At Donut, we believe any good investment starts with trust. By talking openly and honestly about DeFi, we're building a community where all investors understand this emerging asset class, its opportunities and its potential risks.
DeFi is a complex space with many moving pieces, but here we'll zoom in on the three major types of risk to consider when investing in DeFi and crypto-based financial products. Further, you'll learn how the Donut team works to keep you and your money safe and secure every day.
There's plenty to read below, but it's all in actual English - no finance degree necessary! We hope this primer will help all investors in our community make informed, confident decisions as they grow their wealth with DeFi.
What are the risks of DeFi investing? 📈
All investment opportunities entail some degree of risk. Even the most common investments run the risk of fluctuations, losses and even market failure. In the 2008 Financial Crisis, the S&P 500 lost about 10 years worth of gains in only a few weeks and even the most conservative investors faced major losses.
Smart investing relies on disciplined habits. Consistency over luck. Diversification, not overexposure. And, of course, understanding risks and your personal tolerance for them. DeFi is an emerging technology and as such, its risks differ from those in traditional markets.
On Donut, we convert your USD to stablecoins called DAI, which our lending partners loan to hedge funds and other institutions in decentralized money markets. Thanks to DeFi's unique architecture, you earn higher interest in real time and can add or withdraw funds anytime.
There are three categories of risk to consider when using Donut to earn with DeFi:
- Technology Risk: decentralized finance (DeFi) is actually a catch-all term for financial products and systems that utilize smart contracts to validate transactions. Donut, and countless other DeFi businesses, rely on Ethereum's infrastructure to deliver value to customers. Therefore, if a smart contract (such as one governing a lending-borrowing agreement) were to fail or break due to a bug, then Donut and all businesses relying on it would fail as well.
This type of failure, however, is very unlikely. Ethereum is a hub of innovation in the space, supporting trillions of dollars in transactions each year. Nevertheless, it's important to note that a failure in DeFi's underlying technology would affect any financial services in the space.
- Partner Platform Risk: within DeFi, various lending protocols exist to help borrowers access funds and enable lenders to earn higher interest rates. At Donut, we work only with the most vetted and qualified partners in the space—specifically Compound—to give you access to the best earning opportunities.
Compound is one of the most established protocols in the sector with over $4 billion in funds safely earning interest. But, as with any software, it runs the risk of bugs or hacks creating failure. Depending on the bug, Donut users could have issues accessing their invested funds for a period or, in a worst case, lose their principal.
Fortunately, Compound's security measures are extensive - you can read more about them here. With countless 3rd party audits and simulated stress tests, Compound has earned an Economic Safety Grade of 95% from DeFi Pulse.
- Lending Risk: in every securities lending market—where someone borrows an asset, offers up collateral and pays interest on the loan—there is a risk that a borrower defaults. 2008 offered an extreme example of this risk, where mass defaults on mortgage-backed securities led to an unprecedented financial crisis.
With Donut, your funds are lent to hedge funds and prime brokers in decentralized money markets to earn interest. One risk inherent in DeFi lending products is the possibility of default. What happens to your funds on Donut when a borrower can't repay the loan?
Our lending partners mitigate this risk in the form of collateral, which provides coverage for your invested funds. Protocols such as Compound require high collateral—upwards of 150%—from borrowers to take out loans. In the case of a default, Compound can liquidate this collateral so lenders may withdraw funds.
High collateralization means that even in the case of a "bank run" (where many users withdraw funds at once), Compound is able to correct supply and demand, providing funds for lenders to withdraw.
In the last calendar year, the DeFi market has grown over 20x as institutions and everyday investors take advantage of earning opportunities. While the risks above exist throughout the sector, new innovations continue to support more robust, scalable and secure financial products.
How are insurance & coverage different?🛡
No matter how conservative your investments, the only place where you can expect near-zero risk is in a FDIC-insured bank account - it's also the place where your money is most likely to collect dust or worse, lose value due to inflation.
So what is financial insurance? After the Great Depression when a nationwide run on banks prevented many from withdrawing their savings, the Federal Deposit Insurance Corporation established protection for individual deposits up to a certain amount ($250,000 as of 2021). This insurance means that no matter what—your bank is hacked, it goes out of business, it can't collect its loans—you are entitled to the money in your account.
Once you're invested in other asset classes, such as ETFs or stocks, this insurance does not apply. In the market, there's the possibility that fluctuations in the market could leave you with less money than your initial investment.
Coverage, on the other hand, is a means of lowering risk on loans. Donut's lending partners require high collateral (100-200%) from borrowers. This means when you have $5,000 earning with Donut, our lending partners hold collateral (often in the form of ETH) worth $5,000-10,000. For the borrower, this enables them to leverage their existing asset (ETH) to make new investments with DAI and other stablecoins.
In the case of a default, the partner can liquidate the collateral to ensure you still have access to your funds. Coverage through high collateralization is a way to reduce lending risk (see above).
Coverage, however, is not insurance. In the case of platform or technology failures within DeFi, there is a possibility you'll lose access to funds or even lose your investment.
It is important that you keep this distinction in mind when investing with Donut, or any other financial product; only invest amounts you could, in an unlikely scenario, tolerate losing. Donut is a simple way to invest in DeFi and diversify your portfolio—it is not an alternative to an FDIC-insured bank account.
How secure is Donut? 🔐
Understanding the risks is only a part of safe investing—Donut's team is hard at work on our end to make sure all information and transactions are as secure as possible.
At the account level, we encrypt all user data using the AES-256 standard and protect accounts at the highest level with a personal PIN number and two-factor authentication (2FA). This ensures that access to your account is as secure as other finance and payment apps such as Venmo or Robinhood. For additional user safety, we stick to stringent KYC standards to avoid fraudulent users and regularly audit activity on the app to flag suspicious behavior.
On the bank account side, we manage all bank connections securely with Plaid, the industry leader in bank integrations. Whenever you add a bank account or card to Donut, Plaid facilitates the connection through its secure servers. This is the same banking integration used by hundreds of financial services including Venmo and American Express.
We're also committed to working with industry-leading partners. For USD deposits and withdrawals, we've partnered with Evolve Bank and Trust, an FDIC insured and accredited bank providing banking solutions to fintechs across the country. A partnership with Wyre, a best-in-class crypto payments platform, enables us to easily convert your funds to stablecoin so they can start earning interest in real time. Dozens of leading cryptocurrency businesses, including Maker and Argent, trust Wyre's architecture to support their services.
Finally, our lending partners—including Compound as well as prime lenders and other institutions—adhere to robust security and coverage practices to ensure your money's safety while it earns the best possible rates. If you'd like to learn more about Donut's lending partners, check out Compound here.
So what happens next?
There's a lot to consider when making your first investment in DeFi, and we hope this guide has helped clarify some of the risks. We encourage all members of our community to be mindful when investing and understand the potential risks, no matter how unlikely they may be.
Donut, whether you earn with Fixed or Variable interest, can be part of a diversified investing strategy that also includes stocks, ETFs, bonds and other digital assets. How you choose and allocate your investments is up to you.
Lastly, remember that funds on Donut, as with all digital currencies, are not legal tender or FDIC insured. The FDIC specifically insures USD deposits and does not apply to stablecoins (such as DAI) and other cryptocurrencies.
And this is alright by us - Donut is not here to replace your bank account, but to help you discover new ways to save smarter, work your money harder and grow your wealth.
Real Talk 🚨
Any saving and investment strategy puts your capital at risk.
The above information is intended for informational purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.