DeFi is a term used to describe a network of financial applications developed on top of a blockchain. Its shared purpose is to grow and operate without the use of middlemen such as banks, payment service providers, or investment funds.
However, due to the DeFi platform's rapid and insurgent development, there are some risks involved in the system that can be difficult to manage.
Decentralized Finance
Open finance is another term for decentralized finance (Defi). One of the most important features of Defi is that it creates an open ecosystem for people who would otherwise be unable to access financial services. It provides those users with easy access.
DeFi is still a young technology, with real-world implementation lagging well behind the optimistic theory. DeFi applications must resolve some significant obstacles and risks in order to gain the confidence of people and organisations outside of the crypto-native culture. The following are some of the risks associated with decentralized finance (Defi):
Usability
The accessibility or user interface of Defi protocols is a major flaw closely linked to the technical implementation. These are often difficult to use, unintuitive, and intended for crypto-native users. Beyond those who are already acquainted with Ethereum, Defi projects have failed to gain traction. Many products enable users to manage several tokens in non-custodial wallets on their own.
Realistically, it is still just too early for the general public to put their money on the line in this perilous and uncharted territory. The user experience of DeFi products will undoubtedly be one of the highest priorities for developers once the technological and regulatory risks have been resolved.
Centralization
Many DeFi applications were launched by a single person or organization and are far from decentralized. They usually strive to decentralize governance and decision-making once they've been formed. Counterparty risk exists as long as an application is semi-centralized, and the intermediary with control over the assets can misappropriate the funds.
However, as these DeFi ventures expand in terms of user base and assets locked in, they will undoubtedly be subjected to increased regulatory scrutiny and financial oversight. Financial regulation would necessitate some level of accountability and competence, which may lead to a return to a more central administration of DeFi projects.
Liquidity
In the financial sector, liquidity is critical for efficient pricing. Liquidity in DeFi protocols is currently widely outpaced by central alternatives, which include a plethora of low-cost liquidity suppliers that help to sustain conventional finance. Technical risks, such as the aforementioned technical scalability and congestion problems on the Ethereum blockchain, are closely linked to liquidity risk.
During periods of crisis, the Ethereum network becomes so congested that arbitrageurs and liquidity providers are unable to keep prices consistent across venues, resulting in significant dislocation on individual exchanges, which leads to volatility and a decline in the markets.
Regulation
In most countries, decentralized ventures run without a license, regardless of where the end-user is located. In most jurisdictions, the treatment of DeFi properties is still not well defined in terms of taxation.
Regulators around the world are currently answering regulatory issues surrounding crypto-assets, such as developing new crypto custody license regimes. The Libra association appears to embrace these proposals, despite its refusal to switch to a completely permissionless framework due to political and regulatory pressure.
Collateral
Some types of collateral for securing loans come with their own set of risks. Excessive collateral lowers the volatility risk. If the price of an asset falls too fast, this provision does not guarantee maximum coverage of the loan sum.
Given the will user base and locked-in assets, DeFi assets and goods will almost certainly face increased regulatory scrutiny. Financial regulation would inevitably necessitate the presence of a responsible counterpart, rendering genuinely autonomous governance and decision-making processes for Defi items unthinkable.
Volatility
The volatility of interest rates on several DeFi platforms stands out, casting doubt on the utility of engaging in them. Most likely, arrangements will be reached to replace the floating interest rate with a fixed rate, or other means of rate fixing for a fee. This adds to the overall difficulty of the procedure.
DeFi activity currently accounts for about 1% of overall crypto market activity, which is negligible in relation to global financial markets.
Oracle Manipulation
To obtain information from outside sources, blockchains depend on oracles. The price knowledge is the most reliant on oracles in DeFi. When opposed to the Ethereum blockchain itself, the markets decide the price of ETH. As a result, oracles are used to feed in price data. The oracle may be a combination of several DEXes or exchanges, a DEX like Uniswap, or a service like Chainlink.
When a DeFi dApp only uses one, or possibly two, exchanges as an oracle, Oracle manipulation becomes a possibility. Traders can sway the price by trading a large enough trade to sway the price information given by an oracle.
Ethereum Dependency
One of the disadvantages of Decentralized Finance (DeFi) is that it is highly reliant on the credibility of smart contracts and the blockchain protocol. Any flaw in the code could result in a hack and significant losses for decentralized app users. It's nearly impossible to code without errors, particularly when taking into account potential blockchain protocol innovations.
Furthermore, detecting bugs in smart contracts is a difficult task, partially due to the technology's novelty and the lack of structured procedures.
Technical
Technical risks associated with the underlying blockchain protocol (layer 0) must also be considered. Almost every related DeFi project is based on the Ethereum blockchain. Due to heavy use, Ethereum's blockchain has experienced some clogging problems.
If the network becomes overburdened, the transaction can remain pending, resulting in market inefficiency and information delays. Liquidity risks are inextricably linked to technological scalability issues.