Decentralised finance (DeFi) has gained significant popularity recently, and most people looking for an alternative to centralized financing are more than happy with this new concept.
DeFi is a blockchain-based application network that provides various financial services identical to those offered by traditional financial institutions. The only difference is that decentralized applications, called dapps, run autonomously i..e they do not need any third party as an intermediary. This is because dapps are powered by smart contracts – a special transaction protocol that automatically executes a relevant task when certain predefined conditions or requirements are met.
Through Defi lending, users can now lend their tokens into a liquidity pool and earn attractive returns on these tokens that would otherwise be sitting idle in a crypto wallet. Though this is a beautiful opportunity, it also comes with significant risks.
In this article, we will discuss some of these risks associated with DeFi lending platforms. These include:
When you lend your tokens to a liquidity pool, you risk something called “impermanent loss.” Impermanent loss happens when the price of your assets locked up in a liquidity pool fluctuates after being deposited, leading to an unrealized loss compared to if the liquidity provider had the assets in their crypto wallet.
Since cryptocurrencies are highly volatile, there are chances that the value of your tokens will change after you have deposited them in a liquidity pool.
DeFi protocols involve very little human oversight as these are software applications that run on the internet. Transactions worth millions or billions of dollars are happening across them. DeFi protocols have two main software risks – coding errors, “bugs” that can malfunction software and security vulnerabilities due to which “hackers” break in and steal funds from the protocol. Many popular DeFi protocols, including Yearn Finance, Thorchain, and Pickle finance, have been a victim of hacking when hackers exploited security vulnerabilities in their software. Usually, DeFi protocols with higher deposits and longer track records are considered to have less Software Risk compared to the newer or smaller DeFi protocols.
Flash loan attacks:
Flash loans are another challenging feature of DeFi lending. They allow users to borrow crypto worth millions of dollars with no collateral. The catch is that one has to repay the loan very immediately. This means that the loan should be repaid within the block time of the DeFi platform’s underlying blockchain.
This can be misused because those with bad motives can take out massive loans, converting them into whales and thus influencing a token’s prices. They can also pump the borrowed crypto assets into a vulnerable pool having low liquidity. The rise in the value of one token leads to a dip in the value of the paired token. With this manipulation, they can now buy large amounts of the paired token to sell them in the open market to make gains.
After that, they return the borrowed amount and keep the gains. Amidst this, the price of the dumped token falls drastically because of surplus supply. Thus, if you owned tokens in either of these vulnerable pools, their value will drop considerably owing to the impermanent loss.
DeFi rug pulls:
Over the last few years, there has been an increase in DeFi rug pull incidents.
Rug pulls refer to a type of exit scam wherein fraudulent DeFi developers develop a new token, pair it with a valuable cryptocurrency like tether or ether and create a liquidity pool. They then pump up the price of the newly created token and motivate people to deposit into the pool, often offering high yields. Once the pool collects a significant amount of the leading cryptocurrency, the DeFi developers then exit the project, thus taking investors’ funds.
The simplest way to protect yourself from rug pulls is by entering already established liquidity pools having known crypto pairs. It is not wise to put your money in a liquidity pool with some unknown Nft token.
DeFi is as complex as it is new. Sometimes mere bugs in the smart contract can result in massive losses even though it is no one’s fault. Thus, it is always essential to do detailed research, understand the consequences, and invest only when you think you are prepared to lose the entire amount.