeFi protocols are moving towards decentralised governance, reducing the risks of relying on project founders as well as the chances of further exit scams.
DeFi aims to become an alternative to the traditional financial system, reshaping services and operations such as lending, loans, and trade, providing anyone with access to financial instruments, while eliminating the need for traditional intermediaries. The DeFi sector is not only an opportunity to increase earnings, as the people of emerging economies are finally getting access to the new kind of financial system.
Nevertheless, tremendous growth never comes without substantial risks. It is imperative that users know these risks and consider them if they decide to use DeFi services. High-reward opportunities tend to go with many risks that investors looking for stable growth may not be willing to take on. Summing up, we start with:
Scams and Ponzi schemes
Every emerging market full of new opportunities inevitably attracts the sharks, with the smell of the investors' money being hard to miss. Despite the short history of decentralised finance, this field has mostly not been a target of scams until 2020. Before the C19 crisis and cryptocurrency popularity, it didn’t have even a billion in market cap. Right now, when some tokens such as YFI have surpassed the BTC peak price more than twice (Mid-September it was $43,000) at it’s best, the idea of attracting new people into new services has become much easier. That goes double for fraudsters. Ponzi schemes, exit scams, and investors' deception have become a more traditional fit to the everyday picture, and we are sure that there will be more to come before this field matures or faces some regulations aimed to protect investors.
There are liquidity and credit risks in the decentralised finance field, as well as volatility risks that account for system ones. If the price of underlying assets locked falls rapidly, massive asset liquidation occurs, and the system may collapse. For this not to happen, and to mitigate such possible risks, DeFi protocols are currently trying to provide loans with excess assets, which has a low impact on these assets' prices. The decades-long history of cryptocurrencies shows that it can lose capitalisation overnight. If the platform is not secured against the adverse effects of a sharp price drop, there is a risk of collapse. An alternative solution is to use excess assets to secure loans, but this solution is not always applicable.
The smart contracts vulnerability
Smart contract security has greatly improved during the last years, but security flaws still remain a major issue for Dapps and smart contracts. Crypto criminals and hackers are still able to spot vulnerabilities to steal cryptocurrencies. Some DeFi products received security audits, some not, but it’s up to users to make a choice and decide whether the catch is worth the game
Those who use cryptocurrency take on the risk associated with their potential failure to act in ways that put their assets at risk. No matter how hard the developers aim to craft their products as safely as possible - it's the cryptocurrency users’ responsibility to store and secure their private keys. Such things as a hardware wallet, multi-factor authentication, and secrecy of your funds are some of the most vital steps to consider. Constantly updated protocols and changing service terms among various cryptocurrency projects, digital wallets, and exchanges is also a topic for consideration for safe play.
Experienced investors used to rely on historical data and annual inflation statements of their native currency as well as the risk-free return rate to evaluate possible investment opportunities for the future. The risk-free rate refers to how much a possible investor can expect to make from a certain offering. For now, the lack of extensive historical data and benchmarks for the young and emerging decentralised finance market makes it difficult to evaluate the risk of investments in legal terms. Moreover, the extreme asset volatility in this field even surpassed the risks of the purchase of standard cryptocurrencies.
Lack of clear responsibility
There is not a single really responsible department that will be responsible for the chaos or order within the system. The logic of “crowd wisdom” can fail if we move away from ideal visionary work: not all users are interested in collective prosperity. In theory, participants should actively develop the ecosystem, but this is not always the case.
Lack of capital in decentralised finance loans
Despite its merits, such as inclusiveness, DeFi loans are inferior to loans in the traditional finance sector, since the money amounts that can be obtained with appropriate collateral are relatively small. So far, this resembles microfinance and is mostly inferior to banking services of this kind in scale.
To meet ever-growing needs, any project needs to scale. But the rapid rise in popularity of DeFi platforms does not allow developers to respond to changes in the ecosystem quickly.
Difficult to spot the rogues
The market is oversaturated already, and it is challenging to distinguish scam projects from efficient implementations (if there is no blatant deception in the form of vast percentages of income).
The harsch volatility of cryptocurrencies used as collateral in decentralised finance systems makes them highly risky in case of an unexpected market crash. When the price of underlying assets locked in protocols drops sharply, users begin to liquidate them en masse, which can bring the entire system to a halt. Credit protocols try to secure loans with excess assets to prevent this from happening, but this lowers their cost.
Unpegging of stablecoins
Nowadays, most of today's stablecoins are pegged 1:1 to the US dollar or Euro. In the case it varies significantly, there would be unintended negative consequences for those borrowing or lending stablecoins through DeFi protocols. For example, if a client obtains a loan using a stablecoin as collateral and its peg drops below $1, then the loan itself may become undercollateralized, further resulting in liquidation. Conversely, suppose you are borrowing stablecoins, and the value of the peg goes above the dollar mark. In that case, the debt may cause you to pay more in interest than anticipated and potentially end up liquidated if it surpasses the amount held as collateral.
Risk of “bad harvests”
The rapid emergence of yield farming created a new widespread trend, and crypto agrarians expect a high quality of new products appearing on the markets. Putting it simply, if the value of the tokens earned through these incentive systems drops significantly, users may start opting out from providing liquidity to the protocols. Furthermore, if there is a sudden large drop in these tokens' prices, it could lead to a liquidity shock, which would further exacerbate the protocol’s issues.
Centralization of data flow
Blockchain protocols extract data from the outside world using oracles. If the oracle acts maliciously, the smart contract's correct execution will be in jeopardy. Centralized data oracles are a vulnerability for DeFi, too, although decentralized alternatives have already been developed.
Risk of market overheating
Negative but expected events happened in the first week of October 2020, as the decentralised finance markets took a sharp downturn with the combined capitalization of DeFi assets falling 25% while volumes shrunk 30%. The crypto market has been engulfed in a sea of red this week, with most DeFi blue chips recording double digit losses over the past 7 days.
Over the past week, the vast majority of DeFi tokens have recorded double-digit losses. The main outsiders were the most popular tokens of the projects Sushiswap (SUSHI), Uniswap (UNI), yEarn.Finance (YFI). From historical highs, the median price of DeFi tokens has fallen by more than 60%. Some in such negative dynamics found confirmation of their gloomy forecasts of a deflation of the formed bubble and an obvious overheating of the market.
Pretty much like in every emerging market, there’s no better way to learn how DeFi and the products work rather than trying it out with small amounts of digital currency. That said, there remain significant hurdles to evaluate DeFi products as investment opportunities properly, and investments in DeFi should be considered high-risk.
Overall, there is no shortage of innovation — or risks — within the DeFi space. The top DeFi protocols have successfully managed to create multi-stakeholder incentives systems, perhaps like nothing we have seen before. Leveraging blockchain’s transparent nature, these projects have improved upon each other and accelerated the pace of innovation.
But it's important to understand that the DeFi sector is an experimental arena that exists in a regulatory grey area. Regulators don't seem to be a major issue for the DeFi sector yet. But we're sure they just haven't gotten to it yet. Recent stories from Libra, Telegram, and companies that have conducted major ICOs have shown what regulators expect from massive blockchain projects. And the DeFi sector is still weak (or, rather, does not comply at all) with the KYC / AML requirements.
Until the main technical problems and the risks listed above are eliminated, decentralized finance will not be ready for mass use. The current early phase of DeFi development is for researchers, professionals, or very sophisticated speculators. Once the risks can be properly addressed by users and regulations, DeFi will be one step closer to becoming an effective way to become a viable alternative to the current financial system.
When investing in decentralised finance, remember that investors must also consider the technical and systemic risks beyond the question of how much the investment will bring. The universal formula “the higher the yield, the higher the risk” clearly shows how much you risk investing in DeFi. For the sector to grow further, it needs to better engage with users, and not just focus on creating incentives in the form of governance tokens.
Article By Gregory Klumov, CEO of STASIS