Risks Involved in Decentralized finance (Defi)
Introduction
DeFi refers to an ecosystem of financial applications that are built on top of a blockchain. Its common goal is to develop and operate in a decentralized way, without intermediaries such as banks, payment service providers or investment funds
However, due to the rapid and insurgent growth of the DeFi platform, there are certain risks that are involved in the system which can be challenging.
In this article, we will provide a detailed guide on the vulnerabilities associated or the risks involved in the Decentralized finance. Let us look into this review in detail now,
What is Defi?
Decentralized finance (Defi) is also commonly referred to as Open Finance. One of the main significant benefits of Defi is that it provides an open ecosystem for individuals who otherwise would not have access to any financial services. It offers convenient access to those users.
DeFi is still a nascent technology and the real-time adoption lags far behind the promising theory. In order to gain the trust of people and institutions beyond the crypto-native community, DeFi applications have to overcome some major obstacles and risks. Risks Involved in Decentralized finance (Defi) briefly listed below:
Usability Risk
A major weak point closely related to the technical implementation is the usability or user experience of Defi protocols. These are often complicated, unintuitive, and designed for crypto-native users. Defi projects have struggled to gain traction beyond those that are inherently familiar with Ethereum. Many products require users to handle multiple tokens within their own, non-custodial wallets.
Realistically, it is still way too early for the mainstream audience to risk their money in this complicated and unchartered territory. Once the technical and regulatory risks are addressed, the UX of DeFi products will certainly be one of the top priorities for developers.
Centralization Risk
Many DeFi applications were kick-started by a certain team or company and are far from being truly decentralized. Although once established, they generally aim towards decentralizing governance and decision making. As long as an application is semi-centralized, counterparty risk exists and the intermediary that has control over the assets may use the funds maliciously.
On the other hand, once these DeFi projects grow in terms of user base and assets locked in, they will definitely fall under stronger regulatory scrutiny and a financial supervisory. Financial regulation will require some degree of responsibility and competent counterpart, which could, in turn, engender a move back towards a more central administration of DeFi projects.
Liquidity Risk
Liquidity is crucial for efficient pricing in the financial industry. Currently, liquidity in DeFi protocols is largely outpaced by central alternatives with many low-fee liquidity providers that stabilize traditional finance. The liquidity risk is closely related to technical risks, i.e. the aforementioned technical scalability and congestion issues on the Ethereum platform.
In times of crisis, the Ethereum network becomes so congested that arbitrageurs and liquidity providers cannot keep prices in a line across venues, causing massive dislocation on individual exchanges, which then triggers uncertainty and the markets to drop.
Regulation Risk
Decentralized projects operate without a license in most jurisdictions, regardless of where the end-user is based. With regard to taxation, the handling of DeFi assets is also not clearly outlined in most jurisdictions.
In the same way that regulators around the world are currently addressing regulatory questions regarding crypto-assets, such as establishing new license regimes for crypto custody. The Libra association, renouncing to move towards a fully permissionless system in view of the political and regulatory pressure, seems to support these ideas.
Collateral Risk
There are certain risks involved in some forms of collateral for securing loans. Excessive collateral reduces the risk of volatility. This requirement does not guarantee full coverage of the loan amount if the price of an asset falls too quickly.
DeFi assets and products will certainly fall under stronger regulatory scrutiny given that the user base and locked-in-assets will further grow. Financial regulation will necessarily require some kind of responsible counterpart, which makes truly decentralized governance and decision-making processes for Defi products not yet imaginable.
Volatility risk
A distinguishing point is the volatility of interest rates on many DeFi platforms, which creates doubt on the meaning of participating in them. Most likely, there will be agreements on replacing the floating interest rate with a fixed one, or other methods of fixing rates for an additional fee. This further introduces difficulties in the overall process.
Today, DeFi activity is about 1% of the total crypto market activity, which itself is tiny in comparison with global financial markets.
Oracle Manipulation Risk
Blockchains rely on oracles to get information from outside sources. In DeFi, the biggest dependency on oracles is the price information. The markets determine the price of ETH when compared to the Ethereum blockchain itself. Therefore, price data is fed in using oracles. The oracle may be the average of multiple DEXes or exchanges, DEX such as Uniswap, or an oracle service such as Chainlink.
Oracle manipulation becomes risky when a DeFi dApp uses only a single exchange, or perhaps even two exchanges, as an oracle. Traders can manipulate the price information provided by an oracle by trading a large enough transaction to sway the price.
Smart Contract Risk
One of the cons of Decentralized finance (DeFi) is that it relies heavily on the integrity of smart contracts and the underlying blockchain protocol. Any failure in the code could lead to a hack and to massive losses for users of a decentralized application. It is almost impossible to code error-free, particularly if one has to take into account future developments of the blockchain protocol.
Additionally, the detection of bugs in smart contracts is quite a complicated endeavor, partly due to the novelty of the technology and missing standardized procedures.
Ethereum Dependency Risk
DeFi is very much heavily dependent on Ethereum. Scalability is Ethereum’s biggest weakness, with transaction speeds of around 15 TPS the norm even now, over five years into its lifespan. Furthermore, Ethereum is struggling to keep up as the stable coin transactions are dominating the network traffic.
The long-promised ETH 2.0 upgrade may resolve the issue but the full implementation still appears to be a few years away. So for now, DeFi’s dependence on Ethereum remains on the list of vulnerabilities.
Technical Risk
The technical risks regarding the underlying blockchain protocol (layer 0) also have to be taken seriously. Nearly all relevant DeFi projects are built on top of the Ethereum blockchain. Ethereum has faced a few clogging issues on its blockchain which is related to high usage.
The transaction can remain in a pending state if the network gets trafficked which ultimately results in market inefficiency and information delays. Those technical scalability problems are closely related to liquidity risks.
Conclusion
Overall, the blockchain-powered space of Decentralized Finance is clearly still in its very early days. In 2020, the monthly number of DeFi users ranged between 40,000–60,000, with 90% using decentralized exchanges.
Nevertheless, it is also clear that DeFi offers immense disruptive potential and a very compelling value proposition. Whereas the individuals and institutions make use of broader financial applications without the need for trusted intermediaries.
