DeFi risk levels

DeFi risk levels

[DeFi basics] [Lending] [Staking] [Liquidity Pooling] [DeFi risk levels]

In DeFi, there are many ways to earn a yield on your crypto.

Here's a quick list of the categories of activities you can participate in today, in order of increasing risk (and return):

  • Lending (low-to-medium risk)
  • Staking (low-to-high risk)
  • Liquidity pooling (low-to-high risk)
  • Spot Trading (medium risk)
  • Leveraged trading (very high risk)

I'll discuss each of these categories below.

Lending

When lending crypto, you are subject to:

  1. Counterparty risk
  2. Price risk

Counterparty risk is present in all aspects of DeFi. It refers to the risk of the platform not behaving as it's supposed to. For example, software bugs, hacks or fraud can cause you to lose your funds.

Next: Price risk simply refers to the potential for the crypto price to go down. For example, you might be getting 4% interest for lending ETH, but if the price of ETH falls by more than 4% you end up losing money.

Lending stablecoins is thus the safest way to get a yield in DeFi, since their price is pegged to $1.

Bottom line:

  • Lending stablecoins is low risk (because there is practically no price risk)
  • Lending non-stablecoin cryptos is low-to-medium risk (because there is price risk)

Staking

The risk of staking crypto is simliar to that of lending. There are two main risks:

  1. Counterparty risk
  2. Price risk

(I've covered these two forms of risks above, so I won't repeat them here.)

Staking yields vary widely, as there are many different types of coins/tokens you can stake, each with a unique risk-reward profile. Therefore, depending on the cryptocurrency you're looking at, the risk of staking ranges from low to high.

To be a competent DeFi user, you'll have to develop a keen understanding of which coins/tokens are worth staking, and which aren't. 

Liquidity pooling

In general, liquidity pooling is of medium-to-high risk.

This is due to a third type of risk you take on:

  1. Price risk
  2. Counterparty risk
  3. Impermanent loss risk

The risk of impermanent loss is present in all liquidity pools, with the exception of dual-stablecoin pools... so make sure you understand what impermanent loss is before providing liquidity with your crypto.

Bottom line:

  • Liquidity pooling with two or more stablecoins is low risk.
  • Liquidity pooling with uncorrelated tokens is medium risk.
  • Liquidity pooling with correlated tokens is high risk.

Spot trading

Spot trading refers to the active buying and selling of cryptocurrencies for profit.

It's at least a medium risk activity simply because historically, most traders in financial markets end up losing money.

My personal opinion is that you should only try crypto trading if you have prior experience in other financial markets.

Leveraged trading

Leverage allows traders to multiply their returns, while at the same time multiplying their losses.

And since most people lose money trading, with leverage they typically end up losing large sums of money.

This is why I strongly advise against using leverage in crypto. Leveraged trading is an endeavor that entails very high risk.

Yield farming

One of the most interesting things about DeFi is that you can "layer" services and applications on top of each other.

For example, let's say you're purchased some ETH because you believe its price will go up over the next 3 years.

Instead of just holding and waiting however, you can choose to stake your ETH and earn a yield on it in the meantime.

But that's not all.

With the multitude of DeFi applications available out there, here's what you can do:

  1. Stake your ETH (for 5% yield) and receive a staking token, 
  2. Use that staking token as collateral for a USDC loan (at 1.6% borrow rate),
  3. Use half of that USDC to buy some WBTC,
  4. And provide liquidity for a WBTC-USDC pool (for 10% yield).

This way, your effective yield will be significantly higher than the 5% you'd get if you just staked your ETH. This "layering" process is called yield farming.

Very broadly, yield farming refers to the maximizing of yields on your crypto assets.

It's an umbrella term that includes all combinations of DeFi services and applications. The idea is to get the highest yield for the level of risk you're willing to take.

It can be as simple and safe as lending out stablecoins, or as complicated and risky as taking a loan to provide liquidity on a DEX, then putting up the liquidity pool token as collateral for borrowing another token that you use to stake on a different DEX.

There are many ways to earn a yield in DeFi. The challenge is to do it in a way that suits your personal appetite for risk and reward.

Follow me on my DeFi adventures

There's a lot going on in the DeFi space, as new projects are being released all the time.

To see what I've been doing in DeFi, check out the videos in (and subscribe to) my YouTube channel.

crypto passive income