Decentralised finance (DeFi) comes with many risks. The regulatory safeguards for investors in traditional, regulated financial systems are mostly absent in DeFi.
- Many of the regulatory safeguards investors are used to in traditional financial systems are mostly absent in DeFi.
- DeFi is mostly unregulated, making it both a potential vehicle and popular target for fraud.
What is DeFi?
Decentralised finance, or DeFi, generally refers to financial services provided by using smart contracts on blockchain, without involving intermediaries and centralised institutions.
These financial services, range from trading and insurance to lending and borrowing, among others.
DeFi services are transacted via crypto-assets, such as cryptocurrencies, stablecoins and tokens that are native to the DeFi protocol.
Why the interest in DeFi?
DeFi promises to make financial services cheaper and faster by doing away with the need for traditional financial intermediaries such as exchanges, brokerages, and banks.
Proponents of DeFi also claim it can drive greater competition and financial inclusion by allowing anyone to access financial services on decentralised blockchain networks.
But the practical use cases for DeFi remain limited to date.
Much of the retail investor interest in DeFi in is fuelled by the promise of unsustainably high returns. Some DeFi projects tend to advertise yields or interest rates that are many times higher than that available in the traditional financial system.
What are the risks?
Speculative nature of digital tokens
Cryptocurrencies are closely interlinked with DeFi. Their prices are known to fluctuate wildly, potentially even crashing to zero, no matter how reputable they may be.
Learn more about the risks of cryptocurrencies and digital tokens here.
Investors should be sceptical of claims of consistently high investment returns with little or no risk.
The annual percentage yield (APY) advertised in DeFi is often many times that in the traditional financial system. But it is often unclear what revenue streams fund such spectacular gains, which should be a red flag.
Some lending platforms and crypto funds stake clients’ funds on other DeFi or crypto-platforms which themselves do not have reliable revenue streams.
The open-sourced and decentralised nature of DeFi projects make them more vulnerable to malicious attacks and the level of security varies considerably across protocols.
A report by blockchain analysis firm Chainanalysis in 2022 found that over 70% of stolen cryptocurrency funds in 2021 were taken from DeFi platforms.
DeFi projects are unregulated and are not subject to disclosure requirements unlike traditional financial investment products. The average investor may thus not have access to sufficient information to fully assess the investment risks and suitability.
Opaque and easy-to-manipulate governance structures can also mislead investors. Some of these may be set up to benefit initial backers of the project, like venture capitalists, at the expense of secondary investors.
There may be outright fraud, such as rug pulls or pump and dump schemes.
A rug pull refers to developers abandoning their DeFi project and running away with investors’ funds.
In a pump and dump scheme, fraudsters artificially “pump” the value of a token, such as using misleading or false information to stoke buying demand, then “dump” the tokens they are holding at the inflated price to earn a profit.
Lack of a central party to hold accountable
With no intermediary or central party in charge, you will have nowhere to turn to or no one to hold accountable should things go awry. You have little recourse should your funds be stolen from DeFi projects if something goes wrong with a transaction.Read more about the risks you are exposed to in the process of trading cryptocurrency and their derivatives here.