DeFi Funds: Protect Yourself from these 3 Risks Today

Compared to TradFi investing, crypto funds realize far outstanding returns. The average crypto fund returned more than 128% in 2020, compared to 30% in 2019. Naturally, new types of crypto funds, like DeFi funds, are popping up like mushrooms, and numerous traditional funds are taking this opportunity to diversify into the infantile crypto space. Recently, crypto fund Paradigm closed its latest funding round with a record-breaking $2.5B, signaling the enormous interest in indirect crypto exposure. Moreover, we also see relatively fewer crypto hedge funds strategizing in arbitrage and low-latency trading, where more crypto funds and DeFi-specific funds are choosing a fundamental, long-term approach in a time of heightened interest and promising developments.

When moving off the beaten track into the world of decentralized finance, you are likely to encounter profitable opportunities along with looming risks. Acknowledging and understanding these industry risks will assist in portfolio preservation. Gaining traction and maturity, DeFi unveils itself as a new area to expose institutional investors to as a path for investment in decentralized assets. As DeFi matures and gains traction, it unveils a new era of investment opportunities for funds.

If you’re involved in managing a firm's investments in DeFi assets, this article will break down the three most significant risks for you to know and mitigate.

Custodial Risks

Despite the ongoing movement of Crypto funds favoring Decentralized Exchanges over Centralized exchanges, almost every DeFi fund is still subject to some element of custodial risk. Digital asset custody is in many ways similar to custody of traditional financial assets; custodians take responsibility for securely storing investors’ assets and typically also offer other services including the ability to trade. If not for trading purposes, funds also typically use infrastructural services of centralized third parties like Gemini, Fireblocks or Ledger to manage their digital asset operations.

If you manage a crypto fund that primarily uses central custodians to hold your clients’ funds, you effectively assign responsibility to external parties, running the risk of losing digital assets or custodians limiting digital funds from being withdrawn for long periods. DeFi funds are subject to threats outside of their control by relying on custodians that do not always offer inclusive insurance. So it is only logical to find solutions that limit the likelihood of custodial calamities diminishing your corporate goodwill and client portfolios.

These are three ways to limit your exposure to the custodial risk of DeFi funds:

• Use crypto custody providers with inclusive insurance.
• Build your own infrastructure, eliminating the need for central custodians.
• Buy custodian covers for your CEX’s and uninsured custody providers to protect your crypto funds against hacks and halted withdrawals.

Protocol Risks

Then, there is the threat of protocol hacks and exploits which is the most prevalent risk DeFi funds are exposed to. If there are glitches or vulnerabilities within the smart contract codes of a protocol, funds locked in these smart contracts are at risk. When known to bad actors, glitches and vulnerabilities can be used as back doors to siphon out locked assets through a hack or exploit, or sometimes even a rug pull.

DeFi funds transfer immense value into a highly profitable sector promising investors with alluring profits and yield-bearing assets. As always, the devil is in the details; since the__$250B DeFi market__ has incurred over $10.5B in losses due to illicit activities in 2021, and the number of hacks is ever increasing. Solutions to mitigate these events that frequent the market are welcomed by all possible buyers, but more so by DeFi Funds and other institutions that invest in yield-bearing positions in the DeFi space. It does not come as a surprise that Decentralized Coverage has grown a whopping $1B in insured assets in 2021 and is starting to draw attention among bigger market entrants.

Quantitative strategies involving high-frequency trading continue to be the most common approach amongst DeFi funds. Such dynamic funds are most inclined to take out protocol covers for their preferred decentralized exchanges. However, funds strategizing to hold funds for more extended periods, which might also be beneficial due to tax constraints, are on the rise. For them, investment-specific protocol coverage might be more practical along with possible custodian covers.

For instance, Anchor is a savings protocol offering low-volatility yields on Terra stablecoin deposits and boasts an impressive APY of 20% on stablecoin deposits. However, a hack or exploit might put all your capital at risk, leaving you with nil. Hence, accompanying insurance for a small percentage of 2,6% of your total insured capital is a sensible choice.

Elliptic’s research shows that more than $12 billion has been lost due to DeFi exploits and scams. These losses are accelerating, with more than $10.5 billion of losses in 2021, up from $1.5 billion in 2020. The data shows that protocol loss currently poses the biggest risk and should be the focus area of DeFi funds for mitigating inherent crypto risk. As hacks and exploits are on the rise, this type of risk should be taken into account by DeFi and Crypto Hedge funds when crafting their investment strategy and making their growth projections.

Stablecoin Infrastructure Risk

Whether as a means to safeguard realized profits or as a yield-bearing asset, DeFi funds or crypto funds all make use of the variety of stablecoins available in the crypto space, trusting that their value will remain unchanged.

Traditionally, stablecoins are designed to be pegged to and backed by fiat currencies or other traditional assets, offering price stability for investors. Tether has been surrounded by controversy recently, with many questioning their dubious activities. Only time will tell the legitimacy of their operations. Even so, the scrutiny around Tether highlights the fragility of stablecoins.

Furthermore, next-generation algorithmic stablecoins are slowly but surely gaining market share, with TerraUSD and DAI being the most prominent. While fiat-backed stablecoins can unpeg due to inadequate reserves or the fear of deficiencies, algorithmic stablecoins could depeg due to protocol failure or as a result of failing stabilizing mechanisms.

Two ways to limit your exposure to stable coin infrastructure risks:

• Diversifying your capital among various stablecoins is a simple and effective method of mitigating potential heavy losses.
• Even with a diversified portfolio, covering your stablecoin exposure against de-pegging is an additional solution for risk protection.

On the Bright Union platform, you can compare and select your preferred cover for the best price to alleviate the risks of stablecoins dropping well beneath their pegs. This cover type will ensure you receive the value difference between the peg and the current price after deviating for a certain period, Check out the__available covers__.

Safely Lead the Way

Navigating DeFi is much riskier than TradFi, due to its high volatility and regulation changes. DeFi Fund managers aim to achieve titanic gains in comparison to cover costs. Institutions and private investors enticed to enter the market as outsiders through crypto funds rightfully raise questions about inherent risks and generally welcome mitigating solutions. The introduction of DeFi coverage against the aforementioned risks is a game-changer in safely receiving exposure in crypto. It allows you to differentiate yourself as a safe alternative to competition. Covering your crypto effectively shifts focus towards the upside potential of DeFi investments without the common drawbacks.

Bright Union recently launched a portfolio coverage product directed at specifically protecting DeFi funds’ digital assets against hacks and exploits. Ranging from assistance to direct cover purchasing to fully-fledged coverage, ensuring maximum coverage, continuous updating and rolling over the coverage portfolio based on your DeFi fund’s portfolio changes, including reporting and claims handling. Everything is on-chain and transparent. Taking out portfolio coverage is a valuable way to protect corporate investors’ digital assets against a diversity of risks. Feel free to contact the Bright team for related crypto fund inquiries.

About Bright Union

Bright Union is the world-leading multi-chain DeFi cover marketplace. Its mission is to safeguard your crypto from hacks by empowering the community to cover each other in a decentralized and permissionless manner. Buying DeFi covers has never been this straightforward. Furthermore, Bright Union will soon further release its unique suite of cutting-edge risk solutions, providing investors with outstanding investment and coverage opportunities.

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