Top 3 Risks of DeFi Lending & How to Mitigate Them

Decentralized Finance (DeFi) lending offers a more inclusive and accessible financial system. By eliminating intermediaries and leveraging blockchain technology, DeFi lending platforms allow users to lend and borrow cryptocurrencies quickly, cheaply, and transparently.

However, this innovation comes with certain risks. In this article, we will explore the key risks of DeFi lending and how users can mitigate them.

From smart contract vulnerabilities to regulatory challenges, understanding these challenges is essential for anyone looking to participate in this exciting new frontier of finance.

What Are the Risks of DeFi Lending?

1. Smart Contract Risk

DeFi lending platforms operate on smart contracts, self-executing contracts with the terms of the agreement between buyer and seller directly written into lines of code.

This means that once the smart contract is deployed, it cannot be changed, and any mistakes or vulnerabilities in the code can lead to significant losses for users.

One example of such a vulnerability is a "flash loan attack," where an attacker takes advantage of a vulnerability in a smart contract to borrow funds and then uses them to manipulate the price of an asset.

In 2021, after a flash loan attack on Alpha Homoro, the protocol lost $37 million. Using Iron Bank, hackers carried out numerous flash loans.

To mitigate this risk, users should only use DeFi lending platforms that have undergone rigorous security audits and have a track record of being secure. They should also monitor the platform's social media channels and forums to stay updated on any vulnerabilities or attacks.

2. Liquidity Risk

DeFi lending platforms rely on a pool of liquidity from lenders to provide loans to borrowers. If there is insufficient liquidity in the pool, borrowers can’t borrow and lenders can’t withdraw.

Various factors, including changes in supply and demand, market volatility, smart contract vulnerabilities, and network congestion in liquidity pools can cause liquidity fluctuations.

In 2020, Uniswap’s liquidity dropped 40% in 24 hours. The sharp decline was caused by the termination of its liquidity rewards program, which previously incentivized users to put liquidity in the platform.

This just goes to show that although liquidity can be volatile, strong governance and mechanics can help maintain stability.

To mitigate this risk, users should diversify their lending and borrowing across multiple platforms to reduce the risk of losing all their funds in a single liquidity crisis.

At the same time, they should stick to DeFi lending platforms with a proven track record of maintaining sufficient liquidity in their pools.

It’s also worth seeking platforms that improve liquidity for users by changing their models, likeSturdy's dynamic emission liquidity mining. Emissions are adjusted weekly based on utilization rate, reducing by 10% if utilization falls below 50% and increasing by 10% if it exceeds 70%.

The model maintains the treasury for longevity and incentivizes lending during high utilization, creating a stable ecosystem.

3. Regulatory Risk

DeFi lending platforms operate outside the traditional financial system and are not regulated by financial authorities. This means that users may not have legal recourse in case of fraud or losses, and there may not be clear legal structures in place to protect them.

Plus, regulators may crack down on DeFi lending platforms, leading to their closure.

In recent years, there has been growing interest and scrutiny from regulatory bodies worldwide regarding DeFi and other decentralized technologies.

As the DeFi ecosystem continues to evolve and mature, regulatory bodies will likely continue to monitor and potentially intervene in the space.

For example, in 2022, the US Securities and Exchange Commission (SEC) filed a lawsuit against the DeFi lending platform, BitConnect, accusing it of operating a Ponzi scheme and defrauding investors of $2 billion.

The founder’s location remains unknown, but victims of the fraud are receiving restitution.

To mitigate regulatory risk, users should do their due diligence before using a DeFi lending platform and only use those with a clear legal structure and comply with the regulations in their jurisdiction.

DeFi lending has the potential to revolutionize the financial system and provide more accessible and inclusive lending options for users. However, as with any financial activity, risks are involved, and users need to be aware of them to make informed decisions.

By following best practices and doing their due diligence, users can mitigate the risks and have a positive experience. As the space continues to evolve, users need to stay updated on the latest risks and trends to make the most of their investments.

Note: The author has had a business relationship with Sturdy Finance in the past. Please do your own research before making any financial decisions.