DeFi platforms offer impressive interest packages, but are they worth the risk?

Lending platforms in DeFi have began to offer impressive interest rates that are far superior over traditional financial products, which has resulted in an explosion in growth of people entering this space. But if you've been in this space long enough, the buzz surrounding this emerging interest is eerily similar to that of the ICO craze in 2017. In both situations we have companies offering high potential opportunities while downplaying the risk. Whether it's a case of ignorance or denial, are people really properly assessing the risks involved with lending your money with promises of future returns?

Understanding risks

While it's true that these platforms do not come packaged with the same amount of risk and speculation as ICOs, with such impressive rates comes a number of systemic risks that investors are not always aware of. Although this space is principled by decentralization, a lot can be learned from traditional markets. Traditionally, "Risk takes on many forms but is broadly categorized as the change an outcome or actual gain from the expected outcome or return." Therefore while it's important for investors to consider the potential return on their investment, they should additionally be aware of how the return may differ than expected. One wouldn't catch a falling knife under the assumption that it will "bounce" up, right?

A typical investment goes as follows:

• Consideration of risk tolerance

• The amount of reward compared to that risk - If your tolerance is only $100, you should not lock your capital up in a contract for a $3 interest payment next year. 

• The potential shortcomings of the platform/space as a whole - Ex: Celcius network getting hacked or a market collapse while your capital is tied up in a contract.

So high interest products may come with more risk than those looking for stability can tolerate. In addition to considering a particular platform, an investor should familiarize themselves with the risks involved with blockchain as a whole, which is one of the primary reasons DeFi should be considered risky in general. 

Some of the risks involved with DeFi products include:

Procedural security: 

While it's important to realize that the assets in general inherently carry their own risks, an investor should also consider the potential errors made by developers before entrusting them with their capital. With the demand of these products being so high at the moment, developers may opt for the simplest interface at the cost of security. This opens the door to a whole mess of problems including the potential for the platform getting hacked and losing your assets. On top of that, many of these platforms do not even offer compensation in the event of something like theft occurring on their network. In a situation where prices rally significantly higher, this can even lead to malicious behavior by developers to run away with your cash under the guise of a "network breach" as we have seen so many times over the last few years. Therefore it is important for investors to own their own keys - "Not your keys, not your crypto." The best option for protecting your assets is hardware wallets, disconnected from the internet or networks as a whole. 

Smart contract vulnerability:

Many of these platforms offer payments after entering a smart contract with them. While smart contracts have come a long way since Ethereum's DAO in 2017, it would be extremely irresponsible to not consider the risks that are still involved with the security of Dapps or smart contracts. As the sophistication of products expands, hackers have also been improving and now have a knack for watching Block Explorers in an effort to learn and exploit potential vulnerabilities involved during the deployment of these contracts. But it should be noted that platforms like Nexus have began to develope forms of insurance in the event of contract failure, however many of the products like this are still in infancy and have not been battle-tested. Moreover, some of these products have received security audits, but at the end of the day the responsibility lies in the hands of the investor about where they trust to store their capital.

Governance:

If you have experience in these markets or the digital space, you're likely aware of the struggle that comes with keeping things updated with rapidly changing protocols or changes in terms of service that are provided by many of these platforms. But as BlockChain has developed, some of these platforms have implemented a DAO that governs certain aspects of a network or protocol. For example, holders of MakerDAO can vote on the Stability Fee to help keep the supply and the demand of Dai stablecoin in check, which at times the fee has been as low as 1% to as high as 20%. So its critical to remain updated on changes within DeFi products. 

Financial Risk:

Lastly, the most obvious risk involved is financial risk. Traditionally, investors use historical performance as an indication of security or to help determine their confidence in the future of an asset. Many choose to opt in to what is called a risk-free rate, which means the potential for gains or the potential to break even, far outweigh the potential for risk. This idea has been recognized by a few lending platforms that have began to offer variable interest rates, to help ensure that investors in their product can maintain the value of their investment during times of volatility or uncertainty. Whether or not this tool is adopted on a mass scale in DeFi, there simply isn't enough historical data in Crypto or the DeFi space to properly assess the risks involved long term in most of these products. 

Assessment

Before onboarding onto a platform you should consider the following:

• With there be 2FA?

• How will the assets be stored?

• Who is the custodian?

• Is there insurance?

• Who owns the private keys?

• Is there anyway to monitor the funds backing the network?(If applicable)

In order to evaluate this test against a real platform, I asked Celsius network the following in their telegram channel: The answers are underlined

1. Is there any insurance provided like FDIC?

There is no insurance provided but are safe with Bitgo and are collateralized by being spread across enough borrowers so there is no central point at risk of being breached. However, we are interested in providing insurance in the future for a fee. 

2. Does Bitgo provide any form of insurance?

Bitgo does not provide insurance.

3. Will any of the deposited crypto be stored in cold storage?

Hopefully none! If it's in cold storage, then we can't earn interest on it. We're always deploying the coins to earn interest for the customers.

4. Who owns the private keys?

All private keys are held by Bitgo and Celsius Network with a multi-sig structure.

5. How will assets be stored that aren't currently loaned? (i.e. in between loans or pre-loan)

We will always deploy as many coins as we can. Any coins that are parked idle are stored on Bitgo. 

6. In the white paper, there is something called a "Lender's protection pool" containing $1,996,000 on page 14. Is there an address where this fund can be monitored on the blockexplorer for transperency?

No answer

Concern

My greatest concern is that this space is a bubble, stemming from unaware investors flooding a space incentivizing competition that drives up the interest rates in order to provide better services that competitors. Many of these platforms are built upon a perverted ponzi scheme business model, that has become dependent on future growth in order to guarantee future returns for their investors. If demand dries up, so do the interest payments. It's at this point that platforms begin to pay out other investors capital only for the funds to inevitably dry up without a steady flow of money coming into the space. Many investors are also unaware of the process in which their interest is generated. These platforms operate in a system that can be compared to the centralized financial and banking institutions. Meaning that your crypto isn't sitting somewhere in a wallet on a network, your coins are being lent out to lenders and your interest payments are facilitated by the interest they pay on their loans. So these platforms are no as decentralized as they seem, the space has drifted away from peer-to-peer with the administrators acting as the middle man, destroying the trustless aspect of DeFi. As a result, you are now dependent on two parties keeping up their end of the deal with making sure you get what you were promised. Issues come into play as this space grows, tragedy of the commons becomes inevitable. Therefore freeriders will eventually take advantage of this space and with it being cryptocurrencies the abuse can be pushed beyond the extremes. In the event that borrowers fail to make payments, the network begins to fall apart. So because of the anonymous nature associated with cryptocurrencies, there is no viable way of guaranteeing that the contract you enture will be honored. 

But the only way to learn about this space and to further innovate is to try them out. Just don't risk the whole pie because there are significant hurdles that come with evaluating the DeFi space. As a product of Blockchain, interest yielding platforms in DeFi have contributed a significant amount of momentum to the expansion of the Cryptocurrency space and holds the promise to finally allow people to gain control over their finances in ways that have been impossible up to this point. Once all of the risks are properly assessed and combatted, DeFi will undoubtedly become another aspect that separates Cryptocurrency from the mainstream financial systems at large.