DeFi lending is attractive as it offers much higher interest rates than the average bank savings account, but investors should also be aware that using these protocols can be much riskier than depositing money into a traditional financial institution.
The biggest risk is that DeFi protocols are unregulated, meaning they are not insured by any government. In the U.S., bank deposits are insured by the FDIC up to an amount of $250,000 per depositor, per institution. The European Union has a similar safety net, with bank deposits there insured by the Deposit Guarantee Scheme up to an amount of €100,000, while in the U.K., the Financial Services Compensation Scheme guarantees deposits of up to £85,000, and up to £170,000 for jointly owned accounts.
Because crypto is decentralized, it’s not covered by any of these insurance schemes, meaning that depositors in DeFi lending protocols are taking on a much bigger risk than those who rely on traditional savings accounts.
The Risk Of Protocol Insolvency
These guarantees are designed to protect consumers against insolvency. Consumers can be reassured that if the bank somehow becomes insolvent, they will still be able to get their money back from the government. But if a DeFi protocol becomes insolvent, there are no such guarantees.
As such, DeFi investors must be able to tolerate a higher level of risk. The dangers are not unwarranted, as the DeFi protocols are vulnerable to smart contract vulnerabilities that could enable hackers to steal the platform’s funds, for example. In addition, poorly designed DeFi protocols can be exploited by intricate “flash loan attacks”, which involve cybercriminals taking out a flash loan – a kind of uncollateralized loan where the amount is borrowed and repaid in a single transaction. Attackers use flash loans in conjunction with various kinds of gimmickry in order to manipulate the market in their favor. They are complex transactions that involve multiple crypto assets and protocols, and have, in some cases, caused the price of more volatile assets to collapse.
The risk of DeFi insolvency is very real, as the industry’s short history is littered with examples of failed protocols, with the likes of Celsius Finance being one of the most visible cases. In the aftermath of Celsius’ crash, it was revealed that the protocol made poor investment decisions, which meant that it didn’t have enough funds on hand to cover all of its creditors.
Flash loan attacks are not an insignificant risk, either. One example of such an attack was PancakeBunny, a BSC-powered DeFi yield farming aggregator. Using a flash loan, an attacker borrowed a large amount of BNB tokens via PancakeSwap, before using these funds to manipulate PancakeBunny’s USDT/BNB and BUNNY/BNB liquidity pools. The attacker was able to make off with a large amount of BUNNY tokens, which were then dumped onto the open market, causing the token’s price to crash by more than 95%. Investigators say the attacker, who was never identified, was able to profit to the tune of almost $3 million, while BUNNY token holders were left with an almost worthless asset.
FDIC-Like Insurance With Smart Contracts
Clearly, there’s a need for DeFi lending protocols to offer stronger guarantees to attract more cautious investors who value the safety net provided by traditional savings accounts. Fortunately, the innovative nature of the crypto industry has created a new breed of DeFi lending protocols that can offer their very own guarantees.
One such example is the real-world asset-based lending protocol Soil, which allows borrowers to tokenize physical assets such as fiat, invoices, income statements and so on, and use these as collateral for their loans.
Not only are lenders covered by the collateral deposits, which are liquidated in the event of the borrower defaults, but they also benefit from Soil’s innovative “Guarantee Fund”, which is designed to protect against platform insolvency.
The Soil Guarantee Fund is a separate fund governed by smart contracts, with locked-in funds that can only be released in the event of the platform itself becoming insolvent, for example if it’s hacked or somehow manipulated through a flash loan attack. The Soil Guarantee Fund guarantees user’s deposits up to a certain amount, which changes as the protocol itself grows, and it functions similarly to the FDIC’s insurance or EU’s Deposit Guarantee Scheme.
Soil funds the Guarantee Fund with a percentage of the revenue generated by the platform, and these funds are boosted by investments in independent DeFi protocols such as Aave and Compound. Investors can provide a wallet address outside of the Polygon blockchain on which Soil is built, so they are insured even if the entire Polygon chain becomes compromised or malfunctions.
The beauty of Soil’s Guarantee Fund is that it’s governed entirely by smart contracts, and it will only pay out if the protocol becomes insolvent and cannot repay its investors. Soil’s guarantees are one of the main reasons behind its substantial growth, with the protocol recently surpassing the $2 million TVL milestone.
Lower-Risk Crypto Lending
DeFi lending pools can never be described as risk free, but it’s clear that some protocols offer much stronger guarantees to investors than others do. Investors can minimize the risks they face by doing their research into the underlying protocol to see exactly what kind of guarantees it offers. DeFi lending platforms that can show they take security seriously, with regular smart contract audits and additional innovations like Soil’s Guarantee Fund offer far more reassurance than those with no such guarantees.
