Sarah was enticed by ads that promised huge DeFi returns. By subtle enticement, she invested her savings for promised ‘guaranteed gains’ and went on to click on approve. She drained her account and slipped into regrets for undertaking an investment without a prior understanding of the processes of the Risks Involved In Using DeFi Applications.
Decentralized Finance, popularly known as DeFi, is a protocol that lets you bypass the bank and money on the blockchain, just like crypto. This process helps users and holders to borrow, lend and earn interest on money without any middleman or centralised party. Due to its freedom from traditional financial systems and its ease of accessibility, it has grown in popularity in recent times in the US and beyond.
Since DeFi promises financial freedom to users, it has its pitfalls and negatives. Issues of flaws in codes could be the sole reason your funds are stolen. Like Sarah, clicks like “approve” could drain your account if you have zero knowledge about the process. You will put yourself into a costly situation if you venture into DeFi without proper understanding.
Risks Involved In Using DeFi Applications
DeFi is designed to run on codes that are self-executing, and these codes are called smart contracts. It works in the same way a vending machine is programmed to perform a trade for a set amount. Nonetheless, smart contracts have no reversal policy when there are errors in the codes and this brings up the concerns of Risks Involved In Using DeFi applications.
Since US regulations are still catching up with DeFi, there is a big difficulty in getting back funds once they are hacked and stolen.
Bugs act as loopholes in codes that hackers exploit to steal funds, and this was seen when a former Amazon engineer hacked a huge amount of funds. It is easier to check and validate the security history of platforms before engaging in any smart contract.
Liquidity Risks in DeFi
A liquidity pool works in a way where everyone contributes crypto tokens together to achieve a set goal. It is very common in DeFi platforms.
The users have tagged Liquidity Providers (LPs), who, with an equal value of two tokens, commit to a pool and easily swap tokens without a centralized party for trading. LPs, in turn, earn fees for providing liquidity.
Situations often arise when there are pools with low liquidity and swapping a small amount can cause a high percentage of price swing. This leads to an impermanent loss where the value of the LP token appears to shrink. To avoid this, check the value of the total pool locked before lending your token.
Market Risk in DeFi
The crypto space can be rather dramatic, and a single action could cause a wild turn of events with lots of panic and greed. The rate of volatility is wilder with DeFi, where prices can soar and plummet at any cause. Due to its reliance on crypto, a price swing on the crypto side can throw DeFi investments off balance.
Loan liquidations can be triggered by a sudden drop, leading to a domino effect that can wipe out an entire fund faster than one can imagine. Although DeFi is a thrilling space, it cannot be recommended for someone with a faint heart.
It can only be advised that one take the risk he is willing to stomach or one that will not leave him homeless and broke should the funds sink in the ocean of downturns. It is best to take caution before entering into certain investments to avoid losses. Take the risk you are willing to bear.
Regulatory Risks in DeFi
In the US, the regulations for DeFi risk are still a work in progress and will soon be out to guide such investments. On the part of the SEC, some tokens are considered securities, which require registration. The CFTC focuses on aspects like derivatives trading. This uncertainty can be risky for users.
Regulations in the future will certainly bring clarity to users and how the DeFi space should work. Potential rules could include one to ensure that users’ identity are verified by platforms to ensure a better protection for users. This will definitely have its impact on users’ experience with new steps added to the transactional process. Moreover, this can lead to a lasting trust between platforms and users in the long run, plus an added security measure. Keeping an eye out for regulations from SEC and CTFC can help you make informed decisions and bring added clarity to the investment process.
Scam Risk in DeFi
Scammers are hovering around, looking for the slightest opportunity to defraud anyone. Like in Sarah’s case, they promise great returns that are too good to be true to potential victims. This “rug pull vanishes withthe investments once they get the money. Watch out for projects that are of high pressure to ‘get in early’; they probably will vanish once you are in.
When they appear too good to be true, it probably is a scam out there. Research thoroughly on the project’s roadmap, development team and community before venturing into it.
Go for projects that have a locked liquidity pool and fair token distribution. Stick with established DeFi platforms with a proven track record and independent security audits. While DeFi offers innovation, prioritise platforms that prioritise user safety.
Risk Management Strategies in DeFi
Since the DeFi space is very slippery for newbies and unsuspecting investors, follow the following rules to stay abreast and avoid impending losses.
1. Investigate before investing: Do not blindly jump in, investigate DeFi platforms before turning in your funds.
2. Start small and steady: Invest only what you are comfortable potentially losing. This isn’t a get-rich-quick scheme.
3. Spread your investments: Don’t concentrate on one platform or choice. Diversify your crypto investment to cushion fails and losses.
4. Look for DeFi that is built on secure smart codes. Stay informed and keep yourself updated with the latest information and regulations in the DeFi space.
Conclusion
In the US, there are risks involved in using DeFi applications, despite their promises. Funds can vanish through bugs, which act as loopholes for hackers. Freedom from regulations could also amount to exploitation by scammers who pose as DeFi platforms.
It is important that potential investors do thorough research on all platforms and read through their contracts and roadmaps to be able to make informed decisions.
Never forget the rule that says ‘Invest only what you can lose’. Before entering this evolving space, take the time to learn and make informed decisions. Your financial well-being depends on it!