Decentralized finance (or DeFi) is changing the way individuals handle money. Contrary to conventional banks, DeFi enables people to lend, borrow, trade and invest through blockchain technology and smart contracts. It eliminates authority at the center and puts more power in the hands of people. Although DeFi holds a bright future, there are many risks and challenges involved. Anyone involved in this ecosystem must be knowledgeable about the DeFi governance and its risks.
The primary promise of DeFi is transparency, efficiency and decentralization. The user will be able to make selections, receive interest, and be a part of the governance process without the use of banks. These advantages have their costs, however. To avoid losses and fraud, investors have to keep up to date and have to work on the management of investing assets.
The Role of Governance in DeFi
DeFi governance enables the user to take part in the decision-making of a platform. Usually, the votes of token holders are applicable to approve protocol changes, including fees, interest rates, or other additions. The idea behind this democratic system is to put power into the hands of the community, instead of a central authority.
But there are many different ways of governance and not all of them are safe. On most platforms, most of the voting power is in the hands of a small number of large token holders or so-called whales. This may cause few to make decisions that may favor many. As an example, whales can either vote to raise the fees imposed on regular users or they can vote in favor of risky changes that could be beneficial to them.
Good governance needs transparency, equitable allocation of tokens, and involvement of communities to minimize chances of market misconduct. An environment where active participation is possible, clear vote processes and greatly restricting the impact of big holders tends to gain more confidence and long term commitment.
Common Risks in DeFi
The rewards are very high on DeFi platforms, and there is an involvement of severe risks. Being aware of these risks enables investors to make good decisions and prevent possible losses. The most popular risks are as follows:
Smart Contract Vulnerabilities
Smart contracts are programs that automatically execute in the blockchain and handle transactions. They eliminate the middle men, but they are not error-free. Hackers may infiltrate the system and steal money or alter the system by coding errors or code weaknesses. Smart contract exploits have been costly to several high-profile DeFi platforms in the multi-million-dollar range.
Market Manipulation
DeFi markets are less regulated and newer than regular finance. This will draw in malpractice like pump-and-dump schemes, artificial trading volumes, and wash trading. These activities can have a significant impact on the prices of crypto coins, exposing novice investors to risks. The most popular cryptocurrency to invest in may also turn volatile within a short time when the manipulators focus on smaller DeFi markets.
Liquidity Risks
Liquidity is the ease with which you can purchase or sell an asset without any impact on its value. Most DeFi applications are liquidity pools backed by users. Liquidity may run dry when many users withdraw their money at the same time, leading to sudden losses and drastic price fluctuations.
Regulatory Uncertainty
DeFi is legal gray area. Regulations regarding the platforms that will decentralize are still in the works by governments all over the world. Regulations may limit access to some services in future, introduce new taxes or even prohibit some DeFi. This is an additional risk to investors.
The Platform and Governance Risks
There are a few platforms with poor governance. Decision-making will rely with a small group of token holder’s/platform developers. This puts the community at risk of making decisions that benefit the insiders but not the community. Weak governance may also reduce the speed at which people will address the vulnerabilities exposing the platform to attack.
The impact of DeFi Risks on the Economy
DeFi is not a niche market alone, it can have an impact on the overall economy. Significant losses in DeFi platforms will decrease people’s trust in cryptocurrencies and decelerate the use of blockchain technologies. To illustrate the point, there is a significant risk of a large-scale hack causing panicked selling of crypto coins and reducing their market value and corresponding investor confidence.
Another way DeFi intersects with traditional finance is in the form of tokenized fiat currencies. This brings about the dangers of dollar domination. Should DeFi platforms not be able to support the value of dollar-backed tokens, this may affect the stability of the financial system more broadly, particularly in markets that depend on dollar-pegged assets.
What is more, the decentralized model of DeFi complicates the ability of authorities to act in crises. Banks do not have a central authority to balance the system when it is stressed. This control-free nature may perpetuate the risks and threaten the economy in case DeFi keeps growing in size.
Best Practices to be a Safer DeFi participant
DeFi is a risky investment that needs to be well planned. The best practices will help to minimize risks and to secure finances:
Research Before Investing
Never invest in an unfamiliar platform. Test its governance structure, team credibility and audit reports. Knowledge on the decision-making process helps investors to shun platforms that are prone to market malpractices.
Diversify Investments
Never invest in a single system or asset. Invest in, and spread investments in DeFi protocols and cryptocurrency to reduce the effect of losses in the event of a platform failure.
Oversee Governance Proposals
Your investments can be safeguarded through active participation in the governance. The vote on the proposals, follow the changes to come, and participate in discussions in the community. Participation fosters a feeling that your interests are heard.
How DeFi Can Improve Governance
Despite the risks, DeFi could enhance a better governance than traditional finance. Some strategies include:
Quadratic Voting: The small holders will gain more voting power and less whale power.
Time-Locked Voting: Voting is activated with a time delay, and, in the meantime, users can react to the change and prevent its negative consequences.
Multi-Signature Governance: Important decisions must be made by more than one trusted party which makes them more secure.
Incentivized participation: Users can be incentivized to vote and engage in governance across platforms, which will encourage more people to engage.
Final Words
DeFi is transforming the financial system through endowing the user with control, financial freedom and participation in governance. However, the biggest problems include smart contract vulnerabilities, market manipulation, liquidity, governance and regulatory uncertainty.
The most important part of risk reduction is to understand the DeFi governance and participate in decision-making. Best practice would help investors hedge against bad behavior and losses by investing in audited platforms and diversifying funds.
DeFi has a broader impact, not just on results of individual investment, the economy, price of crypto coins, and dollar dominance on financial markets. DeFi provides promising prospects to any person looking at investing in a cryptocurrency, just with due investigations and responsible involvement.