Decentralised finance can provide great earning potentials; however, like all investments, there are inherent risks.
DeFi or decentralised finance is a buzzword these days, especially if you are involved in cryptocurrency. However, there are intricacies about DeFi that cryptocurrency investors should understand.
Decentralised finance refers to a network of activities that remove intermediaries in traditional financial services such as banking. Its umbrella includes interest-earning accounts, loans, insurance, money transfers, and cryptocurrency exchanges. An example would be a user who can lend a certain amount of Bitcoin through DeFi and earn loan interest from that without the involvement of a traditional lender.
One of the prominent features ,when Bitcoin was launched was its decentralised feature. Before the concept of Bitcoin, digital money needed a third party such as the government or a bank to authenticate transactions and assure payments. Bitcoin is powered by blockchain technology that allows DeFi to remove intermediaries.
DeFi expedites transactions because it eliminates paperwork and costs. For instance, an application for a loan does not require a credit score; however, one needs to use cryptocurrency as collateral. However, it is to be emphasised that DeFi applications also bring other risks.
The following are four points that crypto investors need to know about DeFi.
1. DeFi Protections Are Not Similar To Traditional Banks
Accounts in the traditional bank and investment companies offer a different kind of protection that is not absent in decentralised finance. Thus, an investor must know that there might not be a safety net when something goes wrong.
For instance, if a traditional bank goes bankrupt, savings are insured by FDIC of up to $250,000 per eligible account (Excludes brokerage accounts as these are covered by SIPC). Most bank account owners do not worry about their banks failing. However, there is a higher probability that a decentralised finance platform could fail, and there will be less protection with its investors.
2. DeFi Is Flourishing
The ever-increasing high regard for cryptocurrencies by investors has pushed the increasing strength of the decentralised finance industry. An estimated 490 billion is invested in DeFi right now, according to DeFi Pulse’s report, an analytics and rankings site.
DeFi Pulse monitors the Total Value Locked (TVL). TVL is the total fund value deposited in different DeFi applications, which is a parameter of the market size. Most DeFi applications are built on the Ethereum (ETH) network, which shows the influence of Ethereum on TVL, including the amount of money invested in DeFi.
TVs increased from $8.5 billion to $25 billion from 2019 to 2020. As a result, there is a high probability that TVL will reach $100 billion at the end of this year.
3. Imminent DeFi Regulation
With the recent governmental talks about crypto and DeFi, there is an imminent possibility that DeFi will be regulated. Different government authorities such as the SEC and the Treasury have voiced the need to handle this industry. It has been said that DeFi platforms offer similar services to traditional banks without guaranteeing the same level of consumer protection. Furthermore, DeFi services can anonymously be used to go about existing laws to prevent illegal activities such as money laundering and terrorism. DeFi investors can gain huge revenues but also have risks of losing money because DeFi is not moderated, regulated, hosted, or validated by a central authority. DeFi only works through P2P and is operated by smart contracts.
4. Numerous methods to earn in DeFi.
Getting involved with the DeFi industry has lots of ways involved. One of these is to purchase DeFi crypto tokens. With the increasing value of crypto and DeFi, DeFi crypto’s worth has also increased.
DeFi also allows investors to earn interest in cryptocurrency. This involves borrowing and lending in these DeFi platforms, which pay higher rates than a traditional savings account. Another method is to utilise these platforms to stake coins, which means linking them to provide the general security and maintenance of that specific crypto network. If you are interested in how cryptocurrency works and start trading, click on Bitcoin Profit.
However, the following are factors that need to be considered before engaging in DeFi.
- Scams: CipherTrace reports that DeFi fraud and hacks had stolen an estimated $471 million as of August this year. It is to be noted that it is difficult to retrieve stolen crypto funds. Thus, DeFi applications must be researched before depositing funds. Online reviews and crypto forums can help verify if these DeFi applications are reliable.
- Technical Risks: Removing the middlemen has its drawback because a piece of code replaces an organisation. This is okay if the code is reliable and controversial if not. It is best to look for open source projects as everyone can access the code and verify for bugs. Also, potential investors should be alert of new projects that have not been tested. Investors should check for red flags that include applications that do not publicise their code or disregard security concerns in their social feeds and forums. It is recommended that when an investor chooses a blockchain, exchange or protocol network, this should not be controlled by a small group of leaders, has affordable transaction fees, and can manage heavy user demands.
- Asset Storage: Platforms that secure most of their assets offline should be prioritised over those who hold them online. The former is called cold storage. In addition, these platforms should be insured against crime or hacking. It is best to have security features and third-party audits with these platforms.
- Use of Assets: Several DeFi platforms promise high payment interest rates on the crypto deposited by investors. These platforms lend out these funds and pay partial interest to investors on the amount borrowers pay them. Platforms should be transparent, so people will know where these funds are and the risk involved with these loans.
Like other kinds of cryptocurrency investment, if you decide to transact with DeFi applications, only invest in money you can afford to lose. In addition, you should research the industry that you want to invest in, plus its inherent risks.