4 Major Challenges in DeFi Lending & Tips to Mitigate Risks!

Cryptocurrency has ever-growing demands for investments and decentralizing finance. A lending service has evolved to provide fund access to cryptocurrency investors. The best thing about lending on DeFi is that it evades geographical restrictions. 

It gives borrowers access to cryptocurrency loans without restriction and needing central banks.

Potential risks in DeFi lending may not be predictable to the individual protocols.

How does DeFi Lending Work?

DeFi lending is short for decentralized finance lending. It involves a bank-like lending setting for decentralized applications.

This kind of creepy credit works so that a lender must deposit funds via a smart contract in advance. It is linked to a specific cryptocurrency on the DeFi lending platform. It is equal to the amount the borrower has taken a loan. 

They call this "collateral," which can be any cryptocurrency. It will open a liquidation position. This will recover the loss if the value of the collateral happens to go below the value of the loan amount.

What's interesting is that anybody can become a leader in DeFi lending. Any wallet is free to deposit cryptocurrency into the pools of lending protocols. It provides liquidity and earns interest.

Let’s identify the risks related to the lending industry in DeFi. We will provide practical solutions to these unique risks.

Read more: DeFi Vs CeFi in the Crypto Market!

Borrowing Mechanism in DeFi

Over-collateralization

In DeFi, over-collateralization is a typical practice. Due to variations in cryptocurrency prices, DeFi borrowers must deposit crypto in more than the loan amount. This is in contrast to traditional loans, in which collateral might vary. 

A smart contract holds the collateral until it is repaid.

Under-collateralization

When the collateral value is less than the loan, it can be challenging to achieve under-collateralization in DeFi. 

Creditworthiness is ignored by over-collateralization. But, lending to people without assets can be challenging. 

DeFi enthusiasts look for loans that are easily accessible and research off-chain and blockchain data to assess credit.

Flash loans

Although they require knowledge, flash loans present a novel alternative to under-collateralization. 

They execute instantly, unlike conventional loans, and default erases the debt. They allow for rapid profit-making through swaps and arbitrage. 

As under-collateralized loan alternatives develop, flash loans become more widely accepted.

The challenges of DeFi Lending

The Risks of DeFi Lending

DeFi lending has many benefits. However, there are dangers as well. It is commonly connected with four risks.

Liquidation Risk

The value of cryptocurrency can swing dramatically. Smart contracts liquidate collateral when its value drops below a threshold, which accrues at the expense of the borrower's investment. 

Even worse, no go-between lowers counterparty risk in DeFi lending since borrowers and lenders deal directly. Lenders may lose their investment if the borrower defaults, and there is no way to recover it.

Smart Contract Risk

Once activated, smart contracts cannot be modified. Attackers can take advantage of a bug and steal money. Audits can reduce this risk, although they are not 100% effective.

Flash Loan Attacks

In a flash loan attack, the attacker takes out a massive loan in Bitcoin to carry out several manipulative transactions. They may use smart contract flaws to carry out other destructive actions. 

The attacker's efforts must produce a profit larger than the borrowed amount plus costs because the loan must be returned in one transaction. 

If successful, flash loan attacks could cause DeFi protocols and users to suffer large financial losses. 

One prominent instance of a flash loan assault is the bZx affair.

Impermanent Loss

Price swings of locked assets cause this in cryptocurrency liquidity pools, especially when the token ratio is not uniform. 

By offering stablecoins in liquidity pools, liquidity providers (LPs) can reduce the risk and minimize losses. 

Trading fees are used by platforms such as Uniswap to pay limited partners for temporary losses, safeguarding their interests.

Ways to Reduce the Risks in DeFi Lending

Here are some of the ways you can mitigate the risks of DeFi lending:

Monitor Investments

Check the platform's performance and the value of your collateral regularly. Consider selling your investment if you see any red flags, such as a sharp decline in the value of the collateral or a rise in loans that have fallen into default.

Understand Smart Contracts

Get acquainted with the smart contract on the platform. If you need clarification on how it operates, get expert help.

Consider Insurance

Specific DeFi solutions offer protection from hackers and security lapses. Select platforms that offer this function to improve the security of your investments.

Security Audits

Perform security audits on smart contracts regularly. Audits conducted by impartial third parties can assist in locating weaknesses before they are taken advantage of.

Formal Verification

Prove the accuracy of smart contracts mathematically using formal verification techniques. This meticulous procedure helps guarantee that the code operates as intended in every scenario.

Insurance Funds

Create insurance reserves to reimburse customers for losses brought on by unanticipated circumstances. In the event of attacks or weaknesses, these funds serve as a safety net for users.

Flash Loan Guards

Put in place certain safeguards against flash loan assaults, like limiting the maximum transaction size, asking users to repay flash loans before using specified capabilities, or imposing transaction delays.

Final Note!

The biggest concerns to the sustainability of DeFi financing in the market are smart contract weaknesses and liquidation threats. 

We have recommended many steps to reduce the risks stated above. In particular, people should be aware of smart contracts and monitor their assets. DeFi protocols should also regularly audit security and put preventative measures in place.

For more crypto tax-related and due diligence information, contact Crypto Accountants!