What Investors Need To Know About DeFi

Decentralized finance (commonly referred to as DeFi) is widely used in the cryptocurrency industry and has attracted attention in the mainstream investing world thanks to the opportunity of high returns on investment. Global funds locked in DeFi currently exceed US$90 billion, according to relevant analysis data. But what exactly is DeFi, and are there any dangers involved in participating in DeFi? BigONE believes it’s worth reviewing the following facts about DeFi before you take the next step to invest.

What is DeFi?

DeFi is an umbrella term for a set of financial activities that eliminate the need for intermediaries in traditional financial services. Loans, savings, remittances, insurance, and cryptocurrency transactions are all included. For example, some people will use DeFi to lend a friend $100 in Bitcoin, and as the lender they will earn interest on the loan without traditional intermediaries. As the FT explained DeFi is, “an umbrella term for a collection of crypto asset projects that aim to do away with a centralized intermediary — like a bank or an exchange — to provide financial services. They use DApps to execute common services like lending, savings accounts and trading coins”.

When Bitcoin was first introduced, one of its most impressive features was its decentralized nature. Previously, digital currencies required the assistance of a third party to verify the transaction process and payment links. Blockchain, as technical support for Bitcoin, liberated the decentralized financial industry from the constraints of such third parties. As a result, DeFi can lower transaction costs and simplify document certification, while also speeding up transactions. For example, thanks to DeFi a borrower does not need to submit a credit score to qualify for a loan; instead, they only need to provide some cryptocurrency as collateral to obtain a loan. According to CoinDesk: “Lending markets are one popular form of DeFi, which connects borrowers to lenders of cryptocurrencies. One popular platform, Compound, allows users to borrow cryptocurrencies or offer their own loans. Users can make money off of interest for lending out their money. Compound sets the interest rates algorithmically, so if there’s higher demand to borrow a cryptocurrency, the interest rates will be pushed higher.”

Key DeFi points to consider:

⦁ DeFi is booming

DeFi is expanding and developing because of the growing interest in cryptocurrency. According to latest data, the funds invested globally in DeFi have surpassed US$90 billion. The increasing value of funds stored in various DeFi applications indicates that the DeFi market has maintained a good growth momentum. Some institutions predict that the funds locked in DeFi will exceed US$100 billion by the end of 2021, that’s up significantly from the $11 billion in October 2020, which represented more than a tenfold growth during 2020, according to Wikipedia.

⦁ DeFi does not provide the same safety net as traditional finance

Some of the consumer safeguards found in the traditional financial industry do not exist in DeFi. As a result, investors should take care to anticipate and respond to risks. For example, if the bank fails, an insurance company will pay a portion of the insurance money to each of your eligible accounts. However, if there is a failure in the DeFi platform that results in the loss of your account assets, you won’t be covered by government-backed compensation schemes that support traditional banking.

As reported recently in the FT, the decentralized benefits of DeFi also mean there’s a lack of regulation. “Researchers at Cornell University found that automated bots could front-run certain trades — for instance, executing open orders at an unfavorable price before they can be cancelled when prices change. With no one to report this flaw to, the researchers published a blog post detailing the risk, assuming the community would protect itself. Instead, a cottage industry of bots emerged to exploit the idea before the loophole could be closed.”

BigONE believes that before entering the world of DeFi, you should consider the following additional factors:

How will your assets be stored?

Choose a platform that can store most of the assets offline in a cold wallet and investigate whether the platform has protection against hackers or other crimes. If the platform has third-party auditing and other security features, it will be helpful for investors’ asset security.

How will your assets be used?

Some DeFi platforms promise to pay high-interest rates in exchange for the cryptocurrency you deposit. To achieve the promise of high-interest rates, they will lend you funds and pay you a portion of the borrower’s interest. Although it may appear to be tempting, you must pay close attention to the transparency of the entire process because you must understand to whom they lent your funds, and whether these loaned funds are at risk. In a cautionary observation of the perils of DeFi, Alyssa Hertig writing in CoinDesk pointed out: “As DeFi has increased in activity and popularity through 2020, many DeFi applications, such as meme coin YAM, have crashed and burned, sending the market capitalization from $60 million to $0 in 35 minutes. Other DeFi projects, including Hotdog and Pizza, faced the same fate, and many investors lost a lot of money.”

Are there technical risks?

Be aware that removing the middleman has the disadvantage of requiring you to replace an organization with a piece of code, commonly referred to as smart contracts. If the smart contract is trustworthy, that’s fine, but if it isn’t, there’s a problem. You can alleviate your concerns by looking for open-source projects because open-source projects allow anyone to view the smart contract’s code and check for errors.

How to prevent online fraud

According to available data, DeFi fraud and hacking incidents cost users $471 million as of September 2021. It is difficult to recover your encrypted funds once stolen, so please carefully review the DeFi application before your depositing funds. Special consideration should be given to online comments made by some users and comments made on encrypted forums, as these are usually the first indications of a potential problem. It is recommended that all investors read BigONE’s articles on asset security before proceeding.

Regulatory policies for DeFi

Global cryptocurrency and DeFi regulation appear to be a probability and no longer a mere possibility. Consider the United States where various regulatory authorities, ranging from the SEC to the Treasury Department, have expressed their views on DeFi regulation, namely that DeFi platforms provide services like the traditional financial industry, but lacks the robust protections for consumers. As reported in Crypto Briefing last month, while DeFi poses challenges for regulators, SEC Chairman Gary Gensler said that “regulators would be able to exercise authority over even supposedly decentralized platforms. It’s a misnomer to say they are just software they put out in the web,” emphasizing that DeFi platforms have “a fair amount of centralization,” in terms of governance mechanisms, fee models, and incentive systems.

How to participate in DeFi

One way to enter the DeFi market is to own DeFi crypto tokens. The value of these currencies rises in tandem with the development of the DeFi industry. In addition, DeFi allows you to earn interest in your cryptocurrency. The DeFi lending services, typically pay much higher interest rates than traditional financial savings. As DeFi lending is primarily collateral-based, so that to take out a loan you first need to put up the required collateral — which is often ether, the token that powers Ethereum. The upside of that is that users don’t need to divulge their identity or worry about the state of their credit score to access a loan.

While DeFi is an exciting new world, the next frontier of finance allowing more and more people around the world to access financial service previously denied. By the same token if you are seriously looking to invest in this emerging sector it will pay dividends to first study DeFi in-depth. BigONE’s bottom line advice is, as with any other cryptocurrency investment, please invest only money you can afford to lose. Make sure that you thoroughly research the industry and are fully aware of the risks involved before participating.