The Risks and Rewards of DeFi
Decentralized Finance (DeFi) is one of the fastest-growing sectors of the crypto industry. DeFi platforms enable users to engage in traditional financial transactions like lending and borrowing through direct peer-to-peer exchanges, eliminating the role of traditional financial intermediaries by directly mediating the transfer of value. DeFi has generated high yields for investors, which makes it an attractive space to be in, however it also comes with certain risks which users should be aware of, and learn how to properly manage for positive outcomes.
Let’s dive deep and understand different types of risks in DeFi and how to deal with them.
1. Smart Contract Attacks
Since codes are what make smart contracts function, hackers can figure out a way to manipulate these codes to their advantage. They can also find loopholes within the codes to exploit the system. One such well-known risk associated with smart contracts is the Flash Loan Attack.
Flash Loans are uncollateralized types of loans, meaning they don’t require any form of a deposit to complete. Hackers can use flash loans to execute a series of transactions in the same instant that typically allow them to attack user funds by draining liquidity pools.
The good thing about smart contracts is that they are open-source, meaning anyone can access them and change the coding. However at the same time, this open source nature makes it easier for bad actors to find exploits and flaws. That said, with every new hack attempt, smart contracts can be reinforced, making them more robust over time.
2. Impermanent Loss
Impermanent Loss (IL) is one of the most well-known risks for liquidity providers in DeFi. Impermanent Loss happens when the number of assets within a liquidity pool no longer matches the number purchased due to negative price changes in the underlying assets. As a result, Impermanent Loss creates an unbalanced market and results in a significantly lesser gain if you compare it to just holding your assets.
According to an article from Finematics on Impermanent Loss, one way for liquidity providers to avoid is to provide liquidity for stable assets like USDC or DAI rather than unstable assets.
3. DeFi Rug Pulls
A rug pull is an elaborate exit scam that involves enticing people to invest in a new cryptocurrency that promises to give them higher yields. This new cryptocurrency is paired with popular cryptocurrencies like Tether or Ether to be legitimate. Then, when the developer has accumulated user deposits into their platform they escape using an intentional exploit in the smart contracts and take all the deposits with them.
Rug pulls can be devastating because people who place their assets within a platform will lose their assets, making it a dangerous risk to the system.
How to avoid DeFi risks
It is evident that understanding the DeFi risks clears the path for solving them. Any individual in the field of DeFi would be unreasonable in assuming that DeFi does not pose any risks. Let us take a look at the recommendations and best practices to avoid the risk with DeFi.
Do Your Own Research (DYOR) is regarded as one of the most important aspects of being a cryptocurrency investor. As a way of combating fraud, it is widely used to encourage investors to gather information, investigate and analyse about the projects on social media platforms before committing for the long term.
Smart contracts are also subject to auditing from other developers, you can check to see if the project’s code has been audited by a reputable third party.
Risk tolerance is something that you should take into consideration while investing. Knowing yourself and how much risk you’re willing to take when it comes to your assets will steer you towards making educated moves. These are your assets on the line, and making the necessary research and the right actions lie entirely up to you.
Join the RAMP Community
Backed by world-class investors, RAMP DEFI is an optimized lending platform that aims to give users the highest deposit yields and lowest borrowing fees on collateral assets within Binance Smart Chain and Polygon.
Using the RAMP solution, users with staked assets can continue to receive staking rewards, retain capital appreciation potential on their staked portfolio, and unlock liquid capital to invest in new opportunities at the same time.
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