The returns on DeFi protocols can easily exceed the bond markets, much fewer savings accounts. However, they also come with additional risks, so it is important to understand them thoroughly before jumping in.
There are three main risks in all of DeFi, smart contract glitches and hacks; impermanent loss, and counter-party risk. Let’s take these one by one.
- Smart contract glitches and hacks
It does happen: The smart contract software was not written correctly or has a glitch that allows hackers in, called a “code exploit.” Millions in cryptocurrency have been lost this way, which is why it is better to stick with larger, more mature exchanges that have been tested more thoroughly.
2. Impermanent loss
Impermanent loss is one of the biggest risks in DeFi. It results when the price of a coin the liquidity provider deposited in the pool falls below that of the price on an external exchange, wiping out potential profits.
This is the key difference between holding coins in a wallet and providing liquidity, so we are going to spend some time exploring it here. You absolutely must understand this to invest in this space.
Unlike a traditional loan, you may be investing in two or more cryptocurrencies at once within a liquidity pool, so the value of coins can move against each other within the pool in a way that diverges from the values on traditional exchanges – and volatile assets can move against each other very fast. That means your coins can earn interest, but also be less than the value of the same coin on an outside exchange. In effect, you have lost money instead of earning it.
There are ways to mitigate this risk, primarily by depositing correlated coins into the same pool, that is – coins that tend to move up and down in price together – such as pairs of stable coins, or different versions of ETH, and by picking less volatile coins and avoiding super high yields and exotic pairs.
The size of the pool also helps. AAVE may be safer for beginners than Yearn.finance, since each pool is a single smart contract rather than a fast-moving strategy designed by the controller.
Find a more granular explanation here.
The problem is created when behind the scenes, arbitragers notice the price differences between the actual markets and the pool and buy up the cheaper coins in the pool to sell it on another exchange, eventually driving the prices back up. That is why it is a safer way to invest is to stick with correlated coins, such as pairs of stable coins or different versions of ETH that move together and avoid volatile pools.
Another way to mitigate risk is to take advantage of LP tokens awarded by the exchange – tokens provided to liquidity providers as an extra incentive for depositing funds. Uniswap, for example, originally awarded Uni’s, making some of the risks worth it.
Many investors still question why HODL when they can also earn? So weigh your own risks carefully.
3. Counterparty risk
The last risk, or counter-party risk, is simply the risk that one side of the contract cannot fulfill its end. This can occur when exchange is new and underfunded, or when a centralized exchange locks markets from trading.
Tips for beginners to lower risk
- Start small. You’ll make mistakes, so make small ones, not big ones.
- Invest in what you understand.
- Stick with established apps and products – 2018 is mature DeFi space – and avoid anything that is BETA.
- Invest in pools with fewer pairs, and avoid exotic pairs.
- Remember, the more volatile the assets, the higher the yield, the greater the risk
- If you use an Ethereum-based DeFi, the fees can also be very high, so check before you invest.
- Read the terms – some pools require you hold the coins for longer amounts of time.
Happy trading!