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The Risks and Rewards of Decentralized Finance (DeFi)

25 August 2022

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The Risks and Rewards of Decentralized Finance (DeFi)
Defining DeFi By What It Seeks to Fix / Types of Decentralized Finance Applications / Main Risks of Decentralized Finance / Key Takeaways: / 

DeFi changes how we interact with finance, but it also comes with a number of risks.

Decentralized Finance (DeFi) is a term that describes the ways someone can hold and exchange value without the use of intermediaries such as banks or corporations. DeFi uses decentralized technologies built on crypto rails to provide the services of typical centralized institutions. DeFi is an emerging ecosystem of protocols and applications seeking to create a more open, equitable, and accessible financial system. But DeFi is young, and it's no stranger to controversy, confusion, and a high degree of systemic risk.

DeFi promises the world, but can it deliver? Let's dive in.

Defining DeFi By What It Seeks to Fix

Currently, most of our financial services exist in a centralized ecosystem. Central authorities oversee transactions and manage user funds along the economic spectrum. Specifically, banks and payment processors act as intermediaries between funds, merchants, and customers in a complex web of centralized control and digital systems, charging fees at every step. The result is that people pay large sums of money to intermediaries without the ability to see how their money moves and functions.

There's also a level of centralization in financial services that goes beyond banks and payment processors. Wall Street provides investment services for the stock market, bonds, and commodities like gold. They also utilize leveraged trading, which allows investors to trade with more money than they have in their accounts. This system creates an opaque, high-risk environment where a select few can make a lot of money while the average person loses out.

The common thread between these centralized financial systems is that they're all middlemen we have no choice but to trust. We trust banks to keep our money safe and accessible, while we trust Wall Street to provide accurate information about investments. But this trust is often misplaced, as we've seen in countless instances of fraud, corruption, and mismanagement. Power implies that those in charge can abuse it, and we've seen this play out time and again in the world of finance.

The DeFi ecosystem is susceptible to security risks and disruptions, so it's essential to do your research before investing. That said, DeFi has the potential to revolutionize the financial system as we know it. Still, it will need more battle testing, better regulations, and more development before it's ready for mass adoption.

DeFi seeks to liberate all forms of finance from the clutches of intermediaries and central authorities. It's quite the lofty promise, so how does DeFi plan on achieving this?

Types of Decentralized Finance Applications

To know how DeFi plans to achieve its goals, we need to understand the different types of DeFi applications. Of course, traditional finance applications are numerous and grow in number every day, but they can be broadly categorized into a few different categories—as can DeFi.

Let's review the main types of DeFi:

  1. Decentralized Exchanges (DEXs)—DEXs are DeFi applications that enable the exchange of cryptocurrency assets in a decentralized manner. In other words, no central entity regulates or oversees the transactions. Instead, smart contracts power token exchanges and record them on the blockchain.
  2. Derivatives—Derivatives are DeFi applications that allow users to speculate on the future price of an asset without actually owning the asset, like futures contracts. The most popular DeFi derivative protocol is Synthetix, which allows users to trade "synthetic" assets on the Ethereum blockchain. For example, a user can trade a synthetic asset that tracks the price of gold without owning any gold or the price of Ethereum without owning any ETH. The performance of the "synth" hinges on the underlying asset's price movements.
  3. Yield Farming—Yield farming is a DeFi application that allows users to earn interest on their cryptocurrency holdings by lending them out or staking them in protocols. Users lend their cryptocurrency to DeFi protocols to add liquidity to the ecosystem and earn interest in return.
  4. Lending and Borrowing—Lending and borrowing DeFi applications allow users to earn interest on their cryptocurrency by lending it out or borrowing it when needed. A DeFi protocol automates the process and takes care of the administrative tasks, like managing the loan agreement, processing the repayments, and so on. Widespread lending and borrowing platforms include MakerDAO, AAVE, and Compound.
  5. Stablecoins—Stablecoins are DeFi applications that seek to provide a more stable alternative to traditional cryptocurrencies, like Bitcoin and Ethereum. Stablecoins are pegged to a fiat currency or asset, like the US dollar, and seek to minimize price volatility. In a perfect world, a dollar underpins each stablecoin in circulation (1:1 ratio), but we've seen that this isn't always the case. Tether (USDT) is a popular stablecoin that's supposed to be backed 1:1 by USD, but there's been much controversy surrounding this claim. If a stablecoin refuses to release an independent audit of its USD reserves, it raises a lot of questions about the project's

Main Risks of Decentralized Finance

DeFi can be one of the riskiest forms of cryptocurrency investment as it's still a relatively new industry with many untested protocols.

  1. Systemic risk—If there's an issue within a DeFi protocol (for example, a buggy smart contract), it can have a ripple effect that spreads to other protocols and even disrupt the entire ecosystem. Disruptions to consensus (as seen in Solana) or lax code review can lead to even more significant security risks.
  2. Governance risk—The governance model for a DeFi protocol is vital as it decides how protocols are updated and what happens when issues arise. With no regulations or audits of those involved, it can be challenging to gauge the competence of the people working on a protocol. Some governance systems allow token holders to participate in decision-making, but these can be susceptible to vote buying and manipulation.
  3. Liquidity risk—Many DeFi protocols require users to add liquidity to earn rewards, but this comes with the risk of being stuck in an illiquid position. If the value of the assets in a pool falls below a certain level, it can be hard to exit the position without taking a loss.
  4. Oracle failure—Data oracles are vital to DeFi protocols as they provide the information to trigger smart contracts. For example, a DeFi protocol might use an oracle to provide the price of an asset, say the price of Ethereum. If the oracle fails to deliver accurate information, it can trigger a cascade of events that lead to the loss of funds. In addition, data oracles often rely on other oracles for their data, so there is a risk of multiple failures.

Decentralized Finance, as it stands, is a technological experiment—DeFi protocols on Ethereum and several other platforms are still in their infancy. The DeFi ecosystem is susceptible to security risks and disruptions, so it's essential to do your research before investing. That said, DeFi has the potential to revolutionize the financial system as we know it. Still, it will need more battle testing, better regulations, and more development before it's ready for mass adoption.

Fundamentally, Bitcoin is purely an application of decentralized finance. However, it's not usually considered part of the DeFi ecosystem because it doesn't run on Ethereum or other platforms. As a result, it can't take advantage of DeFi protocols, so it doesn't offer the same features as other DeFi projects. But this is for a good reason.

We've talked about this before, but Bitcoin is boring. It's just digital money. That's it. But that's a good thing. The protocol is the most secure cryptocurrency, and we need money to be secure. Protocol hacks, liquidity runs, and oracle failures can lead to the loss of millions of dollars in DeFi. We've seen it happen repeatedly, and we can't have that with money if we want a genuinely decentralized financial system.

But if we build on top of a secure protocol, whether it's through Lightning or companies that build on the Bitcoin blockchain (subtle NOAH plug), then we can start to add more "DeFi" features and build a decentralized financial system on top of Bitcoin. We can still offer interest on savings, options for collateralizing your holdings, and ways to earn rewards for participating in the network. But all of these features are built on a rock-solid foundation that entities can't manipulate in the same way DeFi protocols can. As a result, the systemic risk is magnitudes lower.

Key Takeaways:

  • DeFi is a decentralized form of finance that uses blockchain technology to provide everyday financial services without intermediaries or centralized authorities.
  • DeFi hopes to decentralize borrowing, lending, derivatives, and exchange trading through protocols built on Ethereum and other platforms.
  • DeFi protocols are still in their early stages and are susceptible to security risks regarding protocols, governance, liquidity, and data oracles.
  • DeFi as an industry is still an experiment, and it needs time to develop better regulations and protocols before reaching mass adoption.

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