'People have been participating without understanding the risks': Here's what to know about cryptocurrency-based DeFi
Though they potentially have more access to resources, even billionaire investors aren't immune to risk when it comes to decentralized finance, or DeFi.
That includes Mark Cuban, who revealed on Wednesday evening that he was trading a DeFi token from Iron Finance called titan that ended up crashing to zero in one day.
"I got hit like everyone else," Cuban, owner of the Dallas Mavericks and an investor on ABC's "Shark Tank," tweeted on Wednesday.
At first, some in the crypto world speculated that this was the result of a rug pull, which is a type of scam where developers abandon a project and leave with investors' funds. Iron Finance denied those claims. The project said in a blog post that the crash was due to a "bank run," or panic selling, and the token's algorithmic code.
Regardless, Cuban's experience is a good reminder of how volatile and risky investing in crypto, and DeFi especially, can be. His takeaway: "Do your own research," he told CNBC Make It.
Fraud within the space has recently surged; between January and April, $156 million was stolen in DeFi-related hacks, according to CipherTrace. DeFi fraudsters stole an additional $83.4 million.
And although it's rare for coins to completely tank, like with titan, it's still possible, and investors should be aware. "I think it's really important for people participating in the DeFi space to understand the risks and rewards," Meltem Demirors, CoinShares chief strategy officer, told CNBC Make It. "People have been participating in DeFi without understanding the risks."
Even though DeFi has been buzzy lately and you may have FOMO about investing, it's important to research and understand the risks first. Here's what you should know, according to experts.
What is DeFi?
DeFi applications aim to recreate traditional financial systems, such as banks and exchanges, with cryptocurrency. Most run on the Ethereum blockchain.
The difference is that DeFi apps operate "without a central service exercising control over the entire system," said John Wu, president of Ava Labs, a team supporting development of DeFi applications on the Avalanche blockchain.
Through DeFi lending, users can lend out cryptocurrency, like a traditional bank does with fiat currency, and earn interest as a lender. Borrowing and lending are among the most common use cases for DeFi applications, but there are many more increasingly complex options too, such as becoming a liquidity provider to a decentralized exchange.
Interest rates are typically more attractive than with traditional banks, and the barrier to entry to borrow is low compared with that of a traditional system. In most cases, the only requirement to take out a DeFi loan is the ability to provide collateral with other crypto assets. Users can sometimes offer their NFTs, or nonfungible tokens, as collateral, for example, depending on the DeFi protocol used.
However, these factors also contribute to why DeFi is much riskier than a traditional bank.
How risky of an investment is it?
It is important to understand that investing in DeFi is highly risky.
"I think every DeFi protocol and every DeFi project has a different level of risk and a different level of reward," said Demirors. But, "it's important to understand the reason the reward is high is because the risk is higher. The reason we see high yield is there is risk here."
There are three major types of risk to consider, Demirors said.
1. Technology risk
Smart contracts, or collections of code that carry out a set of instructions on the blockchain, are essential for DeFi applications to run. But if there is an issue with a developer's code, then there could potentially be weaknesses within a DeFi protocol.
"At the end of the day, the software is only as good as the coding that was done, and sometimes, there are unknown errors in the code that governs these protocols," Demirors said.
2. Asset risk
When borrowing on a DeFi application, you typically offer other crypto assets owned as collateral. For example, DeFi protocol Maker requires borrowers to collateralize their loan 150% of the loan value at minimum.
Since cryptocurrencies are volatile, their value frequently fluctuates. If there is a downturn, the crypto assets used as collateral may sharply decline in value, and some may see their positions liquidated. That's why some use stablecoins, which are supposed to be pegged to fiat and be less volatile.
3. Product risk
"Typically, less mature pools or newer protocols will have higher yields because they're untested," said Demirors. "There's a significant amount of risk related to how the yield you're earning is being generated."
It's also important to note that, unlike with a traditional bank, there is no regulation or insurance on your money when you use DeFi. Though DeFi loans are collateralized with other crypto assets, borrowers using DeFi protocols cannot be held accountable otherwise if they are unable to effectively pay back a loan.
These risk factors are in part why experts warn to invest only what you can afford to lose and recommend conducting thorough research before buying in.
What should beginners know?
If you decide to invest in any DeFi application, the first thing you should do is vet the applications you're exploring to make sure they're secure and well-audited, Wu said.
When you're choosing an underlying network, such as a blockchain, protocol or exchange, Wu recommends looking for one that isn't controlled by a small group of players, can handle heavy user demand and has affordable transaction fees.
A few "big red flags" include "applications that don't share their code or ignore concerns in their forums and social feeds about security," Wu warned. "Some of the best projects are led by anonymous or pseudo-anonymous founders who protect their privacy, so I don't write a project off for that, but I do expect transparency on the application."
And if something feels off, it likely is.
"DeFi is growing so fast and the yields are so high that opportunities can feel too good to be true. When in doubt, trust your gut or look for more objective members of the community with the technical expertise to thoroughly review the code," Wu said.
What's next for the space?
Looking ahead, Demirors predicts that DeFi applications will continue to replicate financial structures that "we already know and love in the traditional finance world," such as high-yield savings accounts.
Demirors also predicts that there will be new decentralized financial products and services built unlike any of the traditional ones that already exist, including new ways for creators to be paid for online content.
"We really, truly are in the era of the financialization of everything," she said.
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Disclosure: CNBC owns the exclusive off-network cable rights to "Shark Tank."