Is Risk Underpriced in DeFi?
Vitalik Buterin seems to think so: “A further argument against fear of smart contract exploits, of course, is the fact that in every crypto application except prediction markets (eg. Compound, the various yield farming schemes) people are surprisingly blasé about smart contract risks. If people are willing to put their money into all sorts of risky and untested schemes even for a promise of mere 5–8% annual gains, why would they suddenly become over-cautious here?” Vitalik is writing here of mispriced political prediction markets but his comment on DeFi more broadly is interesting.
But is it accurate? Clearly, many DeFi users are targeting returns far above 5–8% annually, hoping to skillfully shift their holdings among the various protocols to maximize yield. Perhaps their higher expected returns are what justifies them running the risk of smart contracts being hacked, resulting in a complete loss of their funds. Is Vitalik’s caution only applicable to those who use a “buy and hold” DeFi strategy? Or is he saying that, no matter what strategy they employ, most users of DeFi applications should not reasonably expect more than a 5–8% annual return and, thus, they are underpricing risk? The answer is unclear but what he is plainly saying is that your expected returns must be greater than 8% to offset the risks of using DeFi.