The potential of DeFi is still unexpressed, with many benefits that have yet to be discovered. But it is essential to know the risks involved as it is still experimental.
The DeFi space has taken over in the last few years with many experiments and protocols that have seen the light. It is no secret that DeFi is bringing a new concept of intending finance to reshape traditional models, but much work must be done.
Many risks include cyber security, lack of audit experts, smart contracts bugs, etc.
1. Liquidity Loss
So, liquidity loss is a risk that we can mostly find in rebalancing protocols. We use AMPL as an example. $AMPL is the stablecoin of Ampleforth. Instead of being linked to the joint USD, it aims to maintain its value at $1 by adjusting its supply dynamically daily, using a code that internalizes the price volatility in the secondary market.
It works in this way:
If the price of AMPL surpasses $1, more tokens are released, decreasing the value of individual units.
Also, if the price of AMPL falls below $1, tokens are taken out of circulation to increase individual value.
When this model internalizes the price volatility in secondary markets, directly altering the supply, it creates liquidity loss risk. This happens because it evaluates you via % of the network held and not by prices. If you own, for example, 1% of the network, which matches with 10k tokens worth 1$, if the price rises to 1.50$, the number of tokens you will hold will increase too, but it will depreciate in $ terms, causing a loss.
This liquidity loss in tokens disappearing becomes a risk factor in DeFi protocols, so knowing which mechanism tokens and projects assume is essential. Skipping the analysis of mechanisms will traduce in a financial disaster.
2. Impermanent Loss
So almost everyone has joined, at least once, a DeFi pool.
"10000% APY, I am gonna go all-in!"
If we have 4000$ to use, we should deposit 0.5 $ETH (2000$) + 2000$ in $USDC because, generally, it is essential to maintain a 50:50 ratio. If $ETH goes to 8000$, picking up our liquidity will mean we will withdraw 5650$ (0, 34 $ETH + 2830$).
This is due to arbitrage, which needs to maintain a 50:50 ratio, rebalancing the assets by reducing $ETH % and increasing $USDC one. By holding, we would have made 6000$ (0,5 $ETH + 2000$ $USDC), a better profit. The impermanent loss is thus at 5.7%.
As said, the loss is "impermanent," which means it is not permanent until we withdraw our funds, as pools can rebalance themselves in our favor
3. Price Slippage
The concept here turns around AMM (Automated market maker) which involves two risks. AMM is a method to allow tokens to trade between each other without permission and automatically by using liquidity pools. Unlike traditional finance, there is no buyer or seller, but an algorithm exists.
So we have previously seen the first risk when you don't trade, and the prices change outside, the impermanent loss. The second one that happens when you actively trade is price slippage.
The main reasons for slippage are liquidity and volatility; as you can imagine, this is amplified in the crypto world. There is both negative and positive price slippage.
Takeaway
Always remember to check potential financial risks way before entering the DeFi world. 99% of the time, people ignore these risks resulting in significant losses or capital damages.
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