In recent years, a whole new industry has emerged in the blockchain and cryptocurrency universe, that of decentralized finance (or DeFi for short). Built primarily on the Ethereum blockchain, DeFi is the crystallization of the ambitions pursued by the architects of cryptocurrencies, to build a complete financial system controlled by a single entity. The arrival of cryptocurrencies allowed us to send and receive money without the intervention of an intermediary (for example, a bank), but the rise of DeFi allows us to borrow, lend, save, speculate and more in the same conditions. For example, with DeFi lending protocols like Compound, anyone can obtain a secured cryptocurrency loan or earn interest by lending their own crypto, regardless of their identity and financial history. Decentralized exchanges (DEXs), on the other hand, facilitate peer-to-peer transactions without the need for a middleman to hold the funds. Unlike traditional crypto exchanges, users can also exchange any Ethereum-compatible token for another, as long as there is supply and demand. As Michael Beck, project manager at DeFi, a UNION risk management firm, explains, “DeFi applications are based on smart contracts, like traditional DApps, but strive to decentralize the governance role and custodian role of the application. ". "It's favorable from a DeFi standpoint, because people place a lot of value on smart contracts, so they want to know that there's not one person who can pull the rug out for them." And Beck is right to suggest that the money is being invested in decentralized finance. According to data from DeFi Pulse, almost €25 billion is currently locked up in DeFi smart contracts, down from just €15 billion earlier this month and less than €1 billion a year ago. However, while it is clear that significant value can be found in this burgeoning new financial ecosystem, there is also considerable risk, especially for the unwitting investor.
DeFi Risk and Reward
Early adopters of new technologies are always positioned to gain more should the product or service enter the mainstream. If someone had bought Bitcoin five years ago, for example, their investment would be worth 100 times its original value today.
However, the benefits of early adoption only materialize if the investor manages to back the right horse. And the same can be said for the many DeFi projects springing up today.
Yield farming is a DeFi practice in which users lend their own cryptocurrency to a project, earning interest in exchange for providing cash. In some cases, actors are also remunerated with a governance token, which gives them a "vote" on the future of the project and can also be traded via a DEX.
To maximize ROI, yield producers often transfer funds between different protocols, seeking the highest annual percentage yield (APY). It is the growth engine of DeFi right now.
However, the risks associated with yield farming are significant, especially for retail investors. High transaction fees, market volatility, and security incidents related to smart contract vulnerabilities can cause the value of an investment to plummet.
"We all trade when we go from centralized to decentralized products," says Beck, who presents the conundrum as a question of reliability versus innovation.
“Centralized products have a strong reputation and brand pedigree and have proven themselves for years. When you move to decentralization, you find a little more innovation, but there is a commensurate level of risk. "Comparisons could be drawn between the current state of DeFi and the ICO boom of 2017-18, in which investors pumped billions of dollars into new crypto projects in the hope that related coins (similar to stocks) ) will increase in value. However, many of these projects were rotten and large numbers of people lost much, if not all of their investment.
Given the esoteric nature of blockchain and the complexity of the different lending and borrowing mechanisms at play in the DeFi ecosystem, it will be difficult for the average investor to distinguish between DeFi projects with real value and those that ride on the hype.
“For someone with only a few tokens in their pocket, DeFi is incredibly risky, expensive, and complex. We see these factors as barriers to participation,” Beck told TechRadar Pro.
"If you think about the aspiration of blockchain and cryptocurrency to ensure the autonomous democratization of finance, it's hard to see how DeFi can be as successful as it is today."
Insure against disasters
Set to launch shortly, the UNION protocol is designed to remove barriers to entry for retail investors by insuring against contingencies that could result in the loss of funds. It does so through the so-called umbrella tokens, which according to Beck can be compared to policies taken out with a traditional insurer, which grant certain benefits to the holder. “These products provide flexible tools, so people don't necessarily have the exposure that they would in an uncovered DeFi market,” he said. The protocol itself allows for different types of composable benefit structures, which can be shared across multiple policies. This means that UNION can support events that could threaten the value of investments, such as collateral optimization issues, fluctuating transaction fees, and smart contract failures. While comparable DeFi insurance platforms such as NexisMutual could insure against the failure of a specific smart contract, UNION hopes to stand out with policies that cover a broader range of risks at once. Unlike other insurance protocols, UNION can also circumvent some Know Your Customer (KYC) requirements, as the holder of an umbrella token does not directly benefit from it. This means that anyone can subscribe to a policy without having to submit any personal information. This combination of qualities, Beck hopes, will help remove risky barriers to entry, while attracting participants for whom confidentiality and decentralization are top concerns. While projects like UNION can go some way to offsetting the risks associated with investing in DeFi, the danger can never be fully eliminated and can also take new forms as the ecosystem evolves. An attribute known as composability means that new DeFi projects can build on and connect to existing applications and infrastructure, creating something entirely new. But it can also pose problems for investors, Beck says. "The more projects there are, the more unexpected the interactions between them."