The decentralized finance (DeFi) ecosystem has seen explosive growth in 2020, with the value locked in DeFi protocols reaching $13.5 billion by the end of November. This growth has been fueled by the launch of a number of new protocols and the influx of new users seeking to capitalize on the lucrative yield-generating opportunities that DeFi offers.
However, as the DeFi ecosystem has grown, so too have the risks associated with participating in it. These risks can be divided into two main categories: those associated with the protocols themselves, and those associated with the underlying blockchain infrastructure.
Protocol risks
The first category of risks is associated with the protocols themselves. These risks can be further divided into two sub-categories: technical risks and financial risks.
Technical risks
The first sub-category of risks is technical risks. These risks arise from the fact that most DeFi protocols are still in their early stages of development and as such, are subject to a range of potential technical issues.
One of the most significant technical risks is the risk of software bugs. Due to the complex nature of the smart contracts that power DeFi protocols, it is difficult to ensure that they are free from errors. If a bug is found in a smart contract, it could potentially be exploited by malicious actors to drain the funds locked in the contract.
Another technical risk is the risk of hacking. Due to the decentralised nature of DeFi protocols, they are often more vulnerable to hacking attacks than traditional centralised systems. This is because there is no central authority that can be held accountable in the event of a hack.
In addition, the way in which many DeFi protocols are designed makes them susceptible to what is known as the “long-tail risk”. This is the risk that a small number of users will control a large proportion of the assets locked in a protocol. This concentration of assets increases the risk of a “rug pull”, where the protocol is suddenly shut down and the assets are stolen by the protocol’s developers.
Financial risks
The second sub-category of risks is financial risks. These risks arise from the fact that DeFi protocols are often highly leveraged, meaning that users can take out loans with very little collateral. This increases the risk of a “margin call”, where the value of the collateral falls below the value of the loan and the user is forced to sell their assets at a loss.
In addition, many DeFi protocols make use of complex financial instruments such as synthetic assets and flash loans. These instruments can be difficult to value and as such, can lead to sudden and unexpected losses for users.
Finally, the high degree of liquidity in the DeFi ecosystem means that there is a risk of sudden and sharp price movements, known as “flash crashes”. These price movements can lead to losses for users who are holding leveraged positions or who have made use of complex financial instruments.
Blockchain infrastructure risks
The second category of risks is associated with the underlying blockchain infrastructure. These risks can be divided into two sub-categories: scalability risks and governance risks.
Scalability risks
The first sub-category of risks is scalability risks. These risks arise from the fact that most blockchain networks are not yet scalable enough to support the high levels of activity that are taking place in the DeFi ecosystem. This is because each transaction that takes place on a blockchain must be verified by all of the nodes in the network, which can take time and consume a lot of energy.
As a result, there is a risk that the DeFi ecosystem will become overloaded and will not be able to handle the increasing number of transactions taking place. This could lead to a “congestion” of the network, which would make it difficult for users to access their funds and could lead to a loss in value.
Governance risks
The second sub-category of risks is governance risks. These risks arise from the fact that most DeFi protocols are governed by decentralized autonomous organizations (DAOs). These DAOs are often controlled by a small number of people, which can lead to a concentration of power.
In addition, the way in which many DAOs are structured means that there is a risk that they will make decisions that are not in the best interests of the users of the protocols they govern. This could lead to a loss of value for the users of the protocols.
Finally, the fact that most DeFi protocols are built on top of Ethereum means that they are subject to the risk of a hard fork. A hard fork is a change to the Ethereum protocol that is not backwards compatible, which could lead to two different versions of the protocol being created. This could lead to a loss of value for the users of the protocols.
Conclusion
The risks associated with DeFi protocols are numerous and varied, but the need for greater regulation is clear. The decentralised nature of these protocols means that there is no central authority to provide oversight or protect users from losses. This has led to a number of high-profile hacks and scams, costing users millions of dollars.
The lack of regulation also makes it difficult for users to know which protocols are safe to use and which are not. This creates a risk-averse environment that could stifle innovation in the space. The need for greater regulation is clear, but the path forward is uncertain.