The DeFi Paradox: Risks and Opportunities

The protocol is the most secure cryptocurrency, and we need money to be secure. Protocol hacks, liquidity runs, and oracle failures can lead to the loss of millions of dollars in DeFi. We’ve seen it happen repeatedly, and we can’t have that with money if we want a genuinely decentralized financial system.


Despite rapid growth in the DeFi space and its open-source ecosystem with the potential to democratise banking and finance, there are significant risks for participants to be aware of. Several projects have been vulnerable to hacks and theft of funds, which has led to safety questions about using DeFi products. Hacks in the DeFi space accounted for nearly 76% of all major hacks worldwide in 2021 so far, according to a report by security firm AtlasVPN.

This article attempts to provide a short background on the current regulatory landscape for DeFi, the role of the United States Securities and Exchange Commission (“SEC”), and highlights two important hurdles that the community should address. Most decentralized exchanges enable trading through the use of liquidity pools. The value of the primary currency is determined by the total number of secondary tokens locked in the contract divided by the number of locked primary tokens. For example, if a liquidity pool has 50 „A tokens“ and 100 „B tokens“ locked in the smart contract, you’d be able to buy one „A token“ with two „B tokens.“ To address these issues, investors, experts, and regulators alike have called for greater regulatory clarity in the realm of DeFi. All eyes are on the federal financial regulators and Congress as those groups of policymakers attempt to navigate a novel and highly complex arena and to construct a workable regulatory regime.

DeFi Protocol Risks: The Paradox of DeFi

It would help if you did your due diligence before participating in a application or protocol. The crypto-asset market is volatile, and exposure to the underlying currency risk and derivative assets, such as protocols built on top of blockchains, comes with significant risk. In moving to DeFi, I suspect most retail investors are not doing so because they seek greater privacy; they are seeking better returns than they believe they can find from other investments. Conversely, well-regulated markets tend to flourish, and I think our U.S. capital markets are prime examples. Because of their reliability and shared adherence to minimum standards of disclosure and conduct, our markets are the destination of choice for investors and entities seeking to raise capital. Our securities laws do not merely serve to impose obligations or burdens, they provide a critical market good.

  • Some DeFi lending protocols use a single liquidity pool to track the price of a token.
  • The volatility in the crypto asset class is expected to decrease as the industry matures.
  • In the current overcollateralized paradigm, the primary embedded risk in the lender-borrower relationship comes from improper collateral valuation and liquidation.
  • Lately, fintech has caused some disruption and helped reduce transaction costs.
  • While the potential for profits attracts attention, sometimes overwhelming attention, there is also confusion, often significant, regarding important aspects of this emerging market.

China who is aspiring for its digital Yuan to replace the US dollar as the reserve currency has already banned crypto. The US as a democratic country might not make such a drastic move as to outright ban crypto, it might instead decide to heavily regulate the crypto industry in an effort to slow it down. The recent approval of the first futures-based BTC ETF is a sign of a certain level of crypto acceptance and a signal that the US probably won’t try to outright ban crypto.

Building a New Financial City

Organisations are emerging to provide better earlier support and one click regulatory solutions. Requirement for monitoring transactions – DeFi applications need more comprehensive checks to ensure transfers to the right addresses. We already have a few potential solutions such as human-readable wallet addresses. To find out more about how DeFi is changing financial services in Europe, download the full report.

Investors should take stock of technological, asset-specific, and compliance risks when considering whether to invest in a project and/or use DeFi networks for their use cases. Several regulators have weighed in with guidance relevant to DeFi developers and users. But the decentralized nature of DeFi makes it uniquely hard to regulate as rule makers are faced with the question of who, what, where, and how to regulate a rapidly changing space. Additional risks may arise from the interface of traditional and crypto finance. The use of DeFi’s could mitigate some risks relative to the provision of services through traditional intermediaries. FTX filed for Chapter 11 bankruptcy in the U.S. on Friday with Sam-Bankman Fried stepping down as the company’s CEO, sparking concern across investors worried about a potential crypto contagion.

Although these programs reduce the chances of exploits, they do not eliminate the risks. Nevertheless, whenever you are engaging in the DeFi ecosystem, you must be aware of the potential technology risks. I recognize that DeFi has experienced significant asset price appreciation, and that is part of what motivated me to write this. The impacts of the information disparities or market conduct on retail investors may not be easy to see until the next DeFi market downturn or crisis.

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