Understanding the Risks in DeFi Investments
Smart Contract Vulnerabilities
Perhaps most important to DeFi platforms is the so-called ‘smart contracts’ included in them, which are self-executing contracts, meaning the terms of the contract are written into the code. So while the code also automates and expedites the process, it can also introduce more risk. Online attacks on, or bugs present in, the code could potentially expose investors to loss of invested funds. For example, a minor coding mistake could result in the loss of a large volume of cryptocurrency because of unauthorised access or other forms of failed transactions.
Lack of Regulation and Oversight
DeFi platforms are not subject to government oversight and regulation. This can be double-edged. On one hand, this offers freedom from Central Bank policies and room for innovation. On the other, investors can be exposed to more risks of fraud and scams without the protections that regulatory bodies offer. This means that, in the instance of mismanagement or malicious activity on DeFi platforms, investors have little recourse than to try to recover their own funds.
Market Volatility
Nor is DeFi protected from the general volatility associated with the cryptocurrency markets, and hence the worth of DeFi tokens can fluctuate dramatically, dependent on market sentiment, technological developments, and macroeconomic factors. This volatility can result in substantial monetary losses, especially for those who aren’t accustomed to managing their investments in a highly volatile domain.
Impermanent Loss
For liquidity providers, impermanent loss is a key risk factor. That’s because the prices of the assets you’ve deposited might change when you take them out of the pool compared with when you put them in. The larger the change, the greater your imperial loss can be. The ‘impermanent’ part only becomes ‘permanent’ if you take the liquidity out at a different price to what you put in, at which point you might be left well out of pocket.
Interoperability Issues
DeFi platforms are often multi-chain, meaning that they operate on several blockchain networks. This could lead to issues of interoperability, meaning that users risk either cancellations of transactions or loss of funds because the functionality of one blockchain doesn’t translate perfectly to another. Strong cross-chain support is a good way of avoiding these issues.
Conclusion
Similarly, investing in DeFi is tempting, but the risks are also quite considerable. Potential investors should consider doing their homework, researching the exact risks of specific DeFi constructions, and diversifying their investment portfolio sufficiently to minimise risks. Staying informed about developments in DeFi, and following best practices for online safety, can also prevent many of the discussed risks to investments.
As the shadow banking system, replacing traditional bricks-and-mortar banks, expands in the DeFi ecosystem, informed and vigilant investment could make the difference in securing success in this ever-alluring and high-risk investment space of tomorrow.
