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Decentralized Finance, simply denoted as DeFi is a booming financial technology that utilizes a secure and decentralized distributed ledger system similar to that of the cryptocurrencies. While many people use DeFi as an alternative to traditional banking systems, the lack of awareness and the inadequacy of proper security measures are leading to frequent risks and losses.
The first thing all the users of DeFi need to understand is that this financial concept is still in its infancy and you need to be cautious when it comes to utilizing the services. This article aims to spread awareness about the risks and rewards of decentralized finance. We will also explore what DeFi is, in detail.
What is Decentralized Finance (DeFi)?
Decentralized Finance is the network of financial services that uses blockchain technology. The network provides tools and services needed for conducting financial transactions directly between the users. DeFi removes the need for a centralized financial system such as banks, providing a more private, and more cost-effective alternative.
DeFi services use digital assets such as cryptocurrencies to offer banking services like lending, borrowing, staking, and trading. To say the least, DeFi allows you to be your bank. The advantages of using DeFi include accessibility to anyone, pseudonymity, flexibility, faster and cheaper transactions, and transparency. However, it also comes with some potential risks such as hacks, fraudulent activities, and regulatory uncertainty.
How Does Decentralized Finance (DeFi)Work?
DeFi is open to anyone and is controlled by the users. It works through decentralized applications (dApps) that connect the users with the blockchain. Meanwhile, smart contract software acts as a protocol between the two parties instead of a middleman. The smart contract protocol executes transactions when the pre-set condition is met.
Users need Web3 browser extensions or applications that facilitate this to access dApps. Usually, the dApps can connect and work together to facilitate complex financial services. By using dApps, you can receive or offer financial services such as lending and borrowing from or to anyone around the world.
Rewards of Using Decentralized Finance
DeFi enables peer-to-peer financial transactions over the blockchain. Here are some of the rewards or advantages of using decentralized finance over other centralized finance institutions:
- Openness: DeFi transactions are open to anyone around the world regardless of geographic location. This gives equal opportunity to anyone who has an internet connection.
- Pseudonymity: Usually, the banking system does not allow you to do any kind of transaction without disclosing your identification. But in DeFi you don’t even need to enter your email address or phone number.
- Low fees and high interest: Since the DeFi network cuts down the need for a trusted middleman, the transaction fee can be low and the parties involved in the transaction can negotiate the interest rate. Unlike in traditional banking, you do not lose a cut of your interest.
- Transparency: Since the transactions are done through blockchain, the ledger is available for anyone to review. However, the records wouldn’t reveal the identity of the parties.
- Immutability: Blockchain is a distributed ledger system where each need keeps an updated copy of the blockchain. So, it is impossible to change or alter the DeFi transactional records.
Challenges and Risks in DeFi?
The emergence of a finance technology that doesn’t involve any third-party authority has been a blessing for the ever-evolving financial landscape. However, this novel concept is still in its infancy and there are quite a few risks associated with it. Let’s see what they are:
1. Weak smart contracts
Historically, the most common risk associated with DeFi has been the weakness of smart contracts. Hackers have proven time after time that they will not let any chance of exploiting smart contracts slide without consequences.
Usually, decentralized finance applications such as exchanges facilitate the buying, selling, and trading of cryptocurrencies through liquidity pools. In the liquidity pool, the tokens are bound by the smart contract.
The smart contract should only transfer the tokens or a portion of the token to another user if they fulfill the preset condition. However, some smart contracts are poorly programmed and invite malicious activities draining the tokens stored in the liquidity pool.
Smart contract developers need to hire professionals to audit the codes before pushing them to the general public.
2. Price manipulation
Some bad actors can manipulate the price of cryptocurrencies. This type of scam is more relevant in the unsecured flash loan DeFi lending protocol.
Here, the scammers manipulate the price of two tokens and only repay a portion of what they borrowed in the first place. This practice can hurt a lot of users specifically the ones who provided liquidity to the affected pool.
3. Recursion Attacks
As we have seen earlier, DeFi is a user-controlled financial space. The entire process is automated and other than the smart contract, there is no one controlling or authorizing the transactions on DeFi. This is why they are subject to recursion attacks from hackers.
Here, the hackers manipulate the algorithm to call back the withdrawal function over and over again (recursion), instead of withdrawing one time and checking the balance to make sure that the user has got what they should.
4. Rug Pulls
Rug pulls are the most common threat in the DeFi space. Unsuspecting victims who are looking to invest in the next big thing in the market often fall victim to these cruel tactics by the creator of the token itself. Here, the creator deceives potential investors by manipulating the demand for the token.
With hype and demand, the price automatically rises and when it reaches a substantial amount, the creator will suddenly sell a substantial amount of the tokens they hold back to the liquidity pool, making huge profits and slamming the value of the token.
5. Lack of Awareness
While planned and organized scams are the biggest threat in the DeFi space, lack of awareness and inadequate research from the users also contribute to many threats and risks in the DeFi space.
The risks associated with lack of awareness include misplacing or accidentally revealing their private keys, forgetting passwords and recovery phrases, and even sending money willingly to the wrong addresses.
6. Legality Risks
The legality of the DeFi industry is questionable, and many DeFi apps such as exchanges have come under scrutiny for money laundering and other illegal activities.
According to the local governing laws, many exchanges are legally restricted in some jurisdictions. So, when choosing a DeFi app such as Exchange, make sure that they are available in your geolocation.
Popular DeFi Projects
Talking about decentralized finance, we should also look at some of the most popular DeFi projects created so far. Below are some examples:
1. Maker
Maker is one of the oldest and largest DeFi applications. It is a decentralized autonomous organization (DAO) that lets you borrow money using cryptocurrency as collateral. The application uses DAI tokens – a stablecoin pegged in a 1:1 ratio with the US dollar as the collateral.
2. Compound
Compound is another DOA that offers the possibility of operating multiple cryptocurrency tokens including stablecoins and altcoins. The application created in 2017 is built on the Ethereum blockchain and it allows users to deposit or borrow cryptocurrency.
The borrowers will have to pay interest, whereas the lenders gain interest just like they would in a traditional banking system.
3. MetaMask
MetaMask is a DeFi cryptocurrency wallet for the Ethereum blockchain. Users can store and manage their Ethereum-based assets on their mobile or through the web easily. MetaMask is a self-custodial wallet, meaning that all the private keys in the wallet are stored locally in the user’s device rather than storing it on the wallet’s server.
4. Codefi Compliance
Codefi Compliance is a customizable risk assessment software developed by Consensys. Here, the application enables businesses to identify regulatory risks such as money laundering, fraud, corruption, and even terrorism while keeping the privacy of transactions intact. Instead of KYC (know your customer), Codefi Compliance uses KYT (know your transactions to limit the risks associated with regulatory compliances.
5. Safe Wallet Safe
Safe Wallet formerly known as Gnosis Safe is another popular DeFi wallet that runs on Ethereum. The wallet needs multiple signatures to approve a transaction, making the wallet safer than other traditional wallets. Due to this property, Gnosis Safe is commonly used to manage pooled DAO funds.
6. Lido
Lido is an application that offers liquid staking solutions – the process of locking cryptocurrency for earning yields. Lido uses staked cryptocurrencies to safeguard transactions through proof of stake consensus. What makes Lido more popular is the fact that it allows users to withdraw their staked tokens anytime.
Read More: Best Practices For Securing Your Crypto Assets
Conclusion
Decentralized Finance (DeFi) is a financial technology that operates on blockchain technology. Defi is open source and anyone can create their finance tools on the network. It has many advantages including pseudonymity, universal accessibility, speed, and lower transaction costs.
However, since the technology is still in its infancy, it has some drawbacks as well. In this article, we have deeply explored some of the most popular risks and threats associated with the DeFi technology. With proper education about the technology and by exercising caution, you can safely use DeFi applications.
