Decentralized finance (DeFi) protocols are estimated to grow in a decade or two to tower over legacy financial substitutions, such as major US-based investment bank JPMorgan, but there are specific, inherent risks that still need to be dealt with.
“DeFi will eat JPMorgan,” according to research analyst at crypto research firm Messari. That said, whether DeFi assets could one day rival today’s largest global financial institutions, or their ceilings are structurally lower, depends on three variables, he argued:
- anti-financial institution sentiment produced by the growing anger at Robinhood and other traditional trading platforms;
- major crypto exchange Coinbase‘s upcoming direct listing and rumors that it will be valued at upwards of USD 50bn – as investors anticipate renewed attention on crypto exchanges, DEXs may be benefiting from Coinbase’s valuation.
However, while “the generous rates DeFi offers relative to traditional yield-bearing instruments is enticing, […] we believe there are significant implied and realized risk premia worth considering,” noted Kraken Intelligence, the exchange’s team of in-house researchers.
1. Currency risks
“Overall, there will be varying degrees of risk-free rates or none depending on the crypto asset,” said the report, “and for those with none, interest rates will be a function of risks unique to each currency, platform, and therefore the yield product.”
Most DeFi platforms are currently built on the Ethereum (ETH) network, so lending/borrowing is carried out in ERC-20 tokens, as well as in wrapped tokens. An example of risk in the custodial element of a token is that custodians hold the native asset and mint the wrapped tokens, while merchants initiate the minting, directly interact with users, and burn tokens.
2. Platform risk
Focusing on DeFi lending and Automated Market Makers (AMMs), the report found that the main risk associated with DeFi applications is the risk of protocol exploitation through bugs or errors in its smart contracts. There has been roughly USD 86m lost from DeFi exploitations in 2020, it said, while many DeFi platforms may not yet have proper coverage or insurance measures put in place that guarantee fund safety.
Besides smart contracts, there are also counterparty, liquidity and collateralization risks, as well as liquidity pool risks, such as the one known as impermanent loss. Furthermore, “as a platform’s rules and the general development of a protocol are impacted by its governance structure, there is a risk that said governance negatively impacts the platform,” said Kraken.
That said, according to Anthony Sassano, SetProtocol product marketing manager and author of the Ethereum-focused newsletter The Daily Gwei, “DeFi’s superpower is in its composability – that is, the ability for all different types of money legos to talk to and interact with each-other.” This cross-collaboration can be extended to different projects and teams within Ethereum and the layer 2 space – what’s more, it will be needed for Ethereum to keep developing, the author suggested. The collaborations “will unlock much more value for the ecosystem over the coming months,” Sassano added.
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