Demystifying DeFi, risky business or not
The crypto community has become very familiar with super-high APRs on all primitives from spot exchanges to money markets to perpetual protocols. However, how well do users understand the risks of using these protocols?
This article will educate readers on the risks associated with DeFi protocols by giving two examples of primitives that can create large value loss. It will reinforce the need for users to review and understand the protocols that they interact with.
Spot Exchanges
Fortunately, most are aware of the risk of impermanent loss when using automated market makers. This is where users observe an uncrystallized loss in value when the ratio of assets in the liquidity pool changes over time. Typically, incentivization of liquidity is sufficient to offset this risk. However, how does the type of AMM impact impermanent loss?
Constant product market makers such as UniSwap v2 (and the early iteration of Osmosis) worked by evenly distributing liquidity across all possible price ranges. The next evolution of exchanges such as UniSwap v3 and Curve v2 both used different forms of concentrated liquidity resulting in more liquidity being distributed within a tighter range.
As a consequence, traders can trade more efficiently with lower slippage. This is beneficial for liquidity providers as it allows them to earn more trading fees. However, it exposes them to a greater risk of impermanent loss too.
Users need to consider this when using exchanges that use concentrated liquidity. The greater efficiency of modern exchanges means that protocols emit lower incentives to liquidity providers which makes them more sensitive to impermanent loss.
Perpetuals Protocols
Perpetual futures markets exist as an innovation that was driven within the DeFi space far beyond what was available previously. Some well-known protocols have used a model that allows users to deposit liquidity to act as a counterparty to traders in exchange for yield. However, many users unknowingly deposit their liquidity in this type of protocol without understanding what is at risk.
At any one time, a market will have traders positioning long and short for an asset. Ideally, markets will want to have equal longs and shorts (thus having minimal skew). Where the skew is large in any direction, it exposes the liquidity providers to risk. While liquidity providers can make even more profit above fees when the price moves against the net traders, they can also lose value if the price moves in favor of the net traders.
Consequently, users need to understand how the perpetual protocol manages skew and risk to understand how exposed their liquidity is to trader performance.
Other General Risks
Several other items can impact users of DeFi protocols that are not specific to any one type of primitive. These include:
- Smart Contract Risk: Vulnerable smart contracts have given rise to some of the biggest value destruction in the DeFi space. The growth of the crypto space has resulted in large amounts of reusable open-source code. However, building bespoke and unique products risks being insecure. Many exploits have come as a result of reentrancy bugs, flash loans, and faulty logic. These can be partially mitigated by having open-source code in tandem with bug bounties and conducting audits of the code and its underlying logic.
- Multi-Sig Risk: Many protocols implement multi-sigs as a last line of defense for the protocol. This is prevalent in Layer-Two blockchains which use multi-sigs to upgrade smart contracts without delays in response to potential security concerns. Many DeFi protocols also include multi-sigs as part of their design. However, these could be exploited by malicious actors to implement upgrades that could see liquidity drained from pools.
- Governance Risk: Similar to risks associated with multi-sigs, protocols that require governance to approve upgrades could also be vulnerable to malicious token holders being able to vote through an upgrade. Moreover, malicious token holders may also be able to use their holdings to extract amounts from treasuries that are controlled by governance.
Conclusion
At this point of the article, you may be questioning whether you should be using DeFi at all, or whether Nolus is safe to use. We recommend and invite our users to go through this article step-by-step and understand what they are using.
DeFi can be done safely, and when done properly, it is especially rewarding and demonstrates clear value above and beyond that which is available in the TradFi world.
If you have any questions about the design and choices made by Nolus, we invite you to our Discord server where we can help bring you up to speed!
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