What is Decentralized Finance?
Decentralized Finance (DeFi) is the financial system built on decentralized blockchain technology. It achieves distributed consensus by utilizing smart contracts over the blockchain, such as Ethereum. It is linked explicitly with the Ethereum blockchain and all cryptocurrencies developed on blockchain.
Hence, decentralized finance allows two parties to perform transactions securely using a peer-to-peer network without any intermediary authority. Using Decentralized finance, everyone can access financial services anytime and anywhere at a lower cost as compared with traditional institutions.
Advantage of Decentralized Finance over Traditional Finance:
- Trusted Source –
In decentralized finance, the public blockchain acts as the trusted source, governing all operations in the financial sector. However, public governance entails laws and licensed financial institutions governing all operations in traditional finance.
- Open and Transparent–
Decentralized finance continues to gain traction in part because it is more open and transparent than traditional finance. The lack of barrier to entry means anybody with programming skills can take part in building financial services and tools on top of public blockchains.
- No need for licenses and authorization–
Complicated barriers to entry have made it improbable to embrace the new trend in the traditional finance system. Traditional finance systems have been limited in innovation due to the need to obtain licenses and authorizations from regulators.
Disadvantages of Decentralized Finance:
The uncertainty issue highly impacts decentralized finance projects as they can automatically inherit instability from their host blockchain. For example, the Ethereum blockchain has gone through various changes lately, where the issue committed at the time of Proof of Work consensus can lead to risk in Ethereum 2.0 Proof of Stake.
Decentralized finance projects encounter tremendous challenges in terms of the scalability of the respective host blockchain. The transactions on the decentralized finance protocol take a bit longer to confirm, which raises the issue of network congestion. Further, at the time of network congestion, decentralized finance protocol transactions might become expensive.
Another essential component is liquidity as the decentralized finance market is still not as big as the traditional financial systems. So, it becomes difficult to put trust in this sector.
6 reasons why Decentralized Finance users are at high risk:
- Intrinsic Protocol Risk–
Intrinsic protocol risk represents the risk mechanics incorporated into the design of the protocol by default. Smart contracts help in automating specific financial primitives on the decentralized finance platforms. The dynamics of the protocols depend upon these smart contracts, which might present significant threats to investment strategies regardless of the working of the protocols.
Intrinsic risk in decentralized finance protocols is the prior reason for risk transportation from centralized, human/developers parties to programmable mechanics in the protocols. For example, slippage is a condition in AMM (automated market-making) protocols. In case, the slippage condition is high, AMM pools can pressurize investors to pay high fees to eliminate liquidity supplied to protocols.
- Exogenous Protocol Risk–
Unlike intrinsic protocols, decentralized finance users are usually exploited due to external factors that change the protocol’s expected behavior. An example of this type of attack would be oracle manipulation or flash loan exploits, which affect decentralized finance’s underlying mechanics.
In October 2022, Cream Finance was exploited in a Flash Loan attack, draining over $130 million of assets. This attack highlighted that exogenous protocol risks are also the omnipresent factors in the decentralized finance evolution.
- Governance Risk–
Another significant aspect of decentralized finance is the governance proposals that manage the decentralized finance protocol’s behavior and are usually the reason for alteration in its liquidity composition affecting users and investors. The rising centralized nature of the governing structure of decentralized finance protocols is also an alarming aspect of decentralized finance governance. Although decentralized finance governance is controlled in a decentralized manner, several small parties can impact the outcome of the proposal.
- Basic Blockchain Risk–
Decentralized finance protocols are dependent upon their intrinsic blockchain, which can turn out as a risk for users and investors. The exploitation of factors, for example, the consensus mechanism over a specific blockchain, can arise vulnerabilities in decentralized finance protocols executing over the platform. For example, decentralized finance protocols can effectively be terminated in proof-of-stake ( PoS ) networks where the number of validators colludes to influence reward distribution.
- Market Risk–
Apart from protocol and infrastructures, there is a high risk of the native market. For example, the AMM pool’s investment could become vulnerable in case the cost of the assets changes from the earlier time when the pool was provided with liquidity. Another example can be an abrupt crash in the cost of an asset that can trigger the massive elimination of liquidity from the pool, resulting in significant slippage.
- Exploits And Vulnerabilities–
Decentralized finance implements a piece of code visible to everyone, whereas a technical person can easily observe and identify bugs in the code and exploit them. While some bugs are discovered unintentionally, others result from deliberate attacks. However, the inevitable technology risk can be eliminated by Best Decentralized Finance practices, such as extensive testing, regular code audits, bug bounties, and by maintaining the dApps.
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