Chapter 14: DeFi – The Rise and Risks in Lending and Borrowing

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During the bullish run of 2020 and 2021, Centralized Finance (CeFi) and Decentralized Finance (DeFi) soared in popularity. CeFi involves centralized platforms, whereas DeFi operates through decentralized protocols, both allowing users to lend their crypto assets to earn interest.

CeFi platforms, like Celsius, offered incredibly attractive interest rates, sometimes up to 20%, enticing around 1.7 million users. Yet, as emphasized, high returns correlate with high risks. While advertised as risk-free, such high returns often signify underlying risks. Celsius’ business model became unsustainable due to crypto market downturns in 2022, leading to liquidity crises.

Problems surfaced when multiple users simultaneously attempted to withdraw funds. Several reasons contributed to these issues: Celsius took overly significant risks with raised funds, incurring substantial losses due to incidents like the LUNA collapse, Stakehound, and Badgerdao hacks, losing millions. Lack of transparency about potential involvement in other hacks also plagued the platform.

Additionally, a substantial portion of Celsius’ ETH was locked in the new ETH 2.0 smart contract for staking rewards. Until Ethereum’s transition to proof-of-stake occured, these funds were inaccessible, hindering liquidity. This situation affected more than 70% of Celsius’ ETH balance, immobilizing substantial funds.

The collapse of Terra LUNA and the UST stablecoin prompted investors to rethink the risks of stablecoin investments and high-return platforms. An influx of withdrawal requests ensued, akin to traditional bank runs, forcing Celsius to freeze withdrawals in an attempt to stay solvent.

Unfortunately, the consequences of the UST and Celsius collapse were devastating for some investors, leading to substantial financial losses, personal bankruptcy, and emotional distress, serving as a cautionary tale about high-risk investments in DeFi.

Understanding Crypto Lending and Borrowing

Crypto lending involves lending out crypto assets, while borrowing means securing crypto loans. Collateralized lending requires providing collateral, securing assets in smart contracts. If the loan is repaid, the collateral is released.

Some opt for collateralized lending to hold onto assets like Bitcoin while using stablecoins as loans for significant purchases. However, the 2022 crypto market downturn affected borrowers, requiring more collateral or risking loan default.

Undercollateralized lending within DeFi exists but lacks certainty for borrowers to repay the loan, posing a higher risk.

Smart contract vulnerabilities are another concern, potentially allowing hackers to exploit collateral. Cryptocurrency market fluctuations also affect loan repayment, as seen with the UST’s collapse, emphasizing the instability of stablecoins.

These risks highlight the importance of caution in lending a significant portion of your crypto holdings. High interest rates come with equally high risks, demanding careful consideration.

Unforeseen Risks in Coin Lending: Understanding Platform Usage and Risk Exposure

When users lend their coins to platforms, they often remain unaware of how these assets are utilized. While aiming for passive income through interest, users might unknowingly expose their funds to considerable risks.

Many lending platforms might leverage these assets for various activities, such as speculative trading, investment in unproven projects, or other high-risk ventures. Unfortunately, users often lack transparency regarding the platform’s practices, leading to potential vulnerability.

These platforms may promise high returns, enticing users to lend their assets without fully comprehending the associated risks. However, without proper insight into the platform’s operational strategies or risk management protocols, users inadvertently put their initial investments at stake.

For instance, a lending platform might direct users’ funds into unverified or high-risk companies or projects, resulting in the loss of the lent assets. Users, expecting passive earnings, may suddenly find themselves facing considerable losses, with little to no recourse.

Moreover, some platforms might not adhere to industry standards or regulatory compliance, further heightening the inherent risks associated with lending. The lack of oversight and regulatory frameworks exposes users to potential fraudulent activities or mismanagement by these platforms.

Therefore, users must conduct thorough research and due diligence before entrusting their assets to lending platforms. Understanding the platform’s operational methods, risk management practices, and assessing their track record are crucial steps to minimize exposure to unforeseen risks.