Risks associated with DeFi
The DeFi industry already has more than 20 unicorn projects (capitalization of at least $1 billion) and is still generating new ones. By the type of products, DeFi protocols are divided into these groups:
- decentralized exchanges (DEX);
- derivatives/synthetic assets;
- prediction/oracle markets;
- lending/borrowing platforms;
- alternative savings/investments.
All of this makes DeFi a great and attractive space to be invested in, but despite DeFi being trustless, open-source, transparent, and borderless, this is also a tricky space and has its own threats.
The three common types of risks of DeFi include:
- Financial risk relates to potential rewards of investment opportunities and management of these opportunities. Financial risk is commonly attributed to the risk tolerance of an individual, also on the objectives of an individual for management of a successful investment portfolio. Things like volatility, impermanent loss, and scam should be considered.
- Technical risk directly relates to hardware and software issues of DeFi products or services.
- Procedural risks relate to the users and the methods they follow for using DeFi products or services that can compromise security. Procedural risks are similar to technical risks with the difference in association with the actions of the end-users. Forgotten password, deposit to wrong chain or address, wrong order type and other issues should be considered by the end user.
In addition to the DeFi risks mentioned above, the downside of DeFi services is their limited popularity as most crypto users are utilizing centralized services that have better interfaces, faster transaction speeds, client support, and higher liquidity.
Users have to register across multiple DeFi platforms to access a full suite of their services. To invest into any kind of DeFi project the client would have to make an extensive research on available opportunities, then set up a wallet that provides a private key (eg., Metamask), understand at least the basics of crypto payments, fees structure and issues (eg.: what to do, if transactions does not get confirmed), then find a way to exchange one's fiat into (the right) crypto in amounts that would make it all worth the investment cost-wise.
The landscape is fragmented into multiple services and requires a few interactions. Each step contains its own specific risks that could end up in huge losses.
An example: A client is new to crypto and DeFi world but has interest in lending Uniswap's UNI token via Compound platform. To lend it the client has to:
- 1.Sign up for a centralized exchange (CEX) account that has UNI market and EUR deposits, and pass their verification process.
- 2.Deposit EUR.
- 3.Trade on UNI/EUR or if such a direct ticker is not available, trade, for example, ETH/EUR and then UNI/ETH to finally acquire UNI.
- 4.Set up a wallet (e.g. Metamask, on supported browsers) and add UNI as a custom token. Some tokens are in a preselected list, others require knowing the token's smart contract address (it is best to double check that address with official project sources vs blockchain explorers).
- 6.Withdraw UNI to Metamask wallet
- 7.Connect Metamask wallet to Compound lending platform.
- 8.Select the market and supply UNI for lending. Enable protocol by confirming Metamask’s transaction.
- 9.Supply desired amount UNI and confirm Metamask transaction (mind gas fees).
- 10.Your wallet has been deposited with Compound’s cUNI. Add this as a custom token to your Metamask wallet as well.
In summary, to invest into one token lending opportunity the client:
- has used 3 platforms: CEX, Metamask and Compound
- Has made 6-7 transactions: Fiat deposit, UNI/Fiat or ETH/Fiat and then UNI/ETH trades, 2 withdrawals (ETH for gas and UNI itself), confirmed UNI on COmpound and then finally has supplied UNI.
- has learned how CEX, Metamask, Ether gas, smart contracts, Uniswap work and Compound work.
It is doable but tricky, risky, costly and time-consuming.
DeFi platforms, which are built mainly on Ethereum blockchain with layer 1 architecture, are experiencing high transaction charges, hindering their mass adoption. For an average person, the Ethereum blockchain is pretty much unusable for average size transactions. Under current network fees, sending an ERC20 token costs around $10. To complete a simple UniSwap trade can cost about $10. Unless you’re willing to pay $100-$200, you can forget about a complex smart contract interaction.
This is a quick overview on typical average costs for a 500 EUR investment:
Costs related to a crypto investment
The dependency of the average fee from investment amount is shown in the following chart. From this chart it is obvious that for investment amounts up to 1000 EUR, the various fees paid to facilitate transactions can take up to 4-5%. It is too much for a product that has a goal of 7-15% return.
As mentioned in example above, some basic DeFi investments involve the use of a few different platforms, each having its own interface and procedures.
Getting a CEX account may involve different complexity and identification processing length in each exchange. Some exchanges require additional software to be installed in order to pass their KYC while larger transactions most likely will require additional documents to be submitted on each CEX. The good thing is there will always be CEX's support service so some issues and mistakes may be solved with no or little loss.
But there is no support on DeFi. A simple mistake may end up in total asset loss. Understanding UI is tricky but much less risky than following the right transactional procedures.
Setting up a wallet will challenge a first time user and involves some risks of sending assets to a wrong address, wrong blockchain, setting wrong gas fees (too high or too low), adding custom tokens (this usually involves using a blockchain explorer usage as well to find/double-check the token's smart contract address).
Most AMM's are very similar in interface but may use different blockchains. A client must be well aware of that and know firmly how to swap the same asset in between blockchains when in need.