Linda Xie, co-founder at Scalar Capital, advisor at the 0x Project, and former product manager at Coinbase, says that if you’re a VC focused on investing in Fintech projects, then you really need to know what’s going in the so-called “decentralized” finance (DeFi) space, which is largely based on Ethereum (ETH).
Xie, a former risk analyst at AIG, notes that DeFi offers several different financial services such as the ability to transact with stablecoins, which aim to serve as digital currencies that are pegged 1-to-1 with fiat money like the USD, EUR, GBP or commodities like gold.
Xie points out that DeFi enables decentralized lending, supports non-custodial exchanges, offers various collateralization options, and allows users to access decentralized ID management systems. However, she cautions that “high returns in DeFi are often accompanied by even higher risks.”
In a blog post published in January 2020, Xie had claimed that new tools were being developed to help investors hedge against serious risks involved with using DeFi platforms. However, it seems that a lot more still needs to be done to address the problems found in many existing DeFi solutions.
In February 2020, bZX, an Ethereum-based decentralized finance lending protocol suffered a security breach. Kyle Kristner, co-founder at bZx, had confirmed that funds had been lost due to the hack.
Approximately 3,300 Ether, valued at about $930,000 at that time, was reported stolen or removed from the bZx protocol, although some industry participants estimated the loss to be around $350,000.
In April 2020, dForce, a Chinese decentralized finance platform also experienced a hack that led to the loss of around $25 million worth of cryptocurrency. Although the hacker returned the funds later on (because their IP address had been tracked and they didn’t want to deal with potentially serious consequences), the incident highlights major issues with offering these so-called DeFi services.
Software developers have been writing source code that has not been properly audited or checked for security vulnerabilities. There are no widely-adopted best practices or standards in the crypto industry to ensure that traders and investors are protected. Although many self-regulatory organizations or SROs have been formed, they are not really operating in a consistent manner.
As reported in August 2020, a critical bug was found in DeFi protocol Yam Finance, which led to a major crash in its native token’s price. This, after $500 million in value had been locked on the platform. Despite these major issues, the platform’s developers quickly announced that they were getting ready to launch Version 2.0, which would not have major problems.
In January 2020, Xie wrote:
“Interestingly, in the long run, DeFi with decentralized identity systems could become another option for people locked out of traditional financial systems. For example, there are one billion people without an official ID, and ~50% of women in low income countries lack an ID. However, many of these people do have smartphones. So it’s possible that once decentralized IDs work in the developed world, that they could be rapidly exported to the developing world as a leapfrog technology — much like smartphones themselves.”
While decentralized ID solutions appear to be a legitimate use case for blockchain tech, as several companies are implementing them, it does not necessarily mean that conducting financial transactions on these platforms will not subject users to serious and unnecessary risks.