DeFi is considered one of the next big things in the tech world and could revolutionize the way we use the web. Yet many are still unfamiliar with the term and what exactly it means. DeFi is shorthand for decentralized finance. In essence, this means finance without needing any traditional financial institutions or governments. It goes beyond a mere cryptocurrency, as DeFi overall aims to replicate all the power and functionality of the banking system but in an open and permissionless way.
In theory, many people can be onboard with DeFi especially when we’ve seen the excesses and corruption in the traditional banking industry. The global financial crisis of 2008 was caused by the irresponsibility of bankers, but a decentralized system removes the human, fallible element. Yet while there are issues with the old system, it was at least possible for some regulation, which is much harder in the DeFi world. This has unfortunately meant the technology has a huge problem with being used for scams by fraudsters and criminal organizations.
Yotam Dar, a blockchain expert, puts it perfectly, “In many ways, blockchain and DeFi’s greatest strengths also serve as its greatest weaknesses, which makes investing in this industry a risky proposition.”
In this article, we will explore further his explanations for why DeFi is a risk, and what he suggests to do in order to stay safe.
The nature of a decentralized platform means it is much easier to maintain anonymity. At banks, you need to provide lots of documentation to prove you are who you say you are. This isn’t true for all DeFi exchanges. Even if the platform verifies who you are, they currently don’t share such information with law enforcement.
A transaction using the blockchain is irreversible and immutable. In traditional finance, if you see a transaction in your bank statement that you didn’t expect, you can alert their fraud teams who are often able to recover the money and put a flag on the fraudulent account. This option doesn’t exist in DeFi. Once the money has left your account, it’s gone and the record is written in the blockchain. There’s no way to get the money back unless you are somehow able to convince the other party to return your money willingly.
It’s very difficult to know if the other party in a transaction is who they say they are. One common scam is called a “rug-pull”. Fraudsters will pretend they are creating a legitimate product and have professional-looking sites backed by marketing campaigns. They’ll only accept money in cryptocurrency, though, and they’ll soon disappear without any product ever being delivered.
In the years leading up to the global financial crisis of 2008, the big financial innovation was the widespread use of derivatives. This meant poor quality assets such as subprime mortgages could have greater worth than the properties they were back by. In hindsight, this was an obvious recipe for disaster but at the time, the product were so complex that regulators failed to understand what was happening in time and the rest is history. People were unwittingly sold worthless assets, and many lost huge amounts of their life savings.
The same situation could be happening today through DeFi. Money is flocking to the system before most people even understand what it is. The financial regulators have been so focused on cleaning up the traditional banking system that the crypto innovators have a huge head start. Regulators will struggle to keep up with the rapid pace of innovation that is occurring in all manner of DeFi assets such as NFTs.
As there isn’t one body responsible for DeFi technologies, then it can be difficult to legislate against and even harder to enforce. If the technology is out there by definition, no centralized body can interfere else it would distort the blockchain and users would flock to a competitor. If regulators decided there were too many scams using Bitcoin, they would have nobody who they could work with to force them to introduce fraud prevention protocols.
Bitcoin and Ethereum are perhaps the best known DeFi technologies, but there are many more alternatives out there. Many of these platforms overpromise on both returns and security. They tell potential customers that they can earn significant amounts whilst also being 100% secure.
This has been proven tragically wrong in several cases. For instance, the Poly Network was hacked and $600 million stolen, which is a number far beyond what many of us will ever see in our lives. Perhaps the worst part about the attack was that most of the money was returned after. This meant the hackers did it for fun and were able to steal such an enormous amount of money. One might think they barely had to even try. Imagine what would happen if hackers with greater malintent prioritized scams on DeFi as more money flows into the system. It’s clear the blockchain has many security flaws that hackers can expose.
Veteran crypto investor Matthew Roszak expects the market to be worth $800bn in 2022. It’s possible many hackers who currently target traditional finance will see the success of the Poly Network hackers and the size of the DeFi market and decide it’s a wise area for them to invest their time in to maximize their criminal income.
It’s not all doom and gloom and there are many bright minds dedicated to making the network more secure, even if there are others acting with the opposite intention.
The first thing you need to do is approach DeFi with a healthy level of skepticism. Don’t just take a platform’s claims at face value and if someone asks you to transfer money through an anonymous system, do not be afraid to ask them for traditional finance details if that makes you feel more comfortable.
For each individual platform, you use, do additional research and seek credible resources from websites you’ve used in the past. Make use of your network and ask people who you trust whether they have any experience with the platform you wish to use.
The important thing is to not become too eager and leave yourself vulnerable to scams. Practice safe internet safeguards, such as using secure passwords and multiple-factor authentication when you can.
If you feel confident, start with small amounts of DeFi before plunging in. It could be the future of the entire financial system.