Over the last years, there’s been much buzz on blockchain and decentralized finance, especially in terms of their risks and challenges. If you’ve come across this article, you a) are definitely interested in DeFi, b) understand there is no perfect solution, that’s why decentralized finance has its drawbacks too, c) have probably read our article on the DeFi advantages over traditional finance and want to see the disadvantages too.
Making the right decision is always about weighing all pros and cons. Whether you are considering moving from centralized finance to DeFi or are just curious about learning more about DeFi – you’re in the right place. In this article, you’ll find our insights into 9 downsides/risks of decentralized finance and why they matter.
As DeFi projects are based on blockchain, most of the blockchain risks and drawbacks can be treated as the DeFi ones too. Let’s look at them closely:
#1. DeFi is Not User-Friendly
Let’s face the music: if you are a non-technical person, it will be more than challenging for you to understand how to “play” with a DeFi product. Currently, it can’t boast offering a smooth learning curve, and its user experience is challenging and not intuitive. All this might even push lots of people away from trying DeFi. Thus, in terms of onboarding people to DeFi, there’s much space for improvement.
#2. DeFi is Unstable
One of the main ideas of decentralized finance is to give you more stability than the traditional financial system can afford. And in most cases that’s true. However, if the blockchain system that hosts your DeFi project experiences stability issues, your DeFi project becomes unstable too. The Ethereum blockchain most DeFi products are built on is still going through many changes that your DeFi project will also inevitably inherit. And vice versa – if one connected protocol is unstable, this will also influence the whole connected ecosystem.
#3. Scalability Is (So Far) Not About Decentralized Finance
Unfortunately, this is a common case with all blockchain-based projects. At times of high transaction activity, the DeFi performance may suffer, taking transactions much time to be processed. Take into account the fact that Ethereum can process no more than 13 transactions per second, which is less than centralized finance can offer, and you’ll understand those who feel doubts about entering DeFi.
#4. You Pay High Gas Fees For Every Transaction
The on-chain gas fees you have to pay for blockchain transactions have always been high – this is not a new thing with blockchain. Still, you need to remember: the more transactions are made on the Ethereum blockchain, the higher gas prices become. Besides, as transactions’ priority is based on the gas fees, those that have lower gas prices might be left pending.
#5. Most DeFi Projects Offer Low Liquidity
Liquidity means the degree, thanks to which a digital asset can be bought/sold without impacting the market price. With high liquidity, digital assets can enjoy price stability and lower transaction time. Currently, most DeFi products do not guarantee high liquidity options, being outpaced by their centralized finance opponents.
#6. Many DeFi Services Suffer From Overcollateralization
The DeFi market prices’ instability leads to the fact that many DeFi services/products become overcollateralized. Let’s take DeFi loaning as an example. When the value of the staked asset is more than the value of the loan, this is called overcollateralization, and it takes place quite often in the DeFi loaning industry. The same goes for the crypto-backed stablecoins: when the price of the reserve cryptocurrency increases due to its volatility, such stablecoins inevitably become overcollateralized either.
#7. Not All DeFi Services Are Decentralized
Being the main feature/concept of the DeFi industry and the reason why people decide to switch from the traditional centralized financial system to DeFi, decentralization provides a high level of trustworthiness and decreases the possibility of scams.
Ironically, not all of the DeFi projects are really decentralized. Some products, like Flexa (FXC), are custodian, though open-source. Or take a look at fiat- or commodity-backed stablecoins that still presuppose a central body to manage their supply and flow.
#8. Smart Contracts Still Include Technical and Thus Financial Risks
In terms of protection, smart contracts presuppose a high level of security, however, it doesn’t mean they are 100% free of errors. Since a smart contract is lines of code written by someone, it’s never totally bug-free – there’s always a probability for a tech risk. This means smart contracts are still vulnerable to frauds and hacking attacks. If there is a flaw in the smart contract code, this could lead to financial losses. And there’s nothing you could do about it – all blockchain transactions are irreversible.
Besides, due to oracles that serve as a bridge between the blockchain network and the real world, smart contracts a priori presuppose some degree of an external risk. Oracles that deliver external on-chain information to blockchain receive this data from a single external source. If a malicious party takes control of it, they could easily influence the way the smart contract operates to manipulate that to their profit.
To reduce technical and financial risks, audits, testing, and verification processes are held. Some platforms, like Nexus Bridge or Cover, are designing insurance protocols to protect against smart contract bugs or hacks, however they are not battle-tested well.
#9. Anonymity Is Sometimes Not A Benefit
The anonymity that all DeFi products provide you with is in most cases viewed as an advantage. And in most cases that’s true since this allows all users to make transactions with no KYC-verification and regardless of their status.
However, as some cases have already shown, anonymity is something frauds can benefit from too as it can literally facilitate malicious manipulations.
At FutureBlock, we aim at boosting your knowledge of decentralized finance – both the benefits you can leverage and the downsides you should also bear in mind. With this in mind, we conduct DeFi Evenings – online meetups held every few weeks, during which our network speakers shed light on important DeFi aspects and use cases.
If you are willing to join us as a listener or as a speaker, feel free to contact us here.