What Crypto Investors Need to Know About DeFi

Decentralized finance can generate high returns, but you need to understand the risks.

The words "decentralized finance" or "DeFi" get used a lot these days, especially if you're into cryptocurrency. But what exactly is DeFi and what do cryptocurrency investors need to know about the industry?

What is DeFi?

Decentralized finance is an umbrella term for a host of activities that cut the middleman out of traditional financial services like banking. It encompasses loans, interest-earning accounts, money transfers, insurance, and cryptocurrency exchanges. For example, I might lend you $100 worth of Bitcoin (BTC) via DeFi, and I'd then earn interest on that loan -- without involving a traditional lender.

When Bitcoin first launched, one of the amazing things about it was its decentralized nature. Previously, digital money required the backing of a third party -- whether a bank or government -- to validate transactions and guarantee payments. The same blockchain technology that powers Bitcoin is what enables the decentralized finance industry to cut out intermediaries.

This can reduce costs and paperwork -- and speed up transactions. In the example above, you wouldn't need a credit score to qualify for the loan -- though you would need to put up some cryptocurrency as collateral. But, as we'll see, DeFi applications also bring additional risks.

Here are four things crypto investors need to know about DeFi.

1. DeFi is booming

The decentralized finance industry has gone from strength to strength, in parallel with the increased interest in cryptocurrencies. Indeed, according to the analytics and rankings site DeFi Pulse, there's around $90 billion locked up in DeFi right now.

DeFi Pulse tracks Total Value Locked (TVL), which represents the value of funds deposited in various DeFi applications, and it's a good indicator of the size of the market. A lot of DeFi applications are built on the Ethereum (ETH) network, which means the price of Ethereum impacts TVL as well as the amount of money that's invested in DeFi.

At the end of 2019, TVL was around $8.5 billion, and by the end of 2020 it had reached about $25 billion. There's a very good chance it will top $100 billion by the end of this year.

2. DeFi doesn't offer the same protections as traditional banks

The protections we take for granted in traditional bank and investment accounts may not be present in decentralized finance. It's important to ask yourself what will happen if something goes wrong because there may not be a safety net.

For example, if a traditional bank fails, FDIC insurance means your savings are covered up to $250,000 per eligible account. (This doesn't include brokerage accounts, but they have another form of insurance called SIPC.) Most people don't give it much thought because their bank hasn't come close to failing. But there's more chance a decentralized finance platform could fail -- and a lot less protection in place if it does.

Here are some other factors to consider before you get into DeFi:

• Where your assets will be stored: Look for platforms that keep the majority of assets offline in what's called cold storage -- and find out whether they have insurance against hacking or other crime. Third-party audits and other security features like bug bounty programs are a plus.
• How your assets will be used: Some DeFi platforms promise to pay high rates of interest on the crypto you deposit. They often do that by lending out your funds and paying you some of the interest that borrowers pay them. Transparency is important here as you want to understand who they might lend your funds to, and how risky those loans are.
• Technical risks: The disadvantage to taking out the middleman is that you're replacing an organization with a piece of code. That's OK if the code is trustworthy, but problematic if it's not. Look for open source projects as that means anyone can view the code and check for bugs. And be wary of new projects that may not have been road tested.
• Scams: According to CipherTrace, $471 million had already been stolen in DeFi fraud and hacks by August of this year -- considerably more than in previous years. And once crypto funds have been stolen, they can be very hard to get back. Research DeFi applications carefully before depositing your money. Pay particular attention to reviews online and on crypto forums in particular, as this is often the first sign of potential problems.

3. Regulation is coming

It seems as if increased crypto and DeFi regulation is no longer just a possibility -- it's a certainty. From the SEC to the Treasury, various authorities have raised the need for additional controls. One concern is that DeFi platforms offer bank-like services but without the same levels of consumer protection as traditional banks. Another is the ease with which anonymous DeFi services can be used to circumvent existing laws that, for example, prevent money laundering.

4. There are many ways to get involved in DeFi

If you're keen to get a piece of the DeFi action, one way is to own DeFi cryptocurrency tokens. As the DeFi industry has grown, so has the value of those currencies.

You can also earn interest on your cryptocurrency through DeFi. We mentioned borrowing and lending platforms above, which often pay much higher rates than what you'll find with a traditional savings account. Another route is to use these platforms to stake your coins -- which involves tying them up to contribute to the overall security and maintenance of that cryptocurrency network.

As with any form of cryptocurrency investment, if you decide to dive into DeFi, only invest money you can afford to lose. And make sure you research the industry carefully to ensure you fully understand the associated risks. It's an exciting new world, but it's also one that doesn't have many safety rails in place.