Defi has become very popular in the last few months in the middle of 2020. Many Defi projects have succeeded in drawing large amounts of funds collected in Total Value Locked (TVL). Defi projects promise passive income for their users. But behind that there are also risks that must be known if you want to invest in Defi. Before discussing the risks of investing in a Defi, it’s good to understand what Defi is.
What is Defi?
Defi stands for decentralized finance. Defi is financial software built on a blockchain network. It’s is a financial service that has traditionally been in banking, but the service is run by smart contracts built on a blockchain protocol network. Currently Defi is mostly built on the Ethereum network. There are several types of Defi, namely DEX (decentralized exchange)-based Defi, loans, and digital asset deposits.
Defi offers loan services, lenders, interest, exchanges and guarantees or collateral. All of these services are built with smart contracts and are open to the public. A person who wants to invest withDefi simply creates or connects his virtual wallet with the existing Defi protocol. For example, for investing in Uniswap, a person can simply connect the Ethereum wallet with Metamask or other wallets with the Uniswap protocol. Registering is also not complicated because everything is integrated. Each project has a different way of registration. With Uniswap it is just to connect the Ethereum wallet while for the Sintetix network one must register by email.
The advantages of Defi compared to financial services in general
Financial services that exist today are traditional services where depositors put their money in the bank with various procedures and verification will earn interest according to the current interest fluctuation. Money that has been deposited can not be withdrawn within a certain period of time. If a bank is in a bad financial condition, sometimes customers’ savings cannot be fully withdrawn. The assets that have been deposited in the bank in the form of deposits seem to be non-liquid assets.
Defi provides services that are almost the same as banks do but all of these services are built on a blockchain network so that they are transparent and can be accessed anywhere on the internet network. Services that exist in Defi include loans, collateral, deposits, and borrowing. Users who deposit their digital assets will get a fee from the product’s profits. Uniswap is a decentralized exchange of various digital assets. Users will benefit from fees withdrawn from exchange transactions at Uniswap. The amount of profit varies between 6% – 9% per year. Liquidity fund providers get a 0.3% fee from digital asset exchange transactions.
The chart above is the total liquid funds deposited by Uniswap users. The funds are quite large, reaching 1.6 billion US dollars. The volume of trade at Uniswap reached 446 million US dollars per day. A very large transaction count for a digital financial market.
Weaknesses and risks of investing in Defi
Although Defi has several advantages over traditional banking financial systems, it also has several weaknesses. All investments have risks, so does investing in Defi. The following are some of the disadvantages and risks of investing in a Defi.
1. Smart contract protocol is vulnerable to hacker attacks
The smart protocol is open source so when Defi has a large amount of assets, it will attract hackers to break into the smart contract and steal the assets inside.
So called decentralized finance (defi) lending platform Bzx on Sunday lost $ 8.1 million in a new hacking attack, the third this year, caused by a
flawed code in its smart contract.
The defi protocol Bzx was hacked and lost 8.1 million dollars
2. Defi protocol is not audited by trusted institutions
Smart contracts allow independent auditors to engage in protocol definition to control asset cash flow. The unaudited protocol allows the misuse of stored funds by either the developer or from hacker attacks. The defi scam case on YFDX.finance is an example of theft committed by the developers themselves. More than 20 million dollars in funds were stolen by YFDX.finance.
3. Defi token looks to be a bubble that is ready to burst
The value of the Defi token is actually 0.00 $ but the developers and investors behind Defi make the Defi token’s valuation much higher. They made large purchases to attract traders to buy Defi tokens. But within hours, the Defi token price can drop drastically. The volatility of Defi tokens is very high and this is the game of traders. For some established Defi, such as Uniswap, Compound and Maker, the token price tends to be more stable than new projects. Learning from the experience of the outbreak of ICO projects in 2017 and 2018, many of those ICO projects were only pump and dump projects. By launching a native token, Defi tokens have the potential to become a project to raise funds only. New Defi tokens prices will increase in the market, this is not only due to natural purchases by traders, but the increase is often made by the investors behind the project. By suddenly increasing prices, panic buying will result in prices soaring drastically. After the developer makes a healthy profit, they will then release the tokens they have at low prices so that the value of the tokens will drop fast, this practice in cryptocurrency trading is called pump and dump. After the market finds out that the token is worthless, token holders will release their tokens on the market , creating excess supply and making the token completely lose its value.
4. The legality of defi is questionable
Current Defi projects have not fully obtained the approval of regulators in countries around the world. In Indonesia itself, there are no clear regulations regarding Defi projects. However, in the next few years, the government will certainly take a stand regarding Defi. Currently, the regulations regarding cryptocurrency are clear that cryptocurrency is a digital property and not as a means of payment. What about Defi, a project collecting and raising funds from outside an institution or system. Collecting and raising of funds from the community are only permitted for a few institutions such as banking, cooperatives, insurance, capital markets, venture capital companies, leasing companies, and pension funds. Which type of institution is Defi included? Here the position is not clear, so the Defi project in Indonesia has no legal status.
Is it safe to invest in Defi?
All types of investment carry risks as well as investing in Defi. Investing digital assets at Defi means sending assets that you own into the Defi protocol. The funds that you have now are not completely in your hands because the funds have left your personal wallet that has the private key. Funds in the Defi protocol are the same as funds deposited on an exchange, meaning you don’t have a private key to return lost funds. As long as the Defi protocol is running normally, your funds are safe. But if the Defi protocol gets a hacker or developer attack and the funds in that protocol are stolen, your funds will be lost too.
Apart from security issues, investing in Defi is also very sensitive to the volatility of the assets you hold. When the asset value decreases, you will automatically bear the loss of the assets that are locked in the Defi protocol. However, on the other hand, if the price of the assets you hold increases, you will benefit from the increase in the assets you have. For long-term investment, Defi still cannot provide certainty because the technology and protocol for it are still in the development stage. Storing digital assets in personal wallets is safer in the long run.
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