With decentralised finance (DeFi) gaining ground, we see the scope of cryptocurrencies moving beyond a transfer of value to more complex financial functions. One of these functions is DeFi lending.

Through Defi lending, we can lend our tokens to a liquidity pool. In exchange, we can earn handsome returns on these tokens that would otherwise be sitting dormant in a crypto wallet. While this is an amazing opportunity, it comes with risks similar to any financial instrument.

This article discusses some of these risks and how you can avoid them when providing your tokens to a DeFi lending protocol.

Impermanent Loss

Impermanent loss is one of the most common risks when it comes to DeFi lending. As cryptocurrencies are highly volatile, the value of your tokens can change after you've deposited them into a liquidity pool.

Liquidity pools use ratio protocols and rely on arbitrage traders to help balance the value of tokens within the pool with the market outside. While this works, it is not as perfect yet and can lead to unrealised losses as compared to if you had kept the tokens in your wallet.

For instance, say you provided 10 ETH and 1,000 USDC to a liquidity pool when 1 ETH was worth 100 USDC (or roughly $100). This means that the total value you provided to the pool is $2,000 at a 50:50 ratio between ETH and USDC.

Also, the overall pool contains 100 ETH and 10,000 USDC. This means your contribution represents 10 percent of the pool's total holdings.

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Now, let's say that, after a few days, the price of 1 ETH shoots up to 400 USDC. Arbitrage traders will exchange their USDC for ETH in the liquidity pool and sell it on other platforms to make a profit.

This results in the pool having more USDC than ETH. Let's say it now has 50 ETH and 20,000 USDC. Therefore, when you withdraw your 10 percent liquidity, you get 5 ETH and 2,000 USDC. So, the value of your tokens is $4,000. That might seem like a nice profit. However, if you just kept the ETH and USDC in your wallet, your 10 ETH alone would be worth $4,000.

How do you avoid impermanent losses?

You can avoid impermanent losses in three ways — first, you can lend to liquidity pools with stablecoins. This way, the fluctuations are minute, and the volatility will not have much of an effect.

Second, you can opt for platforms that share transaction fees with liquidity providers. This way, you can make up for the impermanent losses with the added income. Third and lastly, you can opt for impermanent loss insurance which is readily available on some trusted LP platforms.

DeFi rug pulls

There has been a rise in DeFi rug pulls over the last few years. Bad actors create a fake token and pair it with an established token (say USDC) on a liquidity pool they have set up. Then they promise high returns for liquidity providers, so users buy the fake token and enter the pool along with their USDC.

Once enough USDC is accumulated in the pool, the bad actors take off with all the coins, leaving investors holding the bag of worthless fake tokens. It's like someone pulled out the rug from beneath their feet. Hence the name 'rug pull.'

The easiest way to avoid rug pulls is to enter established liquidity pools with known crypto pairs. It is a certain red flag if a liquidity pool has some unknown token and offers lucrative returns. Only proceed once you have thoroughly researched the token and the lending platform.

Flash loan attacks

Flash loans are a unique feature of DeFi lending. They allow you to borrow millions of dollars’ worth of crypto with no collateral. The catch is that you need to repay the loan almost immediately. By immediately, we mean within the block time of the DeFi protocol's underlying blockchain.

Therefore, if you were borrowing on Compound, you would have around 13 seconds to repay the loan. This is because Compound is built on Ethereum, which has a block time of about 13 seconds.

Therefore, these loans are only feasible for those who can code what they plan to do with the borrowed funds and have bots carry out the transactions.

How is any of this bad?

Bad actors can take out massive loans, turning them into whales that can now easily influence a token's prices. They can pump the borrowed tokens into a vulnerable pool with low liquidity. The increase in one token causes the value of the paired token to dip significantly. Now, they can buy massive amounts of the paired token and sell it in the open market, resulting in huge gains.

They then return the borrowed amount and pocket the gains. Meanwhile, the price of the dumped token crashes due to the excess supply. Therefore, if you had tokens in one of these vulnerable pools, the value of your holdings drops considerably due to impermanent loss.

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Pools with less liquidity are easy targets for bad actors. Therefore, one way to protect yourself against flash loan attacks is by lending to trusted liquidity pools with volumes so large that even millions in transactions wouldn't drastically drive down prices.

Conclusion

DeFi is as complicated as it is new. Sometimes just bugs in the smart contract can cause losses in the millions that are essentially no one's fault. Fortunately, we have newer instruments such as impermanent loss and smart contract insurance that ensure you don't lose money due to any of these exploits or bugs. However, it is always important to research, understand what you're getting into, and invest only as much as you're okay with losing entirely.