DeFi Risks - Why I Am Not Afraid Yet
As a computer scientist, I believed and invested a significant (6 digit sum) of my investable money into crypto currency, especially some form of DeFi (decentralized finance), given its promise of high yield interest rate (11%) compared to current fiat currency (1.5%).
What can go wrong with DeFi? Unlike traditional finance, there are major risks in DeFi including risks of regulations, forgetting your passphrases/passwords, sending wrong addresses, smart contract vulnerability, sudden coin value collapse, inflation for non-fixed supply coins and transaction fees spike.
I will share each of the risks and how I am approaching it myself.
Risks of Regulations
An example is Ripple (XRP) who dipped after the US regulators SEC took actions against Ripple. SEC said Ripple did not seek official permission to list or sell their tokens. They are still undergoing many changes as exchanges delist the token.
Libra, an initiative for a global digital currency by Facebook, also got threatened by regulations early on but still remain and renamed as diem.
Many regulators are still undecided on how to manage crypto currencies.
- As a country (e.g. China, US, Russia or Venezuela) , would you prevent a technology that can overthrow your hold on people?
Early on, China did took actions but the coins from China still exist in other countries. Coins like NEO and Binance still exist till date.
Like Gary Vee said (an early adopter of Bitcoin putting in $25,000), do you really think a country as big and powerful as China or US cannot stop decentralized finance? While they cannot destroy it completely, I believe they can dismantle and disrupt greatly, like how they managed crimes like Silk Road.
That's said, I felt the situation is the same as illegal trapping of animal parts. Regulators understood that overregulation will just lead to a spike in demand since the supply got reduced and things will still go underground (imagine people using VPN to access Google within China).
If I am a regulator, I will probably provide viable alternative to the problem e.g. digital Yuan as the first step and maybe a better interest rates like government bonds to get adoption and trust.
Risk of forgetting your passphrase or poor password protection practice
Almost $140 billion of BTC are lost due to millionaires forgetting their passwords/passphrases in the offline wallet. In fact, there are businesses like Wallet Recovery Services that make money recovering people money since 2013.
While this is not a problem of the technology, this is a inherit weakness of human. The crypto currency stored in a wallet requires you to keep the digital keys or passphrase of about 12 to 24 words (i.e. recovery seed).
On the other hand, poor password protection practice is rampart too given it is impossible to remember the sequence of words. People will just write it down openly eventually in paper. I won't be surprised that in 20 years time, I will start seeing 12-24 words post it on people desk that can unlock a digital wallet.
Risk of smart contract vulnerability
Most of the higher interest rates provided by DeFi relied on the concept of smart contract. Using smart contracts, there is reducing the needs of middle man, cutting down the costs and time.
There are instances where middle man are still required which usually relied on a "oracle" (e.g. to determine exchange rates in real world) and these are vulnerability to the smart contract executing correctly. This is already happening with reports of millions loss from manipulation of the "oracle".
A more farfetched vulnerability is the introduction of technology like cloud computing or quantum technology. Earlier I mentioned Wallet Recovery Service and they used cloud computing to brute force "hack" into wallet for recovery. Another idea was that quantum technology advances breaks cryptography. If cost is low enough, this method could also be used by unauthorized people.
Risks of coin collapse
Unlike regulated market like oil or stock market, it is still the Wild Wild West for crypto currency. A drop of 10% in a particular stock can easily result in a halt in trading that prevent further damage until further clarification. Likewise, for oil, OPEC can choose to reduce or increase supply when needed.
For Bitcoin, the supply is unlikely to change as it was already defined. Therefore a sudden change in demand can result in a major sell-off. Imagine waking up and finding you lost 30% of your money as it trades even when you sleep.
Coins can also be forked resulting in spike of "supply". Ethereum got splited into Ethereum Classic and Ethereum as people disagreed on the philosophy of how a hack DAO should be treated. As long as there are disagreement and people, nothing can prevent this.
Risks of inflation for non-fixed supply coins
The promise of Bitcoin was that it is different from fiat currency. There is no endless printing of money that cause inflation. However, not all crypto currency follow the fixed supply concept. Ethereum will keep producing gwei but the eventual goal might be to reduce it and rely on a Proof-of-Stake concept instead of wasting the world's resource into endless mining like Bitcoin.
Either way, due to the ability to fork, any coins could change the supply have enough trust from the community and developers that it is for the greater good.
Risks of transaction fee spike
While crypto currency cut away many middle man, transaction fee are unavoidable. In fact, at the current stage, I think fiat system are more cost-effective than crypto currency.
Unless the entire transactions stay within the same ledger, e.g BTC paid to your wallet and you used BTC to pay for goods, there are fees from 3rd party like exchanges or banks for the conversion to and from fiat currency. Even converting from 1 crypto currency (e.g BTC) to another (e.g. ETH) will cost you fees.
Even if your transactions stay within the same ledger, when BTC is full mined, most likely transaction fees will be imposed to provide incentive for people to process transactions in the ledger.
Many exchanges also impose fees to your "money" similar to current banks. It could be withdrawal fees, giving you a worse "exchange" rates, deposit fee, admin fees. There is no denying that these exchanges are like the new banks in fees.
Unrecoverable transfer to wrong address
Transferring "money" in crypto currency involved sending it to a "address" that consists of a long string of alphanumeric. While you should check and make sure the recipient is intended, human error is unavoidable. You won't be able to find out who it is too.
Another reason for transferring to the wrong address is that malwares will replace a valid address to their "hacked" address.
The main problem is that both are unrecoverable unlike current fiat system. It is "legal" for the other party to just withdraw the money without your permission. Unless the developers decide to hard fork and "reverse" the transaction, no one have the power to recover it.
Risks of 3rd party company failure to safeguard money
"Not your keys not your coins"
Mt Gox was a memorable case whereby the 2014 collapse of the exchange led to a lost of around $450 million at that time (probably many trillions now). They were handling almost 70% of the BTC transactions at that time.
I left this risk last as I am facing this risk now due to my above considerations. I put my token with Celsius.network to earn a higher interest rate because
- I think they sounds compliance to regulators so far as they didn't enter US straight away until they are sure
- I am not good at remembering password (I use Google Chrome password manager) and don't want to risk forgetting my passphrases
- Smart contract vulnerability is not something anyone can prevent but I believe there will be a countermeasure to any technology gradually. I only put my money in ETH, BTC, GUSD and CEL which are generally things I am more aware of and less controversial
- Coin collapse are unavoidable and unpredictable. The only way is to not over-allocate into crypto currency. I do have other assets in life besides crypto currency.
- Inflation can occur for ETH, GUSD that I hold. CEL and BTC technically have a fixed supply. I think ETH plans are to reduce supply if PoS is stable so it should be good news. GUSD is unavoidable again but I think the higher interest rates in DeFi off-set the real world inflation.
- Transaction fees in Celsius remains fair so far ($0). There are some hassle in withdrawing and security features but I can lived with it (e.g every withdrawal address change require 24hr wait). The founder seems truthful in not charging fees and the CEL community is really about HODLing that probably reduce fees to the exchange itself.
- Unrecoverable transfer to wrong address take a very careful eyes and don't install weird apps into your phone performing transactions. One way is to transact a small amount first to "test" it went through, at the expense of incurring slightly more fees. The good news is Celsius is free so you can test first.
- 3rd party exchange is the biggest risk I am taking now. A Mt Gox event happening to Celsius will wipe out my entire crypto currency portfolio. That's said, I somehow trust CEL founder for now. A person who discourage you to buy BTC in Twitter, at the expense of being flamed by trolls sounds too honest to find fault in.
I dumped my thoughts on the risks of DeFi and hoped it is useful for your investment thesis.
If I was to start as a risk-adverse investor interested in crypto despite the risks, I would probably advise going with Celsius with a stable coin like GUSD and just enjoy the 10% interest first to get your feet wet.
Don't FOMO as I did early on, going with ETH at maybe $1,200? (cannot recalled) years ago. I got a friend forgetting his password and you can still recover it and there is no hassle of hardware wallet.
Sky Hoon. Read Full Bio
Website Owner, Twitter-er
He has been trading since 2008. He started this blog to share the journey about option trading. He dabbled in stocks, bitcoin, ethereum (in Celsius Network), ETF (lazy Dollar Cost Averaging) and also built websites for fun. He used this as a platform to share my experiences and mistakes in trading, especially options which I just picked up.