Guest Author: Sviatoslav Pinchuk, editor at TradeCrypto.com
Author link: https://tradecrypto.com/author/esferus/
Types of DeFi Risks
The decentralized finance market has become one of the major breakthroughs of recent years. New promising projects appear every day, attracting many investors. At the same time, DeFi remains a relatively isolated part of the cryptocurrency market due to the novelty of many services and investment risks.
The presence of risks is an integral part of any emerging market. But even despite the risks, DeFi attracts new users and allows you to earn on new technologies. In this article, we want to tell you what are DEXs, and what risks investors face in the DeFi markets and share tips on how you can protect your pocket from them.
To begin with, we note that risks can be attributed to several conditional categories. The first of these is hacker attacks that many large DeFi projects are exposed to. The second group of risk of DeFi is associated with state regulation and in some cases its absence. Another group of risks may be associated with your counterparty or project token, which directly depends on the actions of the team. Now let’s look at these areas in more detail.
photo: Financial Times
Top 5 DeFi Risks
DeFi as a new sector of the economy continues to be explored, and therefore carries certain risks for investors. The main DeFi risks when working on markets are:
- Smart Contract Risks;
- Legal Risks in DeFi;
- Counterparty risks;
- Token Exposure Risks;
- Impermanent Losses.
Now, let’s dive into each of these risks, and explore how we can stay safe when trading and investing in crypto. If you are interested in exploring this topic further, you can find detailed guides on DeFi at tradecrypto.com.
#1 Smart Contract Risk
DeFi uses smart contract technology to function. The code of such protocols contains information about the contract itself, its conditions, participants and amounts of the transaction. Valuable information makes smart contracts a tasty target for hackers. In this way, attackers steal large sums because of DeFi liquidity pools risks or specific transactions.
Smart contracts are most vulnerable when deployed. Practice shows that if hackers fail to install a vulnerability at an early stage of the protocol’s existence, then over time the probability of its cracking decreases. However, even in this case, you need to understand that the smart contract DeFi risk remains, because smart contracts store funds for a certain period.
Photo: Dollero Technology
It is also important to understand that large liquidity pools attract more attention from attackers. But at the same time, they spend more effort to prevent attacks. With this in mind, the amount of funds in a smart contract directly affects the likelihood of a hacker attack.
#2 Legal Risk in DeFi
Despite the philosophy behind the name of the financial industry, the real situation is quite different. The DeFi market has shown significant growth over the past three years. As the industry develops, so does the pressure from government regulators. DeFi has become most popular in the United States, where the SEC has repeatedly expressed a desire to develop mechanisms for controlling the industry. This is why the statement on DeFi risks, regulation and opportunities was introduced, as the first step in an attempt to implement taxes and regulations on crypto traders.
Another problem with DeFi has to do with the growing level of centralization. This makes financial transactions more transparent, but also allows government agencies to monitor and sanction unscrupulous market participants.
Photo: ThinkAdvisor
The decentralization of the DeFi market is the main advantage of the industry compared to other institutions. Decentralized markets are a completely new page in the global economy, but they are trying to regulate it with old regulations. And the higher the level of centralization, the more the industry will fall under the sanctions of the regulator. This, in turn, will provoke transformations within the industry and DeFi will lose its main distinguishing features.
Tax consideration
A less pressing issue with DeFi is taxation. Of course, not in terms of budget revenues. The main questions relate to the taxation of transactions under a smart contract. The problem is that in any liquidity pool, transactions are most often made in tandem with fiat funds, such as USD and EUR. Such a transaction occurs every 15 seconds, and therefore the introduction of a tax on each individual transaction would eliminate the profitability of such transfers.
#3 Counterparty Risk
Despite the ephemeral nature of the decentralized finance market, there are also people behind it. Each project has its own development team, PR department and creators. It is extremely beneficial for projects to disclose their teams and make contact with a potential investor. However, this does not prevent your counterparty from causing your financial losses.
The main risks arise when the user encounters an anonymous command. Therefore, doxy-team projects are very popular on the DeFi market. These are teams where developers and creators do not hide their personalities and actively interact with the audience. Collaborating with an anonymous team, the investor has much more risk to see the project token at $0, while its creators have already flown somewhere to Seychelles.
photo: Soject.com
Therefore, transparency is important in the DeFi sector. Investors want to see the project team, understand that its members have the skills to develop the project. Here, social networks like Twitter, Discord and Medium play a key role, in where information is disseminated. It is important to be in touch with the development team and control the flow of news in order to be more flexible in terms of avoiding risks.
#4 Token Exposure Risk
The impact of the price of a token due to its volatility is one of the main risks in DeFi. For the most part, beginners who do not fully understand the operation of the general system are exposed to it. However, experienced users are not immune from a sharp change in the price of a token.
Such risks arise from the desire to make excess profits or to acquire an asset with increased risk. Such tokens include projects with low liquidity and capitalization. On the one hand, such digital assets provide more opportunities to earn money through scarcity. But on the other hand, this is a very dangerous undertaking due to increased volatility and unforeseen problems with exiting a trade due to lack of liquidity.
photo: bitcoinlist
Such risks primarily concern small projects. Popular tokens that are traded on large DEXs have fairly large liquidity pools. This greatly reduces the risk of losing capital due to the volatility of the token.
Staking cryptocurrencies on DeFi is also considered a big risk. This is due to the instability of cryptocurrencies, which can cause the loss of all your funds. And you would have staking risks on Binance and DeFi. This will always come with risks due to the volatility of the cryptocurrency and the lack of access to it for a certain period after the start of staking.
#5 Impermanent Loss
Intermittent losses are a key risk in the DeFi market. The main problem with such losses is that they are almost impossible to avoid. The greatest risk of losing part of the capital is in bilateral liquidity pools.
For example, let’s take two pools on Uniswap: UNI-USDC and UNI-ETH. The decentralized platform token is based on the Ethereum blockchain and therefore has more correlation (codependency) with an altcoin than a stablecoin. Because of this, with sharp changes in the price of ETH, the price of a DeFi token is more likely to follow Ethereum,
The conclusion suggests itself that regardless of the price movement, the liquidity provider will almost always be on the disadvantageous side of the transaction. And consequently, it will incur non-permanent losses.
DeFi Opportunities and Risk Management
Even though the Statement on DeFi Risks, Regulations, and Opportunities has been published, it is still a bit confusing for some readers. Let’s try to break down the most important highlights you will need in your trading business.
Audit
An effective way to counter any problems is a security audit. There is a big difference between audit programs. Quality security audits report on the following:
- The number of engineer hours.
- Constant source code monitoring
- Number and level of hacker threats and bugs found
- Code Diagnostics
It is extremely important for the project and developers to have an understanding of the source code and the possible identification of weaknesses.
Of course, such a number of problems provoked an active discussion on the DeFi risk score. As a result, some effective ways to reduce the risks when working in decentralized markets have emerged.
Diversification
Don’t put all your eggs in one basket. Everything is clear here: the more valuable and growing tokens in your investment portfolio, the more likely you are to break even when exposed to one of the risks of working with DeFi.
It is also worth thinking about the distribution of assets across different DeFi protocols. This is especially important if you are trading high yield tokens with limited liquidity pools. This approach will allow you to protect funds from losses.
photo: ArthurD.Little
Trading and web bots
Another important way to avoid risks when working on DeFi protocols is to anticipate them. To do this, there are web3 scripts, where the user can configure the parameters of transactions and trading strategies. An automated DeFi risk management system will allow you to avoid the emotional component and other risky elements when dealing with DeFi.
When working with different exchanges, there will always be questions on which to use, where you can find better opportunities, what are Sushiswap and Uniswap, which one to use, and so on. We welcome you to explore our website for more useful information and trade safely!
The DeFi sector continues to evolve and change rapidly. With this in mind, it will be beneficial for any investor to constantly move capital. This significantly reduces the likelihood of exposure to risks. At the same time, the new possibilities of decentralized markets give you additional ways to make a profit.
About the Guest Author:
Man who simply bought some BTC for domestic needs in 2014 and then forgot about it till 2017. The dude who got Etherium in 2017 by misclick and sold it in 2018 “just to try”. Lost 1 Florida house in XEM in 2018, Sviatoslav finally decided to trade reasonably and now he is one of the most analytical and data-driven trader in Crypto Industry. Has Bachelor Degree of Chinese Interpreter and deep practical experience in competitive niches SEO.