The Four Main Risks of DEFI - according to Andreas Antonopoulos

In a recent Vodcast Andreas Antonopoulos outlines four risks associate with DEFI (the video title says five, but to my mind it's really four!):

1. Financial Risk
2. Counter Party Risk
3. Contract Risk
4. Platform Risk

https://www.youtube.com/watch?v=OxNXBhmtDrw

In this post I summarise these risks and offer a few thoughts on how this applies to investing in DEFI on Binance Smart Chain and some other DEFI projects…

The risk of the financial instrument itself

This is the straightforward risk that the DEFI token you are buying and ‘betting on’ will go down in value. Here it’s important to remember that while you, the buyer, are on one side of the ‘bet’ there is always going to be other people on the other side balancing that bet out, or betting against the token going up in value, and either selling said token, and/ or buying competing tokens.

The problem with DEFI, especially on Binance Smart Chain is that all of the coins are so very similar to each other, and so it’s very difficult to know which one to back, and because It’s relatively easy to produce yet another Pancake clone, there’s no way of knowing which new token is going to capture the market in the coming weeks or month.

The way to manage this kind of risk is to ensure you’ve got an appropriate amount of your portfolio devoted to DEFI, and to balance this out with other assets - NB to my mind being diversified across only BSC DEFI platforms is not really ‘diversified’ - hence why I’m also into Rune, and why I’m planning on pulling some of my BSC DEFI Vests into ETH DEFI once I’ve hit certain targets.

I’ve also only got 15% of my portfolio in DEFI projects - that’s probably higher than it should be TBH, but I’m riding the wave!

Counter Party Risk

The amount of risk here depends on how ‘deep’ your DEFI is. The more centralised your DEFI vests, then the more risk you have here because the more dependent you are on intermediaries.

To my mind with Binance Smart Chain there is significant risk here - I’m not convinced that the Chain isn’t controlled by Binance puppets - so effectively by one Company.

As I understand it ETH is genuinely decentralised - i.e. it is a network genuinely maintained by a diverse array of node operators, and so with much less Counter Party Risk - I.e. there isn’t a central company who can just decided to freeze withdrawals or switch the chain off altogether.

And I'm sure Rune is a lot more decentralised than BSC too.

This is something I need to research a bit more!

Contract Risk

Here we have primary and secondary contract risk

Primary contract risks are those contracts which the DEFI platform is based on, those which pertain to the native-token (such as Cub) or manage the yield returns).

However DEFI projects require a complex array of contracts, and they invariably rely on secondary contracts for functions such as multi-sig or governance, and use those that have already been developed or tested.

If any of these contracts develops a bug it can bring down the DEFI platform, freezing it for a time or putting your funds at risk.

I'm sure many of us remember the WLEO hack a few months ago, we were lucky we were compensated - a classic example of a primary contract risk I think!

Generally speaking here, you want to aim to invest in projects which use well tested secondary contracts to minimise the risks of bugs being developed, but I guess Primary Contract risk is a very real problem - of course there's Certik, so maybe a risk mitigating strategy here is to avoid all of those platforms with a 'pending' notice about their Certik audit!?!

Platform Risk

Again there are two categories here:

Firstly there are risks on the platform that make it difficult to execute smart contracts - such as vocality and GAS FEES.

An example of this is make in March 2020 when the price of ETH dropped, many people had ETH in Maker Dao backing the DAI stable coin - when the price dropped, people wanted to pull their collateralised ETH but were unable to do so because the ETH network was too busy, and had to watch as their ETH was sold, unable to anything about it!

Then there are platform vulnerabilities, such as is there a fault in the Ethereum Virtual Machine?

TBH honest I understand very little about the later, but as to the former, I generally avoid ETH because of the fees - I guess using Binance Smart Chain has lees risk here (maybe?) but more risks due to more centralisation?!?

Final Thoughts: How to minimise your compound DEFI risk

Add this stack together and you've got your compound risk!

Antonopoulos suggests that the most effective way is to invest in projects which are well tested and built on long standing smart contracts, so bugs and other points of failure have been ironed out as far as possible. I guess that means ETH DEFI projects, given the simple fact that BSC is so much newer, and Thorchain barely out of nappies.

Even if BSC is fast and cheap and Thorchain has lots of potential with its native staking, one has to remember there are significantly more risks associated with investing in both of these projects, I mean Thorchain is still testing, after all!

The problem with watching anything by Antonopoulos is I always end up feeling a little out of my depth - the first two above I get, but the second two, I honestly don't have the technical knowledge to be able to assess the smart contract and platform risks associated with the various DEFI projects, I'm really just going on trust here!

Although my intuition tells me there is less risk in general associated with Ethereum (as long as you don't collateralise!) this isn't based on any technical knowledge of the network! It's just a gut feeling.

NB I'm not sure where the straight up 'rug pull' fits into these categories - maybe it's counter party risk? Or perhaps Antonopoulos is just assuming none of us are stupid enough to invest in anything so degenerate!?!

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