Decentralized finance, or DeFi, has been a hot topic on Wall Street in 2022. DeFi enthusiasts tout its potential to completely disrupt the traditional banking and financial services industries. DeFi facilitates the use of peer-to-peer payments that rely on blockchain technology rather than banks or brokers to secure transactions.
At first glance, it’s easy to see the appeal of DeFi, which essentially allows investors to serve as their own banks by lending and borrowing on their own and potentially earning much higher yields than those available in traditional savings accounts. However, the lack of regulation in the DeFi space has created vulnerabilities that have been exposed by the 2022 “crypto winter,” and investors should make sure to understand all the risks associated with decentralized finance.
To fully understand DeFi, consider the following:
— What is Defi?
— How can investors make money in DeFi?
— What are the risks of investing in DeFi?
What Is DeFi?
Decentralized finance is a financial system that is not built by or reliant on central institutions, such as banks and governments. Instead, DeFi systems are powered by the users themselves. Responsibilities and security are provided collectively by a number of distributed actors and organizations.
Whereas the Federal Reserve and other central banks are responsible for maintaining the integrity and stability of the traditional financial system, the DeFi system relies on distributed blockchain ledger networks to verify, execute and record transactions. Because it relies on blockchain technology, the de facto currency in the DeFi world is Bitcoin (BTC), Ethereum (ETH) and other cryptocurrencies.
“With DeFi, people can deal directly with one another instead of banks. Blockchain-based ‘smart contracts’ ensure the entire process is fair and trustworthy by offering visibility and transparency to all parties,” says Varun Kumar, founder and CEO of DeFi exchange Hashflow.
Smart contracts are bits of code stored on blockchain networks that execute contracts automatically when certain predetermined conditions are met. These contracts execute an agreement instantly with a certain outcome and without the need for an intermediary, such as a bank, broker or attorney.
Supporters of the DeFi system argue that many traditional economic transactions can be self-executed in a faster, cheaper, easier and more secure manner using smart contracts.
The DeFi system is composed of a collection of lending platforms, exchanges and individual participants operating on their own, without a central authority and completely outside of the traditional financial system. The DeFi space is relatively new and thinly regulated and is often referred to as the “Wild West” of finance.
How Can Investors Make Money in DeFi?
There are many different ways for investors to make money in the DeFi space. First, investors can trade cryptos, non-fungible tokens and other digital assets on decentralized exchanges just like stock traders trade shares of Apple Inc. (ticker: AAPL) and Microsoft Corp. (MSFT) in their brokerage accounts.
In addition, DeFi users can earn income by either lending, staking or liquidity mining.
Staking is a way for investors to earn interest on certain cryptocurrencies by locking up coins and pledging them to a cryptocurrency protocol. Cryptos that use a proof-of-stake consensus mechanism — such as Cardano (ADA), Solana (SOL) and Polkadot (DOT) — rely on these staked coins to validate transactions. Entities that stake coins can become transaction validators, and validators receive rewards in the form of cryptocurrency when they are chosen to validate a block of transactions.
Users earn interest by staking their cryptocurrency. This interest is similar to the interest they would earn in a traditional savings account, but the rates earned via staking are typically much higher than the current savings rates offered by banks.
Liquidity mining is the process of contributing crypto assets to a liquidity pool that helps facilitate trades and transactions within a DeFi protocol. In exchange for contributing to a liquidity pool, liquidity mining participants receive a share of the platform’s fees or new tokens, essentially earning interest on their contributions.
Finally, investors can either lend out crypto directly or deposit it in an interest-bearing account on a crypto lending platform, such as an exchange or DeFi app. Some crypto lending accounts pay variable crypto interest rates, and others pay set interest rates based on a certain lockup period.
What Are the Risks of Investing in DeFi?
Any cryptocurrency investment involves risk due to the extreme volatility and unpredictability of the crypto market. High yields on staking or crypto lending may seem appealing at first glance, but the prices of most major cryptocurrencies are down significantly so far in 2022.
Rising interest rates have prompted investors to sell risk assets such as cryptos, sending the prices of Bitcoin and Ethereum each down more than 50% year to date. Most crypto lenders, stakers and liquidity miners have experienced far greater losses to the value of their principal this year than the interest they have earned on it.
The crypto lending space has also been rocked by a liquidity crunch crisis in 2022. Crypto lending platforms Voyager Digital, BlockFi and Celsius were even forced to freeze customer assets. Voyager Digital and Celsius have both recently filed for bankruptcy, while BlockFi is in trouble after a large client failed to meet a margin call on an overcollateralized loan.
Unfortunately, the DeFi space is very thinly regulated at this point. Investors earning interest in bank accounts are typically ensured by the Federal Deposit Insurance Corporation, or FDIC. DeFi investors are afforded no such protection.
Christopher McGregor, CEO of DeFi protocol Vesto, says well-designed protocols ensure that investors’ money is always protected while assets are on the protocol.
“The only true risk is smart contract failure, which rarely happens. The need for insurance is a must in the crypto/DeFi world, and as DeFi grows, this need will be met,” McGregor says.
Julian Hosp, CEO of Cake DeFi, says investors should look for DeFi projects that have stringent information security standards and are transparent about their operations and offerings.
“Smart contracts risk, project risks and impermanent losses are some of the most common risks. Therefore, it is important to do deep research into the projects you are investing in or access DeFi services via trusted centralized platforms such as Cake DeFi,” Hosp says.
More from U.S. News
Update 07/25/22: This story was published at an earlier date and has been updated with new information.