Everything you need to know about the 5 categories of risk associated with DeFi

Betting on an uncertain outcome in the future is always risky, and that very risk is unavoidable when you’re trading. Tech entrepreneur and Bitcoin advocate Andreas Antonopoulos recently took YouTube to decrypt and analyze the five categories of risk affiliated with Decentralized Finance. 

Highlighting the risk of the financial instrument itself, he said,

“It is the risk that whatever you’re betting on goes in the opposite direction. This is straight forward financial risk that every financial asset has.”

Shedding light on the next category – counter-party risk, he highlighted how centralized finance faced the risk of intermediaries going bankrupt, freezing their accounts, or exiting from the scene post-embezzlement. Highlighting the case for DeFi, he added,  

“That depends on how De your DeFi is. If you have a CeFi, then you’ll have a lot of counterparty risk, but it’s completely decentralized, then you don’t have any counterparty risk because there are no intermediaries in that engagement.”

He further divided the next category – contract risk – into two sub-categories. 

“Primary contract risk is the risk the DeFi platform is based on and is not on contract. It is often based on dozens of contracts and they’re fairly complex composites of multiple different contracts. Secondary contracts are used as building blocks or foundational components that are not part just of this DeFi application, but are a part of multiple DeFi applications.”

In yield farming contracts, for instance, the secondary risk will have more to do with the governance or multisig library that they use. So in retrospect, if either of them has a bug, it could have a ripple effect and bring down that DeFi application completely.

Shedding light on the platform risk, Antonopoulos went on to say,

“The platform risks related to the platform on which the smart contracts are running. This would be the risk of Ethereum itself in that platform risk.”

Conditions like volatility and gas fees on the platform might make it difficult to execute smart contracts and would fall under the platform risk. Apart from that, platform vulnerabilities also pose a fair amount of risk to its users.

The amalgamation of all the risks would give birth to compound risk.  

‘So if you add all of these risks together, you get the compound or the composite risk of the entire DeFi application. So, overtime the things that are at the bottom of the stack, mature and we find fewer and fewer vulnerabilities and critical edge cases and exceptions which makes the things above them more and more stable.”

A recent Bank of Japan report had also pointed out some potential risks, some revolving around the lack of regulations, smart contract failures, and user protection-related complications. The authors of the report also highlighted that user protection-related complications could potentially arise due to a lack of centralized auditing bodies.

The authors were also skeptical about the tamper-proof nature of blockchain networks. They asserted that it could work against DeFi in the world of finance and in extreme cases, a smart contract could trigger a series of “meaningless” automatic program executions that human users would be powerless to stop.

The report also encapsulated the DeFi sector regulatory policy. It highlighted that it would be extremely difficult to ensure the effectiveness of the central bank, financial regulator, and government-imposed regulations due to the nature of the DeFi industry.