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Getting Started in DeFi - Part 2 - Understanding DeFi risks

Welcome to part 2 in this 8-part Getting started in DeFi series. In the last lesson we covered the very basics as well as shared some links where you can read, watch or listen to get more insights.

The full series is as follows:

  1. Introduction to DeFi: This lesson covers what DeFi is, why it's important, and how it's different from traditional finance.

  2. Understanding DeFi risks: This covers the risks associated with DeFi, such as smart contract security, liquidity, and volatility.

  3. Choosing a DeFi platform: This covers the different DeFi platforms available, and how to compare and choose the right one for your needs.

  4. Wallets, Buying and More: This lesson covers the basic steps for getting started with DeFi, including setting up a wallet, buying cryptocurrency, and interacting with DeFi protocols.

  5. DeFi projects and protocols: This lesson introduces some of the most popular DeFi projects and protocols, such as MakerDAO, Compound, and Uniswap, and explains how they work.

  6. Advanced DeFi concepts: This lesson covers more advanced DeFi concepts, such as yield farming, liquidity mining, and composability.

  7. DeFi best practices: This lesson covers best practices for using DeFi, including how to manage risk, protect your assets, and stay up to date with the latest developments in the DeFi space.

  8. Conclusion: This lesson summarises the key takeaways from the course and provides resources for further learning and exploration.

Understanding DeFi Risks

While DeFi has many potential benefits, it also carries certain risks that users should be aware of. Here are some of the key risks associated with DeFi:

Smart contract security: DeFi relies on smart contracts, which are self-executing contracts with the terms of the agreement between buyer and seller being directly written into lines of code. However, smart contracts can contain errors or vulnerabilities that can be exploited by hackers or malicious actors. This can lead to the loss of funds or other damage.

Liquidity risk: DeFi often involves the use of decentralized exchanges, or DEXs, which are used to buy and sell cryptocurrency. However, these exchanges can suffer from liquidity issues, meaning that there may not be enough buyers or sellers to match trades. This can lead to slippage, or the difference between the expected price of a trade and the actual price, and other problems.

Volatility: The value of cryptocurrency and other digital assets is highly volatile, meaning that it can fluctuate greatly in a short period of time. This can be a risk for DeFi users who are holding or using these assets, as their value may decrease significantly in a short period of time.

Regulation: The DeFi space is still largely unregulated, which can make it difficult for users to know what rules and protections apply to their activities. This can create uncertainty and expose users to legal and other risks.

Counterparty risk: DeFi often involves the use of decentralized finance protocols, or DApps, which are built and maintained by third parties. This can expose users to counterparty risk, meaning that they are dependent on the actions and decisions of these third parties. If a DApp fails or is shut down, users may lose their funds or be unable to access their assets.

The folks at The Defiant have this great video summarising some of the other risks in DeFi

In conclusion, DeFi carries certain risks, such as smart contract security, liquidity, volatility, regulation, and counterparty risk. Users should be aware of these risks and take steps to manage and mitigate them. This can include using reputable DeFi platforms and protocols, carefully selecting digital assets, and diversifying their holdings.

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