What are the risks and rewards of DeFi?

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DeFi, a financial system that runs on Blockchain, has turned the concept of traditional banking on its head. Since its introduction, it has captured many fund holders. As the popularity of DeFi grows, more and more investors have been paying attention to DeFi insurance, a means of guarantee that compensates losses in DeFi.

II-What is DeFi insurance?

The dark side of DeFi is that its smart contracts and automated mechanisms are susceptible to hacks and exploits, especially when their security is not strong enough. Once smart contracts loopholes have been detected, they can cause tremendous losses for digital wallet holders and the entire ecosystem. 

However, it’s a pity that currently, only 2 per cent of TVL (total valued locked) in DeFi has been insured. More and more DeFi platform providers have cooperated with DeFi insurers to pay out claims for financial damages under certain circumstances to solve the problem.

How does DeFi insurance work?

Just like the traditional insurance idea, DeFi insurance was coined as a safety net for many DeFi stakeholders who care about the risks of the DeFi environment. In case of money losses from smart contract exploits, hacks, phishing, cryptocurrency manipulation, DeFi users will get their money back if they meet the conditions insurance policies set out. Depending on the platforms and premiums that claimants have chosen, different amounts of compensation will be paid out. 

The thing that sets DeFi insurance apart from conventional insurance is that the DeFi insurance policy is underwritten by the community of users, not a multinational insurer. Premium payers, stakeholders, and pool capital providers vote for forming and modifying their insurance policy protocols. Once having been set, these protocols can’t be revoked or altered as the result of its encryption into smart contracts. 

The smart contracts that the DeFi insurance base its execution on containing pieces of code that will automate verdicts on specific claims and decide if the payouts will be paid or not.

III-What are the risks?

Although DeFi is seen by many as a lucrative sector in the financial world, there are undeniable risks we have to remain on alert for.

Cryptocurrency volatility

There is the fact that Crypto tends to swing drastically and abruptly. This is fortunate for some DeFi participants but is catastrophic to the unlucky ones. A Cryptocurrency such as Bitcoin can rise to an extremely high value and take a plunge in a short time afterwards. Moreover, many DeFi platforms seem to induce leverage towards the volatility of cryptocurrency when the fundholders receive greater loss risks for borrowing more money in the expectation to gain more.

Some DeFi providers offer insurance services to address this problem. They set a base exchange price for a cryptocurrency and claim to repay the stakeholders with this currency rate even when it plummets in value.

Smart contract hack

Some loopholes in the smart contracts used for DeFi transactions can cost a lot when exposed to hackers. So can errors and misconfigurations in smart contracts. In the past two years, it has been reported that almost 300 million dollars have been stolen.

Lack of government regulations

DeFi is created to limit the controlling exertions governments, banks, or any other intermediaries set on transactional participants or crypto account holders. However, this means DeFi users are not under the protection of government insurance policies and supervision. Although many DeFi insurance services have been established to address the issue, a considerable number of crypto assets haven’t been yet to be insured. In this case, if any widespread damage happens, it may be strong enough to take a toll on the entire DeFi ecosystem. On the other hand, a couple of DeFi services seem to violate the financial regulatory obligations of the United States and other governments, such as allowing members to invest in restricted assets. It is hard to impose any approaches to stop this because, in essence, DeFi is not controlled by any intermediaries in its activities.

IV-What are the rewards?

Smart contract security

Smart contracts are fundamental to DeFi transactional activities. They set DeFi joiners free from worries about the ambiguity of their asset whereabouts and their transactional process. Also, smart contracts are encrypted with several security factors that safeguard assets in digital wallets. Only the wallets holders have the right to set protocols for their smart contracts, thus having access to the wallets. 

Greater profit than bond funds

An interesting thing about the DeFi market is that anyone can join it and add to the liquidity pool. The risks of investments in cryptocurrency, as we know, are much more considerable than those in bonds, but along with them comes greater opportunities to make chunks of money with a small number of stakes.

Accelerating expansion of DeFi

We have witnessed the powerful rise of DeFi in popularity and capital in recent years. DeFi platform providers keep coming up with innovations regularly to develop their ecosystems and members’ investment profiles. Many updates on the permanent technology base have been created. One of which is automatically changing DeFi users’ funds among collateral pools, considering the best possible returns for users’ investment profiles. 

The raging-on growth of DeFi asset values has been acknowledged thanks partly to the dynamic innovations of software application providers. In early 2021, over 80$ billion worth of cryptocurrencies were reported in DeFi contracts when the number had been less than 1 billion dollars a year before.

III-Conclusion:

As the digital financial world has been rapidly growing, there are great opportunities for investors and business people to gain big in the DeFi sector. Besides the staggeringly huge numbers that the market has achieved in this sector, there are also examples of significant losses coming from hacks and exploits of smart contracts, digital wallets. We have to be cautious about this and take preventive measures against these financial damages. DeFi insurance is highly recommended to protect our assets under unwanted circumstances to our crypto holdings. Other than that, other factors have to be determined carefully when you set your foot into DeFi, like a reliable DeFi service platform, crypto assets.