Billionaire investors may have access to knowledge and endless resources, but decentralized finance (DeFi) fraudsters haven’t spared them. Their latest victim was Dallas Mavericks owner Mark Cuban. Although these scams happen almost daily, there are many reasons why DeFi is considered the future of finance.
Mark Cuban recently lost a fortune while trading on Titan, a DeFi token he took from Iron Finance that crashed to zero within a day. The Shark Tank investor on ABC said in a tweet: “I got hit like everyone else.” While not all coins could tank completely like Titan, every potential investor should stay informed. CoinShares Chief Strategy Officer Meltem Demirors maintains:
“I think it’s really important for people participating in the DeFi space to understand the risks and rewards […] people have been participating in DeFi without understanding the risks.”
According to CipherTrace, investors lost up to $156 million between January and April in DeFi-related cyber-attacks, while DeFi swindlers stole another $83.4 million. DeFi is still a buzz, and most blockchain savvy individuals are struck with the fear of missing out (FOMO). We share an expert view on what you need to know, including the risks and rewards.
What is DeFi?
DeFi is an Ethereum blockchain-based application that aims to re-invent the banking system using cryptocurrency. However, the program runs against a central service controlling the entire system. Just like your regular bank, users can lend out cryptocurrencies and earn themselves an interest. Lending and borrowing are the primary use cases for DeFi applications. However, more complex use-cases are merging, including becoming liquidity providers for decentralized exchanges.
A low barrier to entry to borrow at higher interest rates when compared to the traditional banking system makes DeFi more attractive. A borrower only needs to provide collateral in terms of cryptocurrency to avail of a loan. Also, depending on different DeFi protocols, a user can give non-fungible tokens (NFT) as collateral. Nonetheless, it’s these same attractive factors that make DeFi much riskier than your regular bank. Demirors adds:
“I think every DeFi protocol and every DeFi project has a different level of risk and a different level of reward […]. It’s important to understand the reason the reward is high is because the risk is higher. The reason we see high yield is there is a risk here.”
The Benefits of DeFi
DeFi transactions are secure, flexible, efficient, and more automated than in the regular financing model. What’s more, the model doesn’t discriminate between an ordinary user and a super-rich guy or institutions that traditional banks give more products. All users can lend money to borrowers and get the potential returns.
DeFi runs on open-source software codes, meaning users can modify them or combine them in numerous ways. For instance, users can easily switch their funds between various collateral pools to see more significant returns for their investment profile. It is benefits like these that have contributed toward DeFi’s exponential growth to peak at over $80 billion in crypto by May 2021 from $1 billion a year earlier.
The Risks of DeFi
On the flipside are several serious concerns every user must beware of. While DeFi can facilitate leverage, blockchain hasn’t eliminated potential investment risks. DeFi magnifies the volatility of digital assets, meaning more significant risks accompany the magnified gains. The lack of a regulator or intermediary means there’s no way to return any funds you transfer erroneously. Also, no one can pay back your investment in the unfortunate case that hackers discover and use vulnerability in the smart contract.
What You Need to Know
If you invest in a DeFi application, diligently vet the application to make sure it’s secure and well audited. Choose a blockchain protocol that’s controlled by a big team. They should have affordable transaction fees and can deal with heavy user demand. Avoid applications that are led by anonymous founders and those that don’t share their codes. John Wu, president of Ava Labs, says:
“DeFi is growing so fast, and the yields are so high that opportunities can feel too good to be true. When in doubt, trust your gut or look for more objective members of the community with the technical expertise to thoroughly review the code.”