Demystifying DeFi
Risks vs. Rewards
The DeFi space has seen rapid expansion over the past year. Capital has been flooding into the ecosystem at an eye-opening rate. At the time of this writing, there is $8.3 billion locked in the DeFi ecosystem.
This capital inflow highlights the strong interest in the breadth of services merging in the DeFi space. These services have the potential to provide cost-savings, efficiency and new opportunities. But many are still struggling to wrap their mind around what DeFi has to offer.
In this article, we will answer some of the common yet important questions on DeFi:
— What exactly is DeFi?
— What are the benefits of using the DeFi ecosystem?
— What are the associated risks?
DeFi — Explained Simply
DeFi is simply the abbreviated form of “Decentralized Finance.” A simplified breakdown of these terms would give us the following:
Decentralized: removal of central control or authority
Finance: the management of money
Essentially, DeFi encompasses the notion of “Money management without a central authority.” Put another way, DeFi is peer-to-peer money management. Some of the facets of money management that we are familiar with include the following:
— Lending money
— Borrowing money
— Trading on Exchanges
— Market making
DeFi is the recreation of these financial activities without a central authority: P2P lending & borrowing, P2P trading, automated market making and so forth. Some examples of projects providing these financial services in a decentralized manner are listed below:
Lending & Borrowing: Aave is a popular noncustodial protocol that allows for p2p borrowing and lending of assets. This allows for more access, inclusivity and better return on investment for both ends of the financial transaction.
Exchanges: IDEX and Loopring both feature a decentralized exchange that allows users to hold the keys to their assets while trading. This is in contrast to centralized exchanges that have control of the users assets, and thus pose increased counterparty risk to the user.
Market Making: Uniswap is a popular Automated Market Making protocol. Individual users deposit their assets into a “liquidity pool.” This pool is then used in conjunction with the protocol to provide market making services to users who want to swap one asset for another. The users who deposit their assets into the “liquidity pool” generate the fees that would have been collected by the exchange (or market maker).
Advantages of DeFi
Decentralized Finance brings several benefits to the table. However, all of these benefits stem from the core feature of “decentralization.” After all, DeFi services are simply offering financial “tools” that already exist in the traditional market.
The main differentiator here is there are no arbitrators or intermediaries. The software handles all decisions and disputes in a manner that will align with the incentives of the users.
From this core feature of decentralization, we get a series of advantages:
- Inclusiveness: DeFi allows for anyone to take advantage of financial services that would otherwise be unavailable to them in the traditional space. There are currently 1.7 billion people who do not have access to basic financial services due to gatekeeping. Decentralization eliminates this gatekeeping and allows access to everyone who has a connection to the internet.
- Reduced counterparty risk: In DeFi ecosystems, users have complete control of their funds at all times. This is in stark contrast to traditional systems, where intermediaries are trusted with assets.
- Reduced cost of services: Intermediaries and arbitrators extract fees from the end users of financial services and thus increase the cost of these financial services. Since decision making of financial products in the DeFi ecosystem are mainly determined by code and decentralized governance models, the costs of the services are drastically reduced.
Risks of DeFi
The opportunities within the DeFi ecosystem are definitely alluring. However, these opportunities aren’t without risk. The decentralized nature of these financial services provides the end user with far more control than they would have had with traditional services.
However, this newfound control and autonomy comes coupled with unfamiliar responsibility. After all, it is a new ecosystem with new dynamics. It is the responsibility of the end-user to familiarize himself with its associated risks. For the purposes of brevity, we will discuss some of the major risks in a few sentences.
Smart Contract Risk
One of the core value propositions of the DeFi ecosystem is that there is no controlling arbitrator or intermediary. Essentially, there is no single human being, or group of humans, that controls the decision making. This value proposition is facilitated by the use of smart contracts, which are essentially pieces of code that replace middlemen as the decision makers.
However, it is within this core value proposition that we have our biggest risk. Smart contracts are still written by human beings. And as humans, we are prone to errors. A bug in the code (deliberate or otherwise) could lead to massive financial losses.
An example of such an incident was when Parity Technology implemented a multisignature wallet using a smart contract that had a bug that went unnoticed. The bug was eventually triggered and resulted in ether (worth almost $300 million dollars at the time) being lost. Today, the value of this lost digital currency would be closer to $400 million.
Spectrum Of Decentralization
Many DeFi products have points of centralization embedded within the protocol. These points of centralization tend to be obscured and go unnoticed. For example, a DeFi product may have embedded “Admin Key” rights.
The Admin Key may allow either a single person or a group to make decisions that may be either helpful or harmful to the entire network. In August 2020, the Yearn Finance community was made aware that Andre Cronje, the protocol’s lead developer, had control of funds amounting to $40 million.
However, the developer was prompt to hand over control to the community of stakeholders. The situation was handled elegantly and swiftly. There was no malicious behaviour — but this may not be the case with other protocols in the future.
As such, a DeFi product may not be as decentralized as a user may believe. The decentralized nature of DeFi products shouldn’t be considered binary but rather as a “spectrum” of decentralization. Some products are “more” decentralized than others, and end users should consider the associated risks involved.
Network Congestion Risk
DeFi Applications are built on blockchains. While blockchains offer the core feature of decentralization, they struggle to balance that with the appropriate amount of scalability and security (the blockchain trilemma). Usually it is the scalability that is sacrificed in an effort to prioritize security and decentralization. This leads to network congestion during critical periods.
If a user is in desperate need of his funds during a period of network congestion, he may have to face exorbitant fees to withdraw his funds. This is a real risk that many users fail to take into consideration when utilizing these DeFi services.
Operations on the blockchain operate under the true essence of capitalism. There are no price ceilings or price floors. When many users are competing for the same services, fees can become shockingly high.
In August, Ethereum miners raked in $117 Million dollars worth of profits from transaction fees. If network activity is high, and a user wants a speedy settlement of his transaction, he may need to fork over fees that may eat into his profits (or increase his losses). The alternative is to sit through extremely long queue times — perhaps indefinitely.
Hence, users should be cognizant of the fact that their funds may be difficult to access during periods of market exuberance and/or anxiety.
Conclusion
The past few months have seen the DeFi space pick up a lot of traction. The developments surrounding DeFi threaten to alter the way we conduct finance in the near future. However, while this new space may usher in exciting opportunities, it also brings forth new risks. Some of these risks may lead to disastrous consequences if left unchecked.
This article provided a brief overview of some of the major risks associated with Decentralized Finance. New entrants are urged to further investigate and evaluate all possible risks before making any serious investment decisions.
Similarly, skeptics are encouraged to explore these new opportunities with an open mind, albeit critically. Decentralized Finance has been attracting increasing amounts of capital, while maturing at a rapid pace. Laggards may find themselves struggling to play catchup if they choose to sleep on the exciting developments unfolding in this space.
