DeFi Is Broken: We Need Better Safety Nets [For Younger Generations]

Nov 21, 2020
A warning sign flashes red with the words "DeFi is broken"

Decentralized Finance (DeFi) has been the source for many adverse news reports, including scams, hacks, and smart contract failures. Such failures have woken up the DeFi space especially after many investors have lost significant amounts of money.

To name a few of the recent DeFi incidents:

  1. Flash loan attacks using bZx and Uniswap
  2. Opyn insurance platform hack
  3. Sushiswap founder exit scam (funds returned)
  4. Yam.Finance inflation bug

This article discusses two problems. First, younger generations accept high-risk (DeFi) investing as the new saving. Secondly, the lack of safety nets for DeFi products and what options we have to solve this problem.

Problem #1: High-Risk Investing Has Become the New Saving

Younger generations can’t benefit from high interest rates for savings accounts. It’s even possible that you have to pay your bank for holding your money - a negative interest rate.

Currently, younger generations have to look for alternatives to grow their capital. It’s not favorable to save money for ten years as inflation will eat up your purchasing power. Imagine you’ve saved €10,000. You decide not to invest this money but instead keep it in a savings account at a bank. When we consult the historical inflation rate for Germany between 2009 and 2019, you’ll lose 15% of your buying power. This calculation tells us that your €10,000 is now worth €8,500.

(Source: rcb.at)

For this reason, younger people tend to accept [high-risk] investing as the new norm. They seek alternative financial products that offer better returns than a savings account. 

Decentralized finance promised what they were looking for. DeFi offered investors crazy returns, sometimes in a matter of days after product launch. 

To profit from those high returns, investors have to take significant risks by being a first-mover. I’ve seen friends throw money at each newly listed Uniswap project in search of the next jackpot. 

It didn’t take long for scam artists to take note. They managed to exploit this hype by listing scam tokens with Uniswap. Next, investors add money to the liquidity pool. Being one of the first liquidity providers allows you to yield a significant amount of tokens. However, these scam artists want to sell their tokens through the newly obtained liquidity and convert their scam token to Ether. Yet, another type of scam the crypto industry has witnessed.

Admittingly, seeing other people make 1,000% returns in a matter of weeks or even days draws a lot of attention. This news spread to many traditional news sources, bringing many new investors to DeFi. Unfortunately, many of them didn’t know much about the mechanisms driving DeFi, let alone how a smart contract or yield farming works.

To conclude, the DeFi boom drew a lot of attention and gave us a new blockchain adoption wave. However, this boom also signaled the outside world about the ‘Wild West’ mentality that still lives among the crypto space.

Problem #2: Lack of DeFi Safety Nets

Let’s explore the lack of DeFi safety nets for investors. We’ve just covered how high-risk investing opens up many paths for scams, exploits, and failures. This section covers what possibilities we currently have to provide safety nets and discusses how a mix of decentralization and regulation can solve the current problems.

First, let’s take a look at projects such as Opyn, Ledger Vault, and OpenLaw.

DeFi Safety With Opyn, Ledger Vault, and OpenLaw

Opyn is a smart-contract based insurance platform. The project was created to provide an insurance solution to the quickly growing DeFi ecosystem. Their insurance policy covers several attack vectors, including technical, financial, and administrative vectors.

Ledger Vault offers advanced custody and security solutions to crypto products. For example, YouHodler is a crypto lending product that handles users’ funds in a custodial manner. Therefore, to guarantee better safety, YouHodler makes use of Ledger Vault’s multi-authorization self-custody management solution. 

The solution protects platforms from:

  1. Hacks - All funds are safely stored in hardware wallets, whereas each private key is stored encrypted in a hardware security module.
  2. Human errors - Ledger Vault allows platforms to define governance rules to access funds and who can perform fund transfers.

Currently, Ledger offers $150 million in pooled crime insurance. It’s a significant step forward to provide better safety solutions for crypto investors.

OpenLaw enables smart contract developers to create legally-enforceable smart contracts. It shows how a mixture of decentralization and regulation can create great opportunities. Using OpenLaw, lawyers can more efficiently engage in transactional work and digitally sign and store legal agreements in a highly secure manner. 

We believe that there’s a clear need for legally-enforceable smart contracts to turn DeFi away from its “Wild West” image. 

The above solutions do a great job at providing crypto investors with safety nets. However, there’s still a long way to stabilize the DeFi space and create financial products that can be safely adopted by non-crypto users.

Flash Loans Are a Broken DeFi By-Product

Flash loans have damaged the DeFi space significantly. The first two flash loan attacks targeted the margin trading protocol bZx, respectively, stealing $350,000 and $600,000. 

As CoinDesk explains, these attacks were magnificent. “... In each attack, a penniless attacker instantaneously borrowed hundreds of thousands of dollars of ETH, threaded it through a chain of vulnerable on-chain protocols, extracted hundreds of thousands of dollars in stolen assets, and then paid back their massive ETH loans. All of this happened in an instant — that is, in a single ethereum transaction.” 

Now, let’s think about the economics behind a flash loan. Traditional lending compensates lenders for two things: the risk for a default they accept, and for the opportunity cost of the capital they’re lending out. For example, the lender can receive a 2% interest rate risk-free using a particular investment product. Therefore, the borrower has to accept an interest rate higher than that at least. 

When we look at flash loans, there’s no risk and also no opportunity cost! The reason for the zero opportunity cost is that we assume time is frozen during a flash loan. The system’s capital was never at risk during a flash loan as a user can’t earn a higher interest elsewhere during these ten seconds. 

However, this creates an ideal environment for attacks. Often, complex DeFi attacks vectors such as arbitrage between liquidity pools require a lot of upfront capital to profit from these opportunities. Besides that, as discussed above, flash loans are entirely risk-free. 

In other words, flash loans provide risk-free access to large sums of capital, which acts as an ideal breeding ground for complex DeFi attacks. Nobody would risk $1 million of Ether to make a 10% profit while you can lose all of your money. In contrast, flash loans require no collateral or whatsoever.

Can We Fix Decentralized Finance?

DeFi brands itself as a high-risk and high-reward environment. We need to change this perception. One of the best products the DeFi space has created is crypto lending. It provides investors with a relatively safe way to earn a fixed interest rate for passively holding cryptocurrencies. While YouHodler is more centralized, it offers loan to value ratios up to 90%, the highest anywhere in the industry and all collateral is protected by Ledger Vault’s $150 million pooled crime insurance fund. 

Besides that, liquidity pool projects solve the liquidity problem for decentralized exchanges. Crypto traders who don’t want to use a centralized exchange can now freely use non-custodial, decentralized exchanges without experiencing any slippage. A lack of liquidity commonly causes slippage.

Uniswap, Bancor, Kyber, and many other liquidity providers allow users to earn passive income on their tokens by contributing liquidity to these swap pools. As a rule of thumb, don’t add liquidity for unknown or new projects until they’ve established themselves. 

However, we’re still far from having a sustainable architecture for building the future's financial system. 

Projects such as Opyn, Ledger Vault, and OpenLaw provide outstanding solutions to offer investors a safety net. Still, there’s a long path ahead to stabilize the DeFi space and create financial products that can be safely adopted by non-crypto users. 

YouHodler is happy to be a part of this initiative that offers a safe and regulated environment for its users that will help build trust and confidence in the industry. At the same time, we aim to be on the cutting edge of innovation (like DeFi) but in a much more honest and transparent way.

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