Defi is a new line of business which is rapidly growing and has the potential to democratize banking and finance as we know it, but with this new technology comes risks which an investor needs to be aware of. The risks can be broken down between technological risk, asset risk and compliance/legal risk.
Technical and operational failures are one of the biggest threats to Defi at the moment. This is due to the current limitations of the blockchain and not being infallible. As Defi has grown so have the number of cyber attacks, bugs and network congestions which can cause an investor to lose their funds.
Hackers stole $120 million from Defi protocols in 2020 through 15 separate attacks. Only 50% of the stolen funds were later recovered.
The blockchain cannot eliminate the risks which are inherent to investing. There is extreme volatility in the Crypto markets opening the investor up to holding assets which can decline in value rapidly and cause liquidity risks.
In extreme circumstance this can lead to panic selling and something known as a “bank run” which can send prices plummeting, sometimes to zero. The market is heavily weighted with retail investors, which increases the volatility.
Defi is still in its early stages and many of the services that are offered are by unincorporated bodies that appear to operate outside of regulatory obligations. As most of the services that Defi essentially offer are digitized and automated software programs, there is no longer the need for the intermediary, such as the bank, which in turn can lead to several risks and result in an uncertain regulatory environment.
No direct guidance from regulatory bodies can lead to a host of problems whether it be anti-money laundering or consumer protection. Regulators in the U.S and elsewhere are increasingly talking about ways to rein in these risks by pushing for greater regulatory clarity.