The Decentralized Finance (DeFi) sphere has been all the hype in 2021, and reached an estimated value of over USD 11 Billion LOCKED in the DeFi lending market alone. Many have already seen high-interest rates on DeFi platforms advertised for different cryptocurrencies. Depositing cryptos for a high return sounds like a great investment in today’s low-interest standards, but everyone knows that with high returns comes higher risks. Let’s delve deeper and understand how DeFi markets work, talk about DeFi’s different concepts and the risks associated with those attractive investments.
Explaining DeFi concepts
Simply put, Decentralized Finance or DeFi for short, is a form of finance that does not rely on financial intermediaries such as brokerages, exchanges, or banks, and instead utilizes smart contracts on blockchains, the most common being Ethereum.
“A smart contract is a computer program or a transaction protocol that is intended to automatically execute, control, or document legally relevant events and actions according to the terms of a contract or an agreement.” (wiki definition).
One main risk associated with DeFi applications, is the risk of exploitation through bugs and errors in the smart contracts. In 2020, multiple lending and automated market maker platforms experienced misuses that resulted in Millions in locked funds drained away. As human-written code is prone to errors, hackers and malicious attackers can take advantage of poorly written code. To mitigate these single points of failure, participants and lending platforms should be proactive in analyzing, and managing their level of exposure to such risks. The industry is still relatively a new one, and one must always prepare for such events.
A liquidity pool is a collection of funds locked in a smart contract. Liquidity pools are used to facilitate decentralized trading, lending, and many more functions. They are the backbone of many decentralized exchanges (DEX), such as Uniswap. Price discrepancies in Automated Market Maker (AMM) exchanges are attractive to arbitrageurs seeking to buy up the difference. That difference eventually creates a permanent loss once the liquidity is withdrawn, and profit is taken out. Stablecoins have become an attractive solution for these pools as there is less volatility among prices.
DeFi platforms offer governance tokens to investors. While the platform is developed by a specialized team, the ultimate aim is to pass over the authority to the token holders. The entity that sets the rules of the platform has a great deal to do with the associated risks and other matters that the platform deals with. Imagine holders of governance tokens to be like the board members of a listed company. The Maker and Synthetix Foundations are two examples of central structures who through their tokens, have transferred power democratically to their respective token holders. Changes to the system are now voted on by the community to decentralize the risks of their platforms.
Collateralization is when a borrower pledges an asset as a means for the lender to recoup their capital in the instance that the borrower defaults on the loan. Think of it as a “down payment”, or a security of some sort in case the borrower defaults. In the case of DeFi, borrowers put cryptos as collateral. Lending in decentralized finance is only as strong as the source of liquidity. In times of volatility, liquidity is often put to the test. When market activity picks up, the price can fluctuate wildly or funds may not be accessible. To prevent such scenarios, many loan providers are taking proactive steps with overcollateralized loans and dynamic interest rates.
Individuals can also earn interest with depositing their funds into crypto interest accounts. Some of those interest accounts provide 4-6% APY on crypto deposits, which may encourage some investors hold their assets for the longer-term.
Should you Jump on the DeFi wagon?
DeFi has opened up access to financial services for both banked and unbanked individuals globally through the use of the internet. With new participants joining in and traditional banks failing to offer appealing rates, people are turning to opportunities that not only offer a generous return but also allow participation in popular financial products that cross geographical boundaries.
If you look at the numbers, in the past 24 hours, the DeFi market as a whole has risen by 28% to reach a market cap of around USD 57.4 Billion. This comes after news that Tesla bought BTC and is soon planning to accept Bitcoins as a payment method. This is huge not only for Bitcoin, but for the crypto industry as a whole. Bitcoin is known to push markets with its price-actions because of its current 62.8% dominance. The latter is sure to fall down as DeFi will rise higher, especially with the latest Robinhood Scandal which you can read all about here.
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