When making investments in the decentralized finance ecosystem, you should consider the risks. There are 5 types of generic risks.
CODING RISK
Errors in the code allow attack vectors that can be exploited in the protocol or platform. DeFi is simply a set of software, created by lines of code, and given the complex nature of DeFi protocols, it is not uncommon for “attack windows” to exist through which funds can be stolen.
Due to the composability in DeFi, (the relationship between various protocols), if one protocol is unstable, it is quite possible that there is a risk to the entire connected ecosystem.
Also considered in this type of risk is that of fraud, or as it is known, “scam”. The malicious intent is developed from the gestation on the platform, in the very code of the contract, allowing the creators an attack vector to appropriate the funds in a given event.
RISK OF CENTRALIZATION
Oracles, whether hardware or software, channel real-world data to smart contracts. They are used by many of the protocols within the DeFi space, to obtain quote information. Liquidity pools using automated market ( AMM ), or decentralized exchanges ( DEX ), which generally receive data from a single source, are vulnerable to attacks on that source of information.
Ironically, while these centralized systems provide some advantages to DeFi platforms, they also represent a significant risk to the functioning of the ecosystem. Oracles are a potential source of systemic risk and their data feed function is prone to manipulation.
FINANCIAL RISK
There is the risk of Impermanent Loss (Impermanent Loss), which refers to the phenomenon where tokens held in an AMM are considered to have a different value than if they were held in a wallet. Due to the synergistic events that occur in an AMM to maintain the functioning of the ecosystem, one may find that their holdings have less value in the AMM than if they had simply kept the holdings in a wallet. Of course, for the loss to materialize, the tokens must be removed from the liquidity pool, otherwise it may be that the low price reverses and the loss disappears.
Liquidity is critical to efficient pricing in the financial industry. Greater liquidity allows for more stable prices. Liquidity risk is closely related to technical scalability.
Finally, the price of the token representing the liquidity investment and its collateral (if any) must also be considered, which may devalue at any given time, or worse, drop in price due to loss of utility value to the market.
REGULATORY RISK
Like the larger cryptoasset sector, the DeFi industry is subject to an uncertain regulatory environment. Due to its birth, the blockchain industry is under intense scrutiny by regulators tasked with protecting the general public.
Unfortunately, due to a combination of factors, such as lack of understanding and the complexities of the technology, some regulators and jurisdictions are not in favor of the DeFi space. Fortunately, this problem is likely to ease over time.
Being a global ecosystem, what may be legal in one country, or tax exempt, may not be in another. It is unlikely to be regulated homogeneously around the world.
UNDERLYING RISK
DeFi protocols are instruments that run on public blockchains. These blockchains typically have a native digital asset. The evolution of the price of the supporting blockchain asset is likely to affect the value of the shares locked in a DeFi protocol. While this may generate gains, losses are also possible.
In addition, the blockchain on which the smart contract runs, could suffer a technical failure, either due to code error or execution error in its development, leading to a terminal impact on the DeFi protocol.
Related article: Scam Alerts in DeFi
