Several cases show us that while there are amazing opportunities for gains in the DeFi space, there are also many risks that must be considered.
The decentralized finance space has grown exponentially over the last few months, to the point where more than $9 billion worth of crypto assets were locked in its protocols before crypto prices started dropping. The space had a little over $500 million locked in back in September 2019.
This exponential growth in the last few months appears to be mainly related to a yield farming trend that started when lending protocol Compound began distributing its COMP governance token to users who interacted with the protocol.
Put simply, yield farming — or liquidity mining — allows DeFi users to generate rewards with their cryptocurrency holdings by interacting with protocols that distribute governance tokens. Farming yield can be a profitable venture on its own, but the tokens being farmed often see their price surge as well.
One of many examples of this is YFI, the governance token of Yearn.finance, a site that helps users find the best yields in DeFi protocols. Over the last 30 days, YFI is up more than 400%.
The risks of chasing short-term gains
Yield farming isn’t simple, however, and rewards rarely go up in a straight line. It’s also not a practice that’s suitable for all crypto holders since it generally requires holders to pledge large amounts of capital in order to earn more rewards. Moreover, in the decentralized finance space, there are various risks that aren’t immediately clear.
One risk associated with yield farming that most people seem to neglect is the very nature of smart contracts. Popular DeFi protocols are developed by small teams with limited resources, which can increase the risk of smart contract bugs and vulnerabilities. Even well-known audited protocols have been hacked.
The smart contract risk is very real and could end up costing a lot of people money. One famous case is that of Yam Finance (YAM), a DeFi project that saw users lock in over $500 million worth of crypto assets on it before a bug that was discovered made it impossible for the community to reach a quorum.
While the creators of Yam Finance did warn users that their smart contract was unaudited, the pursuit of short-term gains saw users lock in over half a billion dollars in it — even though the protocol’s token was not listed on top exchanges — before tragedy struck.
As data shows, after the YAM token hit its high, it crashed from around $100 to $1 in a single day. And now, the tokens are now worth $0.02.
Other risks are related to the inherent volatility of cryptocurrencies and to the intentions of those behind DeFi protocols. SushiSwap, a popular decentralized exchange modeled after leading DEX Uniswap, is a clear example here.
SushiSwap is an exchange that does not work with an order book but with an automated market-making, or AMM, model. This model sees liquidity providers add funds to liquidity pools. It differs from Uniswap thanks to the SUSHI token, which entitles holders to the project’s governance and rewards them with a portion of the fees traders pay.
It was created by the pseudonymous developer Chef Nomi and in just over a week, saw users lock over $1.27 billion worth of crypto assets in Sushi contracts. Chef Nomi, however, decided to cash out a stake of SUSHI tokens for over 38,000 Ether (ETH), leading some to believe it was an exit scam.
The result was a price drop of over 70% for SUSHI, which fell from over $5.3 to $2.3 in less than 20 hours.
Our responsibility to DeFi’s sustainable growth
Chef Nomi ended up giving his admin keys to FTX CEO and Sushi investor Sam Bankman-Fried, who worked on the protocol before announcing he was transferring it to a multi-signature format so no single entity can control the platform.
I offered to help in a bid to support the development of the DeFi space.
— Jay Hao @OKEx (@JayHao8) September 6, 2020
There is also a better, more sustainable way of gaining exposure to the wonders of DeFi while ensuring you don’t lose all your money to a bug or human error.
Diversification is key
Diversification is very often recommended by investors because not “putting all your eggs in one basket” helps ensure you don’t lose everything to scams, unexpected market moves or technical issues, and invest in potential gems while it’s still early.
The components of a DeFi portfolio are up to individual investors. Doing your own research is highly recommended before investing in any crypto asset — or any asset for that matter. A portfolio that invested only in some of the biggest DeFi projects and Ethereum would have likely been affected by YAM’s collapse and the SushiSwap situation but would also benefit from YFI’s growth.
To help you create a portfolio that will let you gain exposure to DeFi, OKEx has created a DeFi tokens tab where you can now access 35 different tokens related to different protocols.
Users can also margin and swap trade a variety of DeFi tokens on the OKEx platform, enabling them to execute strategies to maximize profits while hedging their trading risks. All these different tools allow traders and investors to take advantage of the gains to be had in this growing space while ensuring that any unforeseen event doesn’t see them getting wrecked.
This article does not contain investment advice or recommendations. Every investment and trading move involves risk, readers should conduct their own research when making a decision.
The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.