Decentralized Finance: DeFi Lending Offers Certain Benefits, But Also Poses Risks, Report Explains

Tanay Ved, Lucas Nuzzi & the Coin Metrics team have examined the various features and risks associated with DeFi lending in an extensive report.

The researchers at Coin Metrics noted that “over the years, the digital asset ecosystem has spawned diverse use-cases.”

Among them, decentralized finance (DeFi) has emerged “as a transformative force—enabling a host of financial innovation by building on conventional financial principles and harnessing the unique properties of blockchains.” The Coin Metrics report added that “although the sector still remains in its early innings, this intersection between finance and technology has materialized into an array of financial services, facilitating the issuance, lending, trading and management of crypto-assets, and even real-world assets.”

As stated in the update from Coin Metrics, the Ethereum Network has “served as a hotbed for these services.” Within the larger scheme of things, however, DeFi remains “a nascent sector, with the market capitalization of DeFi ERC-20 tokens accounting for around 6% ($14 billion) of the total ETH market capitalization (~$220 billion), and 17% at its peak in 2021.”

The report acknowledged that “despite this, it forms the largest sector amongst digital asset applications, representing greater than 50% of the asset class (datonomy universe).”

This can be “attributed to DeFi’s ability to provide open, permissionless, and programmable access to financial services, underpinned by the transparency and auditability of blockchains.”

According to the report from Coin Metrics, this sets DeFi apart “from its traditional counterpart, where the core innovation lies in smart contracts that facilitate a host of financial services, effectively eliminating the need for intermediaries or counterparties.”

As explained in the Coin Metrics report, DeFi protocols “are often referred to as ‘money-legos’ due to their composable nature.”

These apps can be “used in conjunction with one another, allowing users to stack financial strategies like building blocks.” For example, a user can “lend ETH on Aave to earn interest, borrow a stablecoin like Dai and then provide the stablecoin as liquidity on Uniswap to earn trading fees—unlocking greater capital efficiency and interoperability.”

However, with this increased innovation and “access to information, the surface area for risks has also expanded.”

The report also mentioned that “while greater transparency, composability and self-custody form the core foundation of DeFi, they also push complexity back towards its users and stakeholders.” Therefore, the very properties that “make DeFi unique, can be a double-edged sword.”

The report concluded:

“Hence, contextualizing the health of DeFi protocols through a holistic view of assets and liabilities becomes crucial for informing effective risk management. In our new special insights report, we zoom into DeFi lending markets to illuminate their unique features and risks, particularly through the lens of recent exploits on Aave and Curve Finance—using a balance sheet-like methodology.”

For more details, check here.

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