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Cryptocurrencies

The Major Risks of Investing in DeFi and How to Mitigate Them

For a crypto enthusiast, there could never be a better time to be alive. First, there’s their growing acceptance as a store of value. Additionally, developers keep churning out exciting products promising to revolutionize our financial lives. One such product is Defi, and 2020 has seen its popularity grow in leaps and bounds.

To the Defi proponents, it is the magic pill that will cure the shortfalls of conventional finance. Often Defi Investments are portrayed as a sure way to wealth. Though, a keen look at the sector reveals the presence of pitfalls amidst the opportunities always touted. Making headway in this space, therefore, demands prudence.

What then are the risks accompanying Defi Investments? What are the ways of mitigating them? Stay with me as we unearth the risks to expect when you invest in the sector and the measures to protect your investments from them.                

Which are the Major Risks in Defi Investments?

We can categorize the risks in the Defi sector into three, namely, technical risk, financial risks, and procedural risks. We shall now embark on explaining each of these briefly.

Technical Risks

Technical risks arise from malfunctions in the protocols, hardware, and software of a Defi platform. They are critical since they compromise the platform’s functions. They include:

Smart Contract Risks

Smart contracts are the lifeline of Defi. They are central to the execution of most functions. Therefore any error in their operation will impact the Defi they run on and imperil users’ funds.

Smart contracts are human-made and, therefore, prone to bugs and other vulnerabilities. Unscrupulous individuals will exploit these to gain unauthorized control over the protocol’s functions. Recently, there have been reports of incidences of smart contract exploits that led to the loss of funds.

Hardware risks 

Hardware is the foundation on which Defi services run. Compromised hardware impacts the proper functioning of a Defi platform. Common hardware risks affecting DeFi systems include:

  • The power issues may cause unreliability of the service or application, diminished service life and performance.
  • Sensitivity risks result from degradation, humidity, dust, or other similar issues.
  •  Incompatibility risks can limit the speed of the system and other issues.

Software Risks

The entire Defi ecosystem runs on software. A corrupted software impedes the proper functioning of the Defi platform. These risks present in different ways:

  • Distributed Denial of Service (DDoS) attacks disrupt the normal functioning of an app or service.
  • Injection risks introduce malicious code into the DeFi software, for instance, SQL injection into web apps.
  • Uncontrolled format strings execute malicious code in a web app.
  • Overflow risks cause the software to skip certain functions or implement them in error.

Financial Risks Related to DeFi

Most information on Defi only speaks of the profit-making part. Whereas it is true that with wise investments, one can make a ton, there’s also the possibility of incurring losses. Financial risks are those that put you in danger of losing your funds. These include:

Impermanent loss

Impermanent loss occurs when you fund a liquidity pool, and the price of your deposited assets falls compared to when you deposited them. In an ironic twist, you discover that you’d have been better off hodling them.

Currency Fluctuations

The whole crypto space is very volatile. Cryptocurrencies experience upturns and downturns spectacularly. If you invest funds in a particular crypto asset, then its price falls, you experience a loss. The same obtains for staked assets. Should the supporting asset decline in value, it will take the supported down with it.  

Scams

The Defi Sector is crawling with persons and entities of dubious intentions. These fashion different kinds of scams to the detriment of unsuspecting investors. Some of the means they employ include:

Exit Scams

Unscrupulous promoters dupe investors by setting up a project with a seemingly attractive concept. They collect funds through an ICO and melt away with the loot. A case in point is YFDEX. Finance’s heist.

Pump and Dump Schemes

Whales create an artificial demand for a coin/token, thereby drawing in investors. Later they withdraw their funds at a profit. Consequently, the market plummets, leaving the rest counting losses.

Fake Airdrops and Rewards

Scammers create fake Airdrops and giveaways to access private keys and personal info. They then use these to defraud you of your funds.

Defi Rug Pulls

Defi rug-pulls scams involve minting new tokens, marketing, and listing them on Uniswap. The masterminds inject liquidity, convincing trusting investors to swap their ETH for the token. After that, the cons withdraw the funds leaving holders high and dry.

Procedural Risks in DeFi

These are the risks arising from one’s usage of the Defi platforms and attendant infrastructure. They include:

Phishing Attacks 

Here a malicious player duplicates a website or service, duping the unsuspecting into sharing sensitive information. Alternatively, they could send emails that install malicious code on their devices. Then they use the victim’s sensitive information siphoning their funds.

Pretexting 

A hacker poses as a representative of a DeFi service and convinces users to share sensitive information.

Exposure of Login Credentials

At times a user may knowingly or unknowingly expose their login details. Anyone with ill motives will use these to access their accounts.

Loss Of Login Details

Users may forget their login credentials. They, therefore, cannot access their accounts, leading to a loss of investments.

How Do You Mitigate Risks Associated With Defi Investments?

The Defi space can be unforgiving to anyone who navigates it without caution. One needs to guard their investments jealously. Here’re a few pointers on how to protect yourself from the risks outlined above:

Deal with Authentic Products and Services Only

Use products and services whose authenticity you’re sure about. Before settling on a product/service, DYOR! Look at reviews and recommendations about them. From there, you’ll get a good feel of what you’re getting into. Negative reviews are your cue to take off.

Use Multi-Factor Authentication

Secure your logins with several verification instruments. Examples include email confirmations, two-factor authentication, and multi-sig authentication.

Keep it Private

Treat your Defi investments like any other sensitive and personal information: private! Doing so helps ward off hackers’ attention.

Secure Your Digital Assets

The security of your investment is a wallet away. Hot wallets are ideal for actively accessing DeFi services. Cold wallets, on the other hand, are suitable for offline storage. Invest in a dependable wallet

Make Updates and Backups Your Friends

You must keep a backup of your sensitive information, including login credentials. Besides improving user experiences, upgrades, and patches of Defi solutions resolve vulnerabilities.

Takeaways

Don’t be fooled! Defi is not always about sunshine and rainbows. Behind the much-publicized good lurks danger. The Defi space is full of risks that can wipe out our investments if we don’t exercise caution. These risks present themselves in three broad categories: that is technical, financial, and procedural. Each of these broad categories has its specific shape of risks as has been elucidated. That said, any investor should take comfort that there are mitigation measures that they can take to protect themselves. Their judicious utilization will shield them from funds loss.

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Crypto Daily Topic Cryptocurrencies

Read This Before Investing in a DeFi Project

Decentralized Finance (DeFi) is a system of financial applications that are powered by smart contracts. Defi has exploded in popularity because of its unprecedented features on cryptographic security, fraud-free transactions, and autonomy. Whether it’s investing, loans, insurance, banking, lending, and staking, pretty much every financial offering exists in DeFi. 

The space’s dramatic growth has led many investors rushing in to get a slice of the DeFi pie. But just like with crypto investing, you can gain some handsome profits, but you can also incur devastating losses, especially if you’re not careful. 

This article will guide you in what you need to do before dipping your feet in the DeFi investment waters. But before that, let’s look at what investing in DeFi entails. 

DeFi Investing: The Basics 

There isn’t much difference in the investment opportunities offered in the traditional financial setup and Defi. Decentralized lending, for instance, follows the same principle as lending in centralized finance systems, except this time, smart contracts are involved, and the returns are invariably better. Smart contracts are used to hold collateral from borrowers and also automatically deliver accrued interest to lenders. There’s also ‘staking.’ Staking in DeFi is when you lock up your crypto and get the right to participate in a network and, in some cases, earn rewards for depositing your crypto. 

We also have ‘yield farming’ in DeFi. Introduced by Synthetix and popularized by Compound, yield farming involves locking up your crypto assets in a project’s protocol and earning rewards. 

Defi investors use their insight to spot lucrative opportunities, just like traditional finance investors capitalize their knowledge on assets such as real estate.

With that, let’s get straight to:

What you need to do before investing in DeFi. 

#1. Carry out extensive research

Before you invest your hard-earned money in a Defi project, it helps to do your research. To verify whether a project is legit, head to Google, and type the project’s name followed by the word “scam.” If this project is a scam, someone else might have already flagged it.

You might have typed the name of the project alongside the term “scam,” and nothing has popped up. This does not mean that the project is completely legitimate. You can use Defi tokens and protocols, which anyone can view since the project is open-source. If you can, evaluate the project’s codes to see if the project is genuine. This method particularly helps if you have programming skills or know your way around smart contracts. 

#2 Observe the number of users and what they are saying

The more the users on a blockchain project, the more the value. With blockchain projects (mostly those on Ethereum where several Defi projects are built), there is real-time reporting. This can be done through Etherscan.io, which is for raw data, or Dune Analytics, which focuses on user-friendly reports. With these tools, you can look at the total users in a given Defi project coupled with the increasing number of users. The goal is to see real people using these protocols. Keep in mind that some of the data you see can also be corrupted as an elaborate ploy to lure in unsuspecting users. These accounts should belong to quality users, and their growth should be quadratic. If you observe such users utilizing the protocol, then it’s genuine.

Also, be keen on what trusted security professionals are saying and writing about these projects. Defi projects typically subject their smart contracts to manual security audits with an air-tight reputation. Some of them include Certik, Quantstamp, and OpenZeppelin.

You can also check what people on Twitter, Reddit, and DeFi-related sites and forums say about the project. You can also check whether the project is recognized by Defi Prime, Defi Pulse, and Defi Market Cap. 

#3. Verification by Etherscan

Once a project has verified their smart contracts on Etherscan, a unique code will be availed. When viewing the contract, the code you see is the same code you ought to get when using it. Of course, this does not mean that your project is invulnerable to hacks or it’s not a scam. Still, having a code that can be publicly assessed without the fear of the code being changed is vital.

ETHProtect is a service provided by Etherscan that enables people to report suspicious activities on the Ethereum blockchain. A “Red Shield,” issued by Etherscan’s security analysts and the Taint Inference Analysis Engine, is something to watch out for when looking at Defi projects. These usually mean that people have launched a complaint against a certain project. When you see a Red Shield attached to a project, know that it’s been identified as a scam. 

#4. Watch out for fake projects

Many fraudsters are ahead in the game – they create fake projects with legit-sounding names. But when you look more closely, you’ll find that the project’s links are either dead or lead to nowhere. Or it may have a website, but it looks all spammy, like requiring people to sign up for freebies – and other suspicious activities. 

You can also know if a project is legit by checking what exchanges its tokens are listed on. It’s almost impossible to find a scam project listed on reputable exchanges like Coinbase, Binance, Huobi, etc. Instead, fake projects are listed on decentralized exchanges or little-known centralized exchanges. 

Closing Thoughts 

Investing in DeFi can be lucrative, but watch out for the loopholes. The crypto space is full of scammers looking to make a quick buck at the expense of unsuspecting users. Luckily, there are ways to identify a fake DeFi project way before you can be duped to invest in one. Also, you can always analyze a project’s code for the tech-savvy investors and determine if it’s legit. Also, don’t forget the first rule of crypto investing: don’t put in more money than you can afford to lose!