The Dangers Of DEFI Loans

Dangers of DEFI loans

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We’re currently watching a massive deleveraging in the bitcoin and the larger cryptocurrency market due to the rehypothecation of funds which has seen many funds and CEFI services limit redemptions because they cannot meet their obligations. In contrast, overs have declared bankruptcy and left their customers high and dry.

The risk of leaving your bitcoin with a custodial service is pretty apparent, but the call to have these financial products pushed to the blockchain as a “safer” alternative is completely misguided, in my opinion.

The DEFI loan ecosystem does not solve the issues that CEFI loan providers have and, in fact, introduces a host of other risks that you might not be aware of and may want to steer clear from in the future, especially loan products not built directly using bitcoin.

On-chain positions can be a target

Taking out a loan on a permissionless smart contract may feel safer than handing over your coins to a centralised service provider, but that doesn’t mean you completely eliminate the risk altogether. Smart contracts can have bugs that can be exploited and leave your capital exposed.

In addition, with these protocols, you have little to no recourse, so if that smart contract is breached and the service isn’t paused in time, the capital could be drained to a point where the protocol provider cannot make you whole or prepay you a portion, and since these services don’t have insurance or collateral that can cover hacks, you’re often left without any option but to eat the loss.

Liquidation bots are on the rise

Another issue with on-chain loans is that people can tie these wallet addresses to different users. A smart trader could look for specific loans and check the wallet tied to it and the capital left in the wallet. If a trader thinks they can push the price down of an asset to get you to liquidate since they can see the capital in your wallet.

It could be worthwhile selling at a loss driving the price down to liquidate a bunch of users and scoop up a large portion of forced selling only to re-sell later or cover short position obligations.

The beauty of having everything in one place and digital means these liquidations can be run on a grand scale using bots, setting specific parameters that can be done at scale and in tandem to maximise profits. These liquidation services are actively encouraged by protocols to purge systems of bad debt and keep liquidity flowing, so depending on how wide the parameters are set for forced liquidations, you could fall into it, despite having the capital to cover the loan.

You can get caught in whale games

While you may have done the proper due diligence and picked a “reliable” smart contract platform with reasonable liquidity and a good track record, that doesn’t mean you’re in the clear. You see, you’re a small fish in a big pond, and when big money goes fishing, there will be collateral damage.

The “reliable” protocols tend to have the larger liquidity pools, the bigger loans and use the “better quality” assets.

That means there is a larger pool to profit from if things don’t go according to plan, and some traders are banking on it. They scour the blockchain for smart contract loans, and since all this information is public knowledge and can be picked up by bots, these positions can be under threat.

If I am a trader who can fund loans close to liquidation points, and I can drive the price down to liquidate these loans, buy up the collateral on the cheap and then re-sell or cover my short position, I could net a pretty profit.

In the process, those margin calls could trigger smaller traders like you, who had nothing to do with these big players but happened to have your loan also get called due to these changes in collateral requirements due to lower prices.

Why isn’t loan targeting liquidations so prevalent in bitcoin?

In bitcoin, when a loan contract is created on-chain, it’s done using a multi-sig address, which could be used for distributed ownership of a wallet or a host of other services, like a treasury. It is not easy to figure out that a certain set of funds is locked with the purpose of a loan.

Since bitcoin doesn’t have these open public smart contracts that can be scraped, traders don’t have the ability to scrape the chain and then make the economic calculations to see how profitable it could be to attack a certain protocols loan book.

Additionally, it takes a large amount of capital to push bitcoin down or cause a flash crash for your margin calls to trigger, unlike that of more illiquid coins. One fringe case where bitcoin could be an issue with a DEFI loan is if you’re using wrapped bitcoin, which would require more bitcoin to be custodied as backing and then minted onto the chain via a bridge which adds risk.

DEFI loans don’t price in the risk

DEFI loans might sound attractive due to their permissionless nature and perhaps the attractive repayment terms. Still, like any loan, you should not consider the fact you can make the weekly or monthly payments as a reason to take out a loan.

It would help if you thought about all the worst-case scenarios you could be exposed to, make sure you have buffers in place and ensure that, if needed, you can close out the loan at any time.

Whenever you take out capital over and above what you can service, you leave yourself exposed to a risk that might not only keep you up and night and cause you to stress but leave you a lot poorer once the liquidation comes rolling around.

When it comes to liquidations backed by bitcoin, that is an opportunity cost loss many will never financially recover from as you lose your position in bitcoin, while others are stacking.

Has your loan gone wrong?

Despite these issues, people are still going to ignore them or discount them as a non-issue, especially during bull markets and take positions that cannot be serviced during times of stress. Each cycle, we hear someone get caught blindsided by volatility, and it can be a tragic story.

Have you taken out a bitcoin-backed loan or DEFI loan? How has it worked out for you? Let us know in the comments down below.

Disclaimer: This article should not be taken as, and is not intended to provide any investment advice. It is for educational and entertainment purposes only. As of the time posting, the writers may or may not have holdings in some of the coins or tokens they cover. Please conduct your own thorough research before investing in any cryptocurrency, as all investments contain risk. All opinions expressed in these articles are my own and are in no way a reflection of the opinions of The Bitcoin Manual

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