Discover the key crypto lending risks before you take out a loan.
There is a high level of risk to any investment. That applies to traditional investments and web 3.0 offers like decentralized Finance (DeFi).
The risks of crypto lending include impermanent loss, flash loan attacks and rug pulls, all of which are common within the crypto space. Knowing how to find the red flags is an essential part of protecting yourself while engaging with DeFi lending.
What is DeFi Lending?
Decentralized finance is an ecosystem of blockchain-based applications that aim to offer a range of financial services similar to those provided by traditional banks, insurance brokers, or any other financial intermediary.
However, DeFi Lending platforms differentiate themselves as they are decentralized and can run autonomously, without the need for any third party. Each decentralized application (dApp) is powered by a smart contract, which is essentially a special computer program responsible for automatically performing a function when specific predefined conditions get met.
DeFi lending is one type of traditional financial service, which is currently available through the peer-to-peer (P2P) operated dApps. In a similar way, as you would deposit funds within a savings account as a means of receiving interest payments, cryptocurrency investors can lock up their funds and use them as a means of providing liquidity across a range of decentralized platforms, whereas a direct result of doing so, they receive regular interest payments.
However, many of these interest rates are significantly greater than anything available within the traditional market. Competitive rates explain why DeFi lending has become an attractive option for people seeking a solid passive income stream via their crypto holdings.
While this sounds excellent on paper, there are a few risks associated with cryptocurrency lending that we are now going to cover.
1. Impermanent Loss
A common risk that you might encounter when committing assets within a liquidity pool is known as “impermanent loss .”This essentially means that the price of the asset locked up within the liquidity pool can change after being deposited, which in turn ends up creating what is known as an unrealized loss.
This can occur for two reasons: the automated market maker (AMM) system, which is utilized by DeFi liquidity pools. DeFi pools essentially maintain a ratio of assets within the pool. This could be fixed at 1:50, for example. This means that anyone who’s willing to provide liquidity has to deposit both of the tokens within that pool at that ratio.
DeFi pools are also reliant on what is known as arbitrage traders as a means of aligning pool asset prices with the current market value. Arbitrage traders might spot the discrepancy and be financially incentivized to add the specific token within the pool to remove any discount.
However, when these arbitrage traders flood the pool with one token, the ratio of the coins in it changes. So once the pool rebalances itself, the rise in the value of the liquidity pool will be less than the value of the assets if the lending protocol holds them, and this is an impermanent loss.
2. Flash Loan Attacks
These attacks are a type of uncollateralized lending which is unique to the Decentralized Finance sphere. Flash Loans are essentially unsecured loans that use smart contracts as a means of mitigating all of the risks associated with traditional banking, The concept here involves a borrower being able to receive thousands of dollars in crypto assets without putting up collateral, but they have to pay back the full amount within the same transaction that it was sent, typically throughout the span of seconds.
However, if this loan is not paid, the lender can roll back the transaction, making it like it never happened. Now, Flash loan attacks occur when bad actors end up borrowing huge sums of money using these special types of loans and then use them to manipulate or exploit vulnerable DeFi protocols for personal gains.
3. Rug Pulls
Rug pulls are an exit scam where DeFi developers create a token, connect it with a lending cryptocurrency, and set up a liquidity pool. They market the token and get people to deposit within the pool, typically promising a high yield.
Once the pool has a solid amount of lending crypto in it, the DeFi developers use back doors which they intentionally coded in the smart contract as a means of minting millions of new coins that they use to sell the cryptocurrency. This drains the cryptocurrency from the pool and leaves millions of worthless coins within it, after which the founders disappear.
An example of a rug pull is the Squid Game Crypto. The team behind the project pushed out a token inspired by the popular South Korean Netflix Series Squid Game, which lost almost all of its value as it was revealed to be a scam. One wallet out of the 43,455 addresses pulled the rug out from under the investors, which held 5% of all of the tokens, an account which transferred $3.36 million to another wallet.
Protect Yourself and Avoid Most of the Crypto Lending Risks
The best way through which you can mitigate potential impermanent loss is to provide liquidity within pools that contain less volatile cryptocurrency assets, such as stablecoins, for example.
Always verify the team’s credibility within a cryptocurrency project, and read through the project’s white paper. Check to see if a project’s code has been audited by a third party, and try to find red flags prior to making any investment.