There’s no such thing as a free lunch, and there’s always a level of risk with any kind of investment. But in order to earn a return on your capital, you’ve got to be willing to tolerate some sort of risk. That’s most definitely the case in the crypto lending industry, which many might consider to be extremely risky. However, the reality is that investors can take steps to safeguard their crypto investments and potentially earn much higher returns than they would within the world of traditional finance.
Crypto trading is generally considered to be risky, not only because of the volatility of digital asset prices, but because many DeFi protocols themselves have proven themselves to be vulnerable to hacking, or worse, downright scams that were created for only one purpose – to steal investor’s money.
That said, crypto lending doesn’t have to be nearly as risky as some people might imagine, so long as investors do their research and choose the right protocol. So let’s take a look at the main risks involved in lending out crypto, and see what we can do to negate them.
The Insolvency Risk
With DeFi lending protocols, it’s possible to earn double-digit interest on your deposits, but understand that, unlike with traditional banks, investors deposits are not insured by the government, meaning there’s a risk that investors could lose everything if the platform provider goes bankrupt.
This is a very real threat, with platforms such as Three Arrows, Voyager Digital and Celsius Network all becoming insolvent in 2022, leaving many of their investors with nothing.
Investors can negate these risks by opting for noncustodial DeFi protocols such as Aave, which allows them to borrow and lend assets without depositing their funds. Instead, investors interact with Aave by connecting a Web3 wallet such as MetaMask, signing transactions with their own wallet. When they lend their funds, they go directly to the borrower – never through Aave’s platform – and the user receives new tokens representing their underlying position and interest rate yield.
In this way, Aave grants users peace of mind, safe in the knowledge that the platform won’t disappear with their savings if it becomes insolvent.
Another strong protection is the Proof-of-Reserves. One of the first DeFi protocols to demonstrate its sound finances was Nexo, which partnered with the independent auditing firm Armanino in 2021 to showcase real-time attestation of its custodial assets, supporting its claim that its assets always exceed its liabilities.
By offering a proof-of-reserves, Nexo has transparent proof that all deposited funds from users are backed by proven assets, with third-party assurance that these are being properly managed and accounted for. In this way, Nexo can always meet any liabilities owed to its investors.
Borrower defaults
Besides the risk of certain DeFi platforms going broke, there’s also the danger that the borrower could default on the loan. In the event of a default, the lender risks losing their funds, but many protocols provide guarantees that will, at the very least, minimize any losses stemming from such incidents.
For instance, the real-world asset-based lending protocol Soil provides users with security by collateralizing loans with tokenized, real world assets that will be returned to creditors in the event of a default. In addition, Soil offers a Guarantee Fund that enhances investor security. The Guarantee Fund is essentially just a smart contract with locked funds, which guarantees users’ deposits up to a certain amount, similar to how many banks will insure deposits in traditional finance. The company’s recent progress, hitting a new milestone of $2 million in total value locked within its protocol, is a testament to the value investors place in this guarantee.
Rug Pulls
Another major risk that cannot be overstated is the danger that the entire protocol itself could be a scam.
To safeguard against the risk of so-called “rug pulls”, which is when the team behind the product simply disappears with customers’ deposits, investors can do their research and search for protocols with strong, reputable teams and investment firms behind them.
One of the best-funded DeFi lending protocols in the industry is Curve Finance, which said in September 2023 it had raised $58 million in an extension of its Series C round, bringing the total amount to more than $133 million. Its main backers in that round included Britannia, IDC Ventures, Cercano Management (which is the venture arm of Microsoft co-founder and philanthropist Paul G. Allen’s estate), Cohen Circle and Outward VC. Given the reputation of its backers, plus its long established history, it’s clear that Curve is almost certainly not a rug pull, so investors won’t have to worry about its team running off with their money.
Security Breaches
The final major risk associated with crypto lending pertains to its level of security. The reality is that every single DeFi protocol’s smart contact code could contain vulnerabilities that could result in them being hacked and customer’s funds disappearing. After all, smart contract code is created by humans, and as skilled as any programmer may be, they can always make unintended mistakes. However, the most reliable and trusted protocols will have undergone expensive audits of their codebase by reputable security firms.
Some protocols go even further. Compound Finance makes it clear that smart contract security is one of its highest priorities and has invested considerable effort into ensuring that its protocol is as safe as it’s possible to be. To that end, it has undergone not one, but two successful audits by OpenZeppelin and ChainSecurity – both of which are highly respected security firms in the DeFi industry. In addition, Compound has made its entire code base and smart contract balanced publicly verifiable, and offers a bug bounty to security researchers who can report any vulnerabilities within its code.
As for Solo, it offers strong guarantees against both rug-pulls and smart contract vulnerabilities. Its co-founders include Nicholas Motz, one of the co-founders of the highly regulated and supervised private debt fund Mount TFI, which is based in Poland and has successfully originated more than $1 billion worth of loans in traditional finance. Having a strong background in traditional finance gives Soil’s investors peace of mind that nobody is attempting to scam anyone. In addition, Soil’s smart contracts underwent an extensive audit by Hacken, another leading DeFi security firm, achieving a perfect security score of 10/10.
Thoughts On Crypto Lending Risks
Like every other kind of investment, crypto lending will never be entirely without risk. But so long as investors understand what the main risks are, they can take precautions to ensure the safety of their investments.
Crypto lending risks can be kept to a minimum by only investing in established and reputable protocols. Investors should always apply caution, research the history of the protocol they’re considering investing in, make sure it’s led by a knowledgeable team with a track record in finance, and check that it takes security seriously and has audited its smart contracts.
By performing this kind of due diligence, investors can be reassured that their investments in crypto lending are likely to be repaid with higher rewards than those that can be found in traditional finance.
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