DeFi is full of opportunities, but making sure you make the most of them is more than a matter of locking funds in the highest-yielding application. To ensure strong returns, you also have to manage risk – and that's a multi-faceted process.
Decentralized Finance, or DeFi, is the killer use case for smart contract platforms like Ethereum. While Bitcoin enabled decentralized payments and saving and has achieved a status of "Digital Gold", the DeFi movement offers easy access to every form of financial service available in the traditional financial sector – and a few more that aren't.
Cutting out the middlemen and removing layers of trust and bureaucracy means decentralized applications, or dApps, are dramatically more efficient than their centralized counterparts. In addition to providing better security and transparency, that also delivers better returns. Much better, in fact: yields can frequently reach 10-15% annually, or even more.
But while maximizing the financial returns will be a key concern for anyone investing in DeFi initiatives, there are other criteria to consider. This is, after all, a new and emerging sector, and the risks can all too often cancel out the returns for the unsuspecting or inexperienced user.
1. Flexibility and Ease of Access
Interacting with DeFi dApps is not like engaging with traditional investment opportunities. The user alone is responsible for their funds and all transactions. Among other things, that means:
- Setting up a crypto wallet
- Storing private keys safely
- Maintaining security
- Paying transaction fees
- Researching the market to ensure capital is used most efficiently
Some or all of these points may be challenging for the new DeFi investor, and mistakes can be costly. For example, in moving capital from one dApp to another to take advantage of better returns, it will be necessary to pay transaction fees. These can be high, and may cancel out the benefits of redeploying funds, especially in the short term. Similarly, secure private key storage is critical if loss or theft of funds is to be avoided.
One alternative is to use a secure, regulated exchange that provides access to DeFi products. The advantages of automation and convenient user experience will likely benefit all but the most tech-savvy and experienced crypto investors.
2. Track record and team
Secondly, check out the team behind the project – whether that's a DeFi-enabled exchange or a specific dApp. In the past, crypto investors have been overly careless about the risks of trusting anonymous developers and entrepreneurs. This has resulted in thefts and scams totalling hundreds of millions of dollars. Since dApp code should be open source, this reduces the possibility of funds being stolen by the team responsible for the app, but it's not unknown for developers to code in vulnerabilities that allow them to siphon off funds at a future date.
The odds of running into problems in this regard plummet with a public and experienced team and the accountability that brings – whether their expertise is in smart contract development, security or the broader fintech sector.
3. Regulatory and legal status
With the growth of the blockchain and cryptocurrency movement, governments and regulators are taking notice of initiatives across the board, from exchanges to ICOs, stablecoins to dApps.
These are global technologies and protocols, but that doesn't mean they are beyond the reach of the authorities. A growing number of blockchain projects have been investigated, fined or even shut down for flouting the rules of one or other jurisdiction.
Consequently, any initiative that is careless about their regulatory status should be treated with caution. If key members such as founders and developers are sought by the authorities, or the project is forced to close down, there will likely be serious financial repercussions for users. In short, make sure that any platform you use is compliant and has taken its legal position seriously.
4. Smart contract risk
DeFi applications are powered by smart contracts: code that runs on the blockchain, and that executes exactly as written. Unfortunately, there have been too many instances where errors in dApps' code have resulted in exploits of one kind or another, with the loss of user funds.
Many dApps are launched without so much as a code audit, which should highlight the most serious issues and allow developers to address them before users put funds at risk. The gold standard of smart contract security is formal verification, which proves that dApps will execute, error-free, with the reliability of a mathematical formula – essentially making unexpected outcomes impossible.
It should go without saying that decentralized finance is decentralized, but all too often dApps and platforms have single points of failure or points of trust that negate the benefits of decentralization. These can range from undue reliance on a single developer or one exchange to poor distribution or tokens or even inadequate decentralization in the underlying blockchain. In all cases, points of centralization introduce vulnerabilities – the risk that development will stop unexpectedly, that trading will be suspended, that a whale will crash the price, or even that a blockchain will be compromised by a double-spend attack.
Do your due diligence before depositing funds. While there is no such thing as risk-free returns, some basic research can avoid the vast majority of problems that new and experienced DeFi investors alike tend to encounter.
The good news is there's no shortage of material online, and most DeFi initiatives have thriving communities who will discuss the different opportunities and risks inherent in getting to grips with both these new technologies as a whole, and specific dApps. Dive in and experiment, by all means – there is no better way to learn than to try out different platforms. But until you're confident that you know what you're doing, it's safest to play only with small amounts of crypto.
To find out more about the opportunities DeFi can offer new and experienced investors, and to engage with DeFi safely and easily, visit Coinchange.io.