With the birth of Decentralized Finance – DeFi, you have the ability to organize your finances as a bank. You are able to lend to protocols and be compensated with a interest rates. There are more than several ways to generate a passive income on your pile of dormant money.
But with this power comes serious responsibility! The DeFi user must be aware of the risk assesment that is linked to using DeFi. On this page we take a closer look to the most common risks.
"Learn from the mistakes of others. You can't live long enough to make them all yourself."
Table of Contents
Mismanagement private and admin keys
One of the most common ways to lose money is by losing access to your wallet files, private keys or passwords. Even a non-custodial wallet needs a password. If you lose this, it’s game over. No one will be able to help you and your money will be lost forever.
Therefore, be sure to always make multiple back-ups of your passwords and private keys. Distribute them in safe locations to avoid becoming a victim of losing money.
But not only should you, as a DeFi user, manage your keys properly. Admin keys will give developers the right to change smart contracts or access to the devfund. In that case developers of the protocol in which you secure your money must handle their keys responsibly.
To ensure reliability to the community, admins will use some security methods such as ‘multi-signature’ and ‘time-locks’. These techniques make it harder for cyber criminals to get acces but do not guarantee absolute security.
The most reliable protocols are transparent about the security of their admin keys or the amount of tokens assigned to each developer. Mostly of the time, in DeFi, the team will first consider possible changes within community before making any changes to the code.
Be alert when the developer is able to move or lock the funds of the protocol.
Hacks and Bugs
The open-source codes of the smart contract are an advantage for people who want to build and develop. But the open-source code becomes a disadvantage when people with bad intentions start using it. Anyone can copy these open-source codes and put a modified version on the blockchain.
When a malicious person finds a way to exploit a smart contract they’ll do so without thinking twice.
To guard against exploitations we can check if these smart contracts have been audited by external parties. But sometimes these audits are not enough, and hackers will find new ways to extract money from even highly secure protocols.
With each new security measurement, new techniques will be used to exploit bugs. Trustworthy DeFi protocols will have additional audits and hire specialized security developers. Where some even award fees for finding bugs, also know as bug bounties.
Extreme volatility
Due to extreme volatility, loans taken in some DeFi protocols can no longer be covered. As a result, positions are liquidated by the protocol. This way a flash crash can ruin you financially.
The volatility also has an impact when you start providing liquidity, this phenomenon the impermanent loss. A possible solution to hedge against the risks of volatility is to use less volatile tokens such as stablecoins.
Scams
(Nearly) everyone knows that messages that ask you money in order to get it back twice afterwards are pure scams. Yet these scams are not always SO obvious. Fake tokens are listed on decentralized exchanges and have the identical name of the original token.
Always pay attention which token you’re trading and double check the token address!
But not only this, ‘phishing sites’ are common in the DeFi. Whereby phishers will ask you to enter your login information on a fake website/application that looks just like the original one.
Never share your login information such as seed phrases, passwords or personal information anywhere! No reliable protocol will ask this from you!
Liquidity crises
If suddenly something happens to the protocol in which you have money staked or deposited, and everyone wants to withdraw their money simultaneously, there could be a problem
Due the lack of liquidity, this will not be possible and because there will not be enough money to pay everyone out a crisis will happen. This is less likely going to happen to trustworthy protocols but this is still a risk you should be aware of.
Partisan governance
Some protocols give the option to the token holders to shape the future of their platform. While this democratizes a protocol it can also be detrimental. Large players, known as whales gain the ability to influence the future of a protocol to their advantage.
Votes for changes in the protocol can be favored in the interest of big players, leaving small DeFi users behind. We notice that the influence of central exchanges is becoming increasingly visible in DeFi.
De-pegging stablecoins
Every time you own stablecoins or pegged tokens, you run the risk of the de-pegging the token. Cryptocurrencies that are pegged to the dollar are at risk when they lose their 1:1 ratio.
This can cause the liquidity of the pool to go to 0, resulting in the stablecoins become worthless. Fortunately, this has never happened to a large stablecoin. But is still a risk to consider when you want to start in decentralized finance – DeFi.
Conclusion
We can conclude that DeFi, like any new technology, has a it risks. Users run the risk of being separated with their money in many different ways. This is both a challenge for the protocols as well as newcomers to decentralized finance.
So educate yourself and recognize how to hedge potential risks of the DeFi world!