DeFi – or to give it its proper name ‘decentralized finance’ – is the overarching term for the new financial applications being launched to enable cryptocurrency or blockchain to disrupt the historically unassailable position help by financial intermediaries.
It is widely recognised that the DeFi revolution has led to a surge in innovation and provided a new way for savvy investors to generate some incredible levels of return on their investments. However, as with all high return platforms, the rewards have not come without risk.
The primary risk for investors is that you are depositing your assets into an internet protocol rather than a tried and trusted banking institution. This means your investment won’t have the same security as a heavily regulated and reputationally strong bank can offer. Then again, a bank will never be able to offer the same level of return as DeFi.
The specific risks posed by DeFi include:
Smart Contracts
Code is prone to errors, hacking and malicious action. Lending platforms have an established infrastructure to nullify these risks, an independent project almost certainly won’t.
Collateralization
Decentralized finance lending can only be as strong as the source of its liquidity. In a volatile market (and the current pandemic has led to a higher than expected level of volatility), liquidity is put under heightened pressure. This could mean increased price fluctuation or even render funds inaccessible. Financial institutions can counter this with collateralization or by moving interest rates, DeFi projects can’t.
Governance
While financial ‘middlemen’ must adhere to the demands of a highly sophisticated regulatory framework, the risk associated with a DeFi platform is dictated by the reputation of the governance structures they are allied to and how much power is held by the user community.
However, aside from the inherent differences between financial institutions and internet protocols, there is an even greater risk to consider. The scale of investment has predictably caught the attention of digital scammers.
Worse still as DeFi is still a relatively new concept, it is currently unregulated. This means that if you have been a victim of one of growing number of DeFi scams, you may find it incredibly difficult to get back what you’ve lost.
As lawyers who specialise in helping clients recover the funds they have lost because of digital scams, we are seeing a growing number of people falling victim to Defi fraud so we thought it may be useful to share some tips that we’ve picked up that will help you reduce the potential risk associated with a DeFi investment.
- Find out the purpose behind project’s purpose
Many crypto assets don’t offer anything new; they’re just trying to ride on DeFi’s coat tails as it’s enjoying such a high profile at the moment.
Before you commit ask what is new about this project. Ask what is unique. Ask how it will improve the digital economy. If the answers are confused, woolly or unforthcoming, be suspicious.
- Check their development activity
Try to examine the code behind the project. Is it static or constantly being changed? True innovation generates activity. You’ll be able to see how frequently the code is being changed as the projects has to be kept open source.
And don’t worry if you don’t know much about coding. If the project is legitimate and gaining popularity, other people will have done the work for you and posted their findings (good or bad) online.
- Is the underlying smart contract audited?
Smart contracts need to be audited to offer users reassurance that they are secure. If the developers aren’t able to produce an audit trail, this could indicate a higher level of risk especially as auditing is expensive so criminals will very rarely pay for an audit.
- Do you know who’s behind the project?
Anonymity and pseudonyms are common in the digital economy. Even the leading developers like the freedom of being able to operate online without having to use their real names. That said, many want their names attached as it adds immediate credibility to a new project.
If you can’t find anything out about the people behind a project, that could be a warning, particularly as it will be almost impossible to start the legal recovery process with no lead on who you gave your money to.
- Ask how the tokens will be distributed
This is key to deciding whether a project is safe or not.
The most usual way for a scammer to make money from a token-based project is to inflate the price of their token before dumping it on the market. To do that the founder will have to take ‘a significant founder allocation’ (40-60% of the total tokens) and while the presence of such an allocation isn’t an indicator of fraud per se, it should persuade you to find out more.
Similarly, take a look at who the tokens are being sold. Is it via an official ICO or IEO or via social media or an airdrop? It is only a very general rule of thumb but the more open the sale is (i.e. via ICO or IEO), the less risk is likely to be involved.
There are huge potential gains to be made from decentralized finance but there is also a growing risk of being scammed. We hope these tips help you reduce the potential risk but if you have become a victim of a DeFi scam (or any other type of bitcoin, cryptocurrency or digital fraud) please call us today on 020 7792 5649 or email us at This email address is being protected from spambots. You need JavaScript enabled to view it..
We will help.
