Investors chasing yields opens the door to DeFi
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Special Report: With instant GME millionaires making headlines, it’s easy to forget we live in a low yield world. Record low cash rates across Australia, the US and Europe combined with muted bond yields thanks to quantitative easing have prompted investors to seek returns from riskier assets, including in Decentralised Finance (DeFi) lending.
There’s no wonder why. Even high-interest accounts with a bank will yield around 1% per annum, but DeFi lending can net anywhere between 2% at the low end and over 8% on the higher yielding options.
With new participants joining the financial services industry as a result of the pandemic, and as traditional banks fail to offer appealing rates, people are experimenting with these new opportunities. For the first time we have individuals participating in commercial lending, often crossing geographical boundaries, with just a few clicks.
How many? Over $US11 billion in DeFi lending – or crypto peer-to-peer lending – has been locked into this market this year alone, according to analytics and rankings website DeFi Pulse.
While the impressive yields offered by various exchange platforms on DeFi lending are extremely attractive in the current environment, Kraken managing director Jonathon Miller cautioned that there are significant risks worth considering, including the inherent volatility of the currency being lent, as well as the security of the platform itself.
Just like the early exchanges before them, many of these DeFi platforms are young and will likely be targets for malicious actors – risks that should be factored in by any potential investors.
“DeFi has opened up access to financial services for both banked and unbanked individuals globally through the use of the internet,” Miller said.
“We hope to educate market participants in the DeFi space while also encouraging individuals to be more security-aware and risk cognisant. The potential impact of DeFi on the ability of individuals to lend and borrow on their own terms is enormous, but you have to tread carefully as this is a relatively new concept in the world of finance.
“This is why we have begun providing Oracle pricing data for DeFi borrowers and lenders. Whilst technically complex, in layman’s terms it means we can help participants compare real world prices from our exchange inside the decentralised protocols.”
The world of cryptocurrencies is vastly different from traditional systems and its offerings, but once investors understand the risks, informed decisions can be made to manage the risks that affect the yield of DeFi investments, Miller said.
Here are the platform-associated risks identified by Kraken that the exchange says DeFi investors should be aware of.
One main risk associated with DeFi applications is the risk of protocol exploitation through bugs or errors in the infrastructure, which can be manipulated by attackers to target accounts for the purpose of making fraudulent transactions.
Roughly $US86 million was lost from DeFi exploitations in 2020, DeFi Pulse analysis has found. Exploitations increased in 2020 with the rise of DeFi, and many platforms did not have proper coverage or insurance to guarantee fund safety.
“As human written code is prone to errors, both participants and lending platforms must find better ways to manage the level of risk on their platforms,” Miller said.
“Proactive security and code audits as well as verifications are now conducted by some platforms to manage this risk across its protocol’s smart contracts. Not only active exploitation attempts, but also the case of unexpected protocol failures can be a source of financial risk to all participants involved.”
DeFi lending comes with a level of liquidity and collateralisation risk, as it can only be as diversified as its sources of liquidity. Robust lending platforms will offer liquidity from a wide set of participants with uncorrelated behaviour, ensuring less risk of liquidity evaporating during times of crises. To be prepared for possible scenarios where a lender won’t be able to exit a position or access their funds whenever they wish, platforms specify collateral instruments and cap the borrowing and withdrawals at the size of liquidity pools.
“Though it’s hard to predict when illiquidity will occur on a platform, looking back at historical events and analysing how markets reacted can help us understand the risks involved in participating in that particular market or venue,” Miller said.
There is also a risk that a platform’s governance could have a negative impact, particularly where applications don’t have an open governance structure, meaning changes to its protocol can be made without the consideration of a majority of participants involved.
“Though it would be misleading to conclude that open governance protocols hold less risk than centralised governance, it’s important to note that fully understanding the governance structure of each protocol, as well as knowing historical market reactions to governance-related changes on the protocol, can be an indicator of possible risks present on a platform,” Miller said.
This article was developed in collaboration with Kraken, a Stockhead advertiser at the time of publishing.
This article does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.