There is a saying: Invest only what you are willing to lose
Yes, but where?
Whether it is decentralized (DeFi) or traditional finance (TradFi), we always talk about investments, and these must be carried out carefully and not made at random or driven by double-digit interests!
Obviously, these sectors have advantages and disadvantages, and based on our needs, or rather our propensity for risk, we choose both the tool and the platform that best suits our needs, but we must understand in detail what these advantages are and especially the disadvantages and risks of this sector.
Benefit and Risks
Decentralized finance (DeFi) and traditional finance (TradFi) represent two different approaches to financial services, each with its own benefits and risks. Here is a detailed comparison:
- Accessibility: DeFi allows anyone with an internet connection to access financial services without geographic restrictions. Instead, TradFi often excludes those without access to the traditional banking system.
- Intermediaries: DeFi eliminates the need for intermediaries such as banks, making transactions more efficient and cost-effective. TradFi relies on centralized intermediaries who charge commissions for their services.
- Transparency: In DeFi, transactions are immutably recorded on the blockchain, ensuring transparency. In TradFi, operations are less transparent and can be subject to manipulation.
- Regulation: DeFi is still largely unregulated, which brings risks for users and innovation. TradFi is highly regulated, offering greater protections but also barriers to entry.
- Hacking Risks: DeFi platforms can be vulnerable to hacking and bugs in smart contracts. In TradFi, centralized institutions are also targets of hacking but have more security resources.
- Volatility: Cryptocurrencies used in DeFi are known for their volatility, which can lead to significant losses. TradFi is generally considered more stable, although it is not immune to market fluctuations.
Famous cases of collapses
Certainly, from what we have seen, decentralized finance has the big problem of cyber attacks, which can drain millions of funds in a few moments, causing incredible damage and leaving nothing for all those who have invested in that platform.
But let's not forget that even in the traditional world, there have been cases of important failures, both of individual companies and of entire banking institutions, both in past years and, unfortunately, also in recent years, showing us that even traditional finance is not doing very well.
In 2021, DeFi cross-chain platform Poly Network was hacked with the equivalent of $600 million in stolen crypto, making it one of the largest hacks in cryptocurrency history. The hacker exploited a vulnerability in the system to transfer assets to Binance Smart Chain, Ethereum and Polygon.
Poly Network publicly addressed the hacker, demanding the return of the funds. Surprisingly, the hacker began returning part of the stolen funds, approximately $342 million, claiming that he did it "for fun" and was not interested in the money. However, a large chunk of the returned funds required two keys to unlock, one held by Poly Network and the other by the hacker himself.
In 2022, the Terra/Luna ecosystem suffered a catastrophic collapse, leading to the disappearance of approximately $60 billion in value. The collapse was triggered by a massive selling event that pushed the price of TerraUSD (UST), an algorithmic stablecoin, below its $1 parity 1. This caused a vicious cycle where the more USTs were redeemed, the more LUNA coins were minted, causing the price of both assets to plummet.
The failure of Terra/Luna had a domino effect throughout the cryptocurrency market, causing significant losses for investors and undermining confidence in the stability of algorithmic stablecoins. It has also raised questions about the sustainability and robustness of DeFi protocols, highlighting the risks associated with these experimental financial systems.
Both of these events, the Poly Network hack, and the Terra/Luna collapse, highlighted the vulnerabilities and risks inherent in the cryptocurrency and decentralized finance space, and they have demonstrated the need for greater safety, regulation, and investor protection mechanisms in this rapidly evolving industry.
The bankruptcy of Lehman Brothers in 2008 was a pivotal event that triggered the global financial crisis. Lehman Brothers was the fourth largest investment bank in the United States, with a history of more than 150 years. However, the bank was heavily exposed to the subprime mortgage market, making loans to high-risk borrowers.
With the bursting of the housing bubble and the Federal Reserve raising interest rates, many borrowers were unable to repay their loans. Lehman Brothers found itself with huge losses and a portfolio full of "toxic" securities linked to subprime mortgages. Despite efforts to find a buyer or a government bailout, Lehman Brothers filed for bankruptcy on September 15, 2008, with assets of $691 billion and 25,000 employees.
The bankruptcy of Lehman Brothers triggered a domino effect on global financial markets, causing a crisis of confidence and a credit crunch. Stock markets collapsed, interbank lending froze, and the global economy fell into recession. Lehman's bankruptcy remains the largest in US history and a symbol of the 2008 financial crisis.
More recently, in March 2023, Silicon Valley Bank (SVB) collapsed after a bank run sparked by concerns about its financial health. SVB was the 16th largest bank in the United States and a major financier of Silicon Valley tech startups.
SVB's problems began when it had to sell part of its portfolio of long-dated securities at a discount to cover customer withdrawals, posting a loss of $1.8 billion. This triggered panic among depositors, leading to mass withdrawals that the bank was unable to meet. On March 11, 2023, regulators shut down SVB, marking the second-largest bank failure in U.S. history.
SVB's failure raised fears of broader contagion in the banking sector, leading regulators to step in to insure all of the bank's deposits, even those above the insured limit of $250,000. This event highlighted the risks associated with banks with concentrated portfolios and the vulnerability of financial institutions to bank runs in the digital age.
Both the failures of Lehman Brothers and Silicon Valley Bank demonstrate the systemic risks present in the financial system and the importance of adequate regulation and oversight to prevent and mitigate financial crises. These events had far-reaching impacts on the global economy and required significant interventions by authorities to stabilize markets and restore confidence in the financial system.
Advantages and disadvantages of decentralized finance (DeFi) and traditional finance (TradFi)
|
Aspect |
DeFi |
TradFi |
|---|
|
Accessibility |
High, anyone with an Internet connection can access |
Limited, it often excludes those without access to the banking system |
|
Intermediaries |
Eliminated, more efficient, and economical transactions |
Present, they charge fees for services |
|
Transparency |
High, transactions recorded immutably on the blockchain |
Low, less transparent and potentially manipulatable operations |
|
Regulation |
Low, risks for users but also innovation |
High, greater protections but also barriers to entry |
|
Hacking Risks |
High, platforms vulnerable to hacking and bugs |
Present, but institutions have greater resources for security |
|
Volatility |
High, cryptocurrencies subject to significant fluctuations |
Low, generally considered more stable |
|
Protection |
Low, only if the platform or individual user has integrated crypto insurance platform |
High, defined procedures to compensate debtors, and a maximum protection ceiling on deposits of up to 250 thousand dollars |
Conclusions
As we have had the opportunity to see and delve into some of the cases and problems that have occurred in recent years, both on the decentralized finance side and on the traditional finance side, this allows us to have a better picture of where, what and how much to invest.
In fact, zero risk does not exist; there are only different levels of risk, and DeFi certainly has the greatest one, but this should not make us fall into error and think that putting money in the bank or investing it in some company or advanced financial instrument is less risky than trading with DeFi.
And it doesn't even make sense not to invest and keep the money under the mattress because, in any case, there is inflation to take into consideration, and using some financial instrument certainly attenuates inflation, but as always, you have to invest the right amount and in the right way. Prudently, delving into those instruments could be interesting and understanding their advantages and all the associated risks, as well as the operating costs, because if the instrument is valid, but we pay too much, in the end, we are financing the financial intermediary out of our own pocket, whether our operation will go well or badly.
