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While they potentially have more access to resources, even billionaire investors are not immune to the risks of decentralized financing, or DeFi.
This includes Mark Cuban, who revealed on Tuesday night that he was trading an Iron Finance DeFi token called titan that ended up dropping to zero in one day.
“I was touched like everyone else,” Cuban, Dallas Mavericks owner and ABC Shark Tank investor, tweeted Tuesday.
At first, some in the crypto world speculated that this was the result of a raffle, which is a type of scam where developers abandon a project and walk away with funds from investors. Iron Finance has denied these allegations. The company said in a blog post that the crash was due to a “bank run” or panic sell, and the token’s algorithmic code.
Either way, the Cuban experience is a good reminder of the volatility and risks of investing in crypto, and in DeFi in particular, perhaps. His takeaway: “Do your own research,” he told CNBC Make It.
Space fraud has recently increased; between January and April, $ 156 million was stolen from DeFi-related hacks, according to CipherTrace. DeFi scammers stole an additional $ 83.4 million.
And while it is rare for coins to collapse completely, as with the titan, it is still possible, and investors should be aware of this. “I think it’s really important that people in the DeFi space understand the risks and the rewards,” Make It Meltem Demirors, CoinShares chief strategy officer, told CNBC. “People have participated in DeFi without understanding the risks.”
Even though DeFi has been buzzing around lately and you may have FOMO to invest in, it’s important to research and understand the risks first. Here’s what you need to know, according to the experts.
What is DeFi?
DeFi apps aim to recreate traditional financial systems, such as banks and stock exchanges, with cryptocurrency. Most run on the Ethereum blockchain.
The difference is that DeFi applications work “without a central service exercising control over the entire system,” says John Wu, president of Ava Labs, a team supporting the development of DeFi applications on the Avalanche blockchain.
Through DeFi Loan, users can lend cryptocurrency, like a traditional bank does with fiat money, and earn interest as a lender. Borrowing and lending are among the most common use cases for DeFi applications, but there are also many increasingly complex options, such as becoming a liquidity provider for a decentralized exchange.
Interest rates are generally more attractive than with traditional banks, and the barrier to entry for borrowing is low compared to a traditional system. In most cases, the only requirement for taking out a DeFi loan is the ability to provide collateral with other crypto assets. Sometimes users can offer their NFTs, or non-fungible tokens, as collateral, for example, depending on the DeFi protocol used.
However, these factors also explain why DeFi is much riskier than a traditional bank.
What is the risk level of an investment?
It is important to understand that investing in DeFi is very risky.
“I think every DeFi protocol and every DeFi project has a different level of risk and a different level of reward,” Demirors says. But, “It’s important to understand why the reward is high is because the risk is higher. The reason we see high return is because there is risk here.”
There are three main types of risks to consider, Demirors says.
1. Technological risk
Smart contracts, or collections of code that execute a set of instructions on the blockchain, are essential to the functioning of DeFi applications. But if there is a problem with a developer’s code, there could be weaknesses in a DeFi protocol.
“At the end of the day, the software is as good as the coding that was done, and sometimes there are unknown errors in the code that governs these protocols,” Demirors explains.
2. Asset risk
When you borrow on a DeFi app, you usually offer other crypto assets held as collateral. For example, DeFi protocol Maker requires borrowers to guarantee their loan at least 150% of the loan value.
As cryptocurrencies are volatile, their value fluctuates frequently. In a downturn, the value of crypto assets used as collateral can drop sharply and, in turn, some may see their positions liquidated. This is why some use stablecoins, which are supposed to be pegged to fiat and, in turn, to be less volatile.
3. Product risk
“Typically, less mature pools or newer protocols will have higher yields because they are not tested,” Demirors explains. “There is a significant risk involved in how the return you earn is generated. “
It’s also important to note that unlike a traditional bank, there is no regulation or insurance on your money when using DeFi. Although DeFi loans are secured by other crypto assets, borrowers using DeFi protocols cannot be held liable otherwise if they are unable to repay a loan effectively.
These risk factors are part of the reason why experts warn to only invest what you can afford to lose, and recommend that you do your research before you buy.
What should beginners know?
If you decide to invest in a DeFi app, the first thing you should do is check the apps you explore to make sure they are secure and well audited, Wu explains.
When choosing an underlying network, such as a blockchain, protocol, or exchange, Wu recommends looking for one that is not controlled by a small group of players, which can handle high demand. of users and offers affordable transaction fees.
Some “big red flags” include “apps that don’t share their code or ignore concerns in their forums and social feeds about security,” Wu warns. “Some of the best projects are run by anonymous or pseudo-founders. anonymous who protect their privacy, so I’m not canceling a project for that, but expect transparency on the app. “
And if something is wrong, it probably is.
“DeFi is growing so quickly and the returns are so high that the opportunities may seem too good to be true. When in doubt, trust your instincts or seek out more objective community members with the technical expertise to thoroughly review the code, ”Wu said.
What’s the next step for space?
Looking ahead, Demirors predicts that DeFi apps will continue to replicate financial structures that “we already know and love in the traditional financial world,” she says, such as high yield savings accounts, for example.
Demirors also predicts that there will be new decentralized financial products and services built unlike the traditional ones that already exist, including new ways for creators to get paid for online content.
“We are really, really in the age of financializing everything,” she says.
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Don’t Miss: Mark Cuban Says ‘Banks Should Be Afraid’ Of Cryptocurrency-Based DeFi
Disclosure: CNBC owns the exclusive rights to the off-grid cable of “Shark Tank”.
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