Centic · Follow
6 min read · Oct 6, 2023
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In response to the rapid development of decentralized finance and the increasing demand for crypto investment, a lending service has emerged to provide crypto investors with opportunities to access capital. The advantage of lending in DeFi is that it overcomes geographic boundaries and gives free access to crypto loans to borrowers without any centralized third party like banks.
However, DeFi lending also comes with significant risks that may be yet fully understood by individuals and protocols. In this article, we’ll pinpoint the risks associated with the lending sector in DeFi and explore effective measures to address them.
As of the writing time, the TVL of the DeFi lending is $14.308b, accounting for 18% of the whole TVL in the DeFi market. At present, lending is the second most developing field in DeFi.
Most TVL of the lending market lies on top 3 prominent lending protocols: Aave with 30%, Justlend with 29% and Compound with 17% (Find out more about the status quo of DeFi lending market in this article)
DeFi lending or decentralized finance lending, works much like the loans you get from banks, however, instead of being provided by banks, it is offered by decentralized apps (DApps).
To take loans in DeFi, the borrower has to make a deposit on a DeFi lending platform via a smart contract associated with a specific cryptocurrency that matches the loan amount. This deposit is called collateral which can be any kind of cryptocurrency. If the collateral’s value falls below the loan amount, a liquidation position will be activated to cover the loss.
Interestingly, in DeFi lending, anyone can be a lender as any wallet can deposit their crypto in the pools of the lending protocols to provide liquidity and receive interest in turn.
Over-collateralization
Over-collateralization is a common practice in DeFi. Unlike traditional loans where collateral can vary, DeFi borrowers must deposit cryptocurrency exceeding the loan value due to crypto price fluctuations. A smart contract holds the collateral until repayment.
Under-collateralization
Achieving under-collateralization in DeFi is a challenge, where collateral value is lower than the loan. Over-collateralization disregards creditworthiness, but lending to those lacking assets is tricky. DeFi enthusiasts seek accessible lending, exploring blockchain data and off-chain info for credit evaluation.
Flash loans
Flash loans offer a unique solution to under-collateralization but require expertise. Unlike traditional loans, they execute in seconds, and non-repayment erases the loan. They’re used for swaps and arbitrage, enabling quick profit-making. As alternatives for under-collateralized loans progress, flash loans may gain wider acceptance.
Despite the advantages of DeFi lending, its rapid development currently reveals many potential risks. There are 4 popular risks associated to DeFi lending.
- Liquidation Risk
Cryptocurrencies are known for their rapid value fluctuations. If the value of the collateral falls below a set threshold, smart contracts automatically liquidate it, leading to the borrower losing their investment. More terribly, in DeFi lending, direct interaction between borrowers and lenders means no intermediary reduces counterparty risk. If the borrower defaults, lenders might lose their investment with no recovery option.
- Smart Contract Risk
Once deployed, smart contracts are unchangeable. If a bug exists, attackers can exploit it, potentially stealing funds. While audits help, they aren’t entirely foolproof in mitigating this risk.
- Flash Loan Attacks
During a flash loan attack, the attacker borrows a large amount of cryptocurrency through a flash loan to perform various manipulative transactions or exploit vulnerabilities in smart contracts to engage in other harmful activities. Because the loan must be repaid within the same transaction, the attacker’s actions must result in a profit greater than the borrowed amount and fees. If successful, flash loan attacks can lead to significant financial losses for DeFi protocols and users. The incident of bZx is a notable example of flash loan attacks.
- Impermanent Loss
This occurs in crypto liquidity pools due to price fluctuations of locked assets, particularly when the token ratio is uneven. Liquidity providers (LPs) can mitigate this risk by providing stablecoins in liquidity pools, minimizing potential losses. Platforms like Uniswap compensate LPs with trading fees to offset impermanent loss, protecting their investments.
Individuals
- Monitor Investments: Regularly check your collateral’s value and the platform’s performance. If you see warning signs like a sudden drop in collateral value or increased defaulted loans, think about withdrawing your investment.
- Understand Smart Contracts: Familiarize yourself with the platform’s smart contract. Seek professional assistance if you’re unsure about how it works.
- Consider Insurance: Some DeFi platforms provide insurance against hacks or security breaches. Opt for platforms with this feature to enhance your investment protection.
DeFi Protocols
- Security Audits: Regularly conduct security audits on smart contracts. Independent third-party audits can help identify vulnerabilities before they are exploited.
- Formal Verification: Use formal verification methods to mathematically prove the correctness of smart contracts. This rigorous process helps ensure the code behaves as intended under all conditions.
- Insurance Funds: Establish insurance funds to compensate users in case of losses due to unforeseen events. These funds act as a safety net for users in case of hacks or vulnerabilities.
- Flash Loan Guards: Implement specific measures to counter flash loan attacks, such as requiring users to repay flash loans before accessing certain functionalities, imposing transaction delays, or limiting the maximum transaction size.
As a comprehensive Web3 data analytics, Centic integrates both on-chain and off-chain data to provide insightful information and a smart Web3 scoring system. Users can not only monitor their assets and trading positions but also manage their Web3 credit score and the scores of other wallets. On that basis, Centic can effectively assist both individuals and lending protocols to manage the risks in DeFi lending.
Users can monitor their own positions and safety status and financial performance so that they can be aware of their risk of liquidation to have prompt prevention.
Moreover, they can also track the performance and activities of DeFi lending protocols on many different blockchains. On that basis, they’re able to get prompt and valuable insights into the market to make informed decisions.
FICO Crypto Credit Score
For individuals, users can be aware of their credit risk to have careful trading strategies and know how to improve their credit trustworthiness to have a higher opportunity to access under-collateralized loans.
For lending protocols, they can identify the wallets that have a high risk of liquidation to be aware of and the potential wallets to provide better capital efficiency.
Project Reputation
This is the Reputation Indicator for Web3 Projects developed by Centic. With this scoring model, users can evaluate the trustworthiness of the Web3 projects, particularly, lending protocols to participate.
Reputation will soon be available in Centic Scores Marketplace. Interestingly, we also allow users to customize the scoring model to get specific insights for your demand.
In the DeFi lending landscape, risks like liquidation threats and smart contract vulnerabilities are the most serious dangers to the sustainability of DeFi lending. To mitigate the above-mentioned risks, we have suggested several measures, especially, individuals should monitor assets and understand smart contracts, while DeFi protocols must conduct regular security audits and implement protective measures.
Centic aims at building a product ecosystem that assesses the trustworthiness of Web3 entities using data analysis. This empowers users to engage in DeFi with confidence, minimizing potential risks.
Centic is a data analytic platform that provides the scores of all entities on Web3 Space by integrating on-chain data in blockchain space and off-chain data in reality.
By providing a comprehensive evaluation system, we assist users in confidently making the right decision both in the traditional and digital world.
