DeFi revenue is growing explosively, but there are 5 risks to watch out for

Unlike Bitcoin, which has been hovering above $9,000 recently but unable to break through the psychological $10,000 mark, Ethereum-based decentralized finance (DeFi) has seen explosive exponential growth in the past few weeks.

Camila Russo, a former Bloomberg journalist from DefiantNews, pointed out on June 19 that the total value locked in DeFi applications has increased by 40% in the past seven days alone. As of press time, according to DeFipulse data, the value locked in the DeFi ecosystem exceeds $1.48 billion.

Data source: DeFipulse

Due to the combined influence of various factors, the appeal of DeFi has increased dramatically. Users can now earn more than 100% APY (Annualized Yield) using stablecoins such as USD Coin or Tether's USDT.

However, based on past experience, such astronomical returns are not without risks. For DeFi, the risks are many.

What’s behind the high returns in Ethereum DeFi?

Most major cryptocurrencies have stagnated recently as bulls and bears are locked in a tug-of-war, so investors are looking for other ways to make money in this emerging market.

One of the most prominent of these new ways to make money over the past week has been through decentralized finance (DeFi) to earn “mining yield,” such as Compound’s liquidity mining.

Due to high demand for borrowing cryptocurrencies, incentives implemented by many DeFi protocols, and other factors, some Ethereum users have seen stablecoin returns of over 100% (annualized yield) over the past week.

That’s more than 100 times the interest rates offered on deposit accounts at Wall Street banks, which don’t offer much return on personal savings because of low policy rates imposed by central banks.

A 100% rate of return means that if you could double $1,000 every year for ten years, you would have $512,000 at the end of ten years.

DeFi is not without risks

However, the high returns offered by DeFi applications are not without risks.

Tony Sheng, a cryptocurrency analyst and investor at MultiCoin Capital, recently identified five risks facing investors seeking high returns on stablecoins. They are as follows:

1. Smart contract vulnerabilities in loan agreements.

2. A smart contract vulnerability in the underlying asset (whether it’s USD Coin, Tether’s USDT, or an altcoin).

3. Liquidation events result in lenders losing their cryptocurrency. Large fluctuations in the price of Ethereum or other cryptocurrencies can trigger such liquidations.

4. Failures in the economic design of a protocol may be caused by misaligned incentives.

5. User operation error.

Sheng added that the risks of DeFi are compounded when you consider that this part of the Ethereum ecosystem is interconnected.

This means that a bug/crash in a smaller protocol could negatively impact the entire field:

“The scariest thing is that these systems involve a lot of different smart contracts. Therefore, there are chain risks in terms of both asset and system security.”

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