To help you understand this concept, think of the DeFi stack as a multi-layer structure, with each layer representing a different level of risk. By learning about these risks, you’ll be better prepared to navigate the DeFi landscape safely and make informed choices about your investments.
Blockchain-Level Risks #
At the base of the DeFi stack is the blockchain framework – the foundation everything else is built on. While blockchains provide a secure and decentralized platform for DeFi apps, they still have risks.
One of the biggest threats at this level is a 51% attack, where one entity controls most of the network’s mining power or staked tokens. This allows them to manipulate transactions and double-spend funds, damaging the integrity of the entire blockchain.
In 2020, the Ethereum Classic blockchain was victim to several 51% attacks, resulting in millions of dollars worth of double-spent transactions. This shows how severe this risk is and why a blockchain’s security measures matter.
Another risk to know about is a long-range or “deep reorg” attack. Here, bad actors try to rewrite a large part of the blockchain’s history by secretly mining an alternative chain and then broadcasting it to the network.
It’s like a group of miners secretly building a different path that eventually takes over the main path, forcing the network to accept their blockchain version as the real one.
The longer the alternative chain, the harder it is for the network to detect and stop the attack. This kind of attack can have far-reaching consequences for DeFi protocols on the affected blockchain, as it can invalidate transactions and disrupt the whole ecosystem.
In addition to security risks, blockchain congestion and high gas fees can also impact the user experience and functionality of DeFi apps.
During periods of high network activity, transaction fees can skyrocket, making it prohibitively expensive for users to interact with DeFi protocols. For example, you may try to take out a loan, but find that the transaction fee costs more than the interest you’d pay on the loan itself.
This is a real concern for DeFi users, especially during times of market volatility when network activity tends to spike.
Blockchain scaling solutions, like layer-2 networks and sidechains, aim to address these issues, but they come with their own set of risks and challenges.
Bridges and cross-chain solutions, which let assets move between different blockchains, add more risks around validation, liquidity, and centralized control. If a bridge fails or is compromised, users’ funds can be lost or stolen.
It’s like crossing a river on a shaky suspension bridge – you trust it will hold your weight and get you safely across, but there’s always a risk it might collapse.
In 2022, the Wormhole bridge was exploited for over $320 million due to a vulnerability in its smart contract code. This shows the potential impact of bridge failures and the importance of thorough security reviews for cross-chain solutions.
It’s worth noting that the specific risks tied to a DeFi app can vary based on the underlying blockchain. EVM chains, app-chains, and modular blockchains each have their own unique security considerations and trade-offs to think about.
Application and Protocol-Level Risks #
Moving up the DeFi stack, we get to the application and protocol layer, where most of the action happens. This is where you’ll find the various lending, trading, and yield farming protocols that make up the DeFi ecosystem.
While these protocols provide exciting opportunities to earn returns, they also come with their own risks.
When evaluating a DeFi protocol’s risks, there are several key factors to consider: complexity, total value locked (TVL), audit quality, team experience, and collateral type.
The more complex a protocol is, the more potential weak spots there are for attackers to take advantage of. It’s like a fortress with many gates and tunnels – the more entry points, the harder it is to defend.
In 2020, the bZx protocol suffered several attacks due to vulnerabilities in its flash loan and margin trading systems, resulting in a $8+ million loss. This shows the importance of thoroughly auditing complex DeFi protocols and the potential risks of novel financial mechanisms.
Another critical factor is the total value locked (TVL) in a protocol. The higher the TVL, the more enticing the protocol is for potential attackers. It’s like a bank vault – the more money inside, the more tempting for thieves to try and break in.
In 2021, the Poly Network was exploited for over $600 million across cryptocurrencies. The attack exploited a vulnerability in the cross-chain messaging system, allowing the attacker to forge transactions and drain funds.
This shows the risks of high-value DeFi protocols and the paramount need for robust security safeguards to shield user funds.
Audit quality and team experience are also key factors when assessing a protocol’s risks.
Audits are like security checkpoints – they help catch potential bugs and weaknesses in smart contracts. However, not all audits are equal, and even audited protocols can still be hacked.
It’s important to seek protocols that have undergone multiple audits by reputable firms and addressed identified issues. Similarly, the team’s experience and reputation provide insights into the protocol’s reliability and security.
A proven team committed to best practices is more likely to build a robust, secure protocol.
Integration risks are another major concern at this level. Many DeFi protocols rely on links with other protocols and contracts to work properly. If one dependency is compromised or fails, it can trigger a cascading failure impacting the whole ecosystem.
It’s like a house of cards – if one card falls, the whole structure can collapse. In 2021, Compound had a major bug due to an issue with its integration of the Open Zeppelin library, used by many DeFi projects.
The bug let users claim more COMP tokens than entitled, causing significant losses. This shows the potential risks of integrations and the need to thoroughly test and audit all dependencies.
Front-end risks like web security holes, DNS hijacking, and malicious UIs can also threaten DeFi users. Attackers may exploit these weaknesses to steal funds or data.
It’s like a thief in disguise – they’ll take advantage of any vulnerability to access your valuables.
In 2020, Balancer suffered a front-end attack where hackers manipulated the approval process to drain $500,000+ in tokens from wallets.
This incident highlights the critical need for secure front-end development and user vigilance when interacting with DeFi interfaces.
One must acknowledge that derivative risks may differ from spot markets. Derivatives often involve more leverage and complexity, amplifying potential losses.
In 2021, the derivatives platform Mango Markets had a major exploit resulting in a $100+ million loss. The attacker manipulated the token’s price by taking out large leveraged positions and inflating its value. This allowed them to borrow and withdraw significant funds, leaving the protocol with a massive deficit.
This highlights the distinct hazards associated with DeFi derivatives and the importance of robust risk management and liquidation mechanisms.
Wallet and User-Level Risks #
At the top of the stack is the wallet and user level. This is where individual users interact with DeFi apps, typically via a web3 wallet or hardware wallet.
While these tools provide greater control, they also have risks.
One major risk is self-custody errors. Holding your own private keys means you alone are responsible for fund security. Losing keys or seed phrases can lead to permanent asset loss.
It’s like losing the key to a safe deposit box – without it, you can’t access your valuables. To reduce this risk, it’s crucial to follow best practices like using hardware wallets and securely storing seed phrases.
Multiple seed phrase backups in different locations are also a good idea in case one is lost or destroyed.
Phishing and social engineering are other big threats. Attackers may try to trick you into revealing keys or approving malicious transactions by posing as legitimate DeFi entities.
It’s like a scammer pretending to be your bank – they’ll say anything to gain trust and steal money.
In 2021, a hacker’s phishing attack stole $8+ million in tokens from BadgerDAO users. This shows the danger of phishing and the need to double-check legitimacy before connecting wallets or providing sensitive info.
Unlimited token approvals and ERC-20 permit functions can also put funds at risk. When you let a protocol access tokens, you’re trusting them with your funds. If compromised or malicious, your assets could be stolen.
It’s like giving someone a blank check. To protect yourself, be cautious in granting approvals and regularly review and revoke unnecessary permissions.
Some wallets allow spending limits on approvals to limit potential damage if a protocol is compromised. Using separate wallets for each protocol also minimizes cross-contamination risks.
To reduce these risks, following secure DeFi wallet and asset management best practices is crucial. This includes using hardware wallets, enabling two-factor authentication, and carefully reviewing all transactions before signing.
Hardware wallets provide extra security by storing keys offline and requiring physical confirmation of transactions. Two-factor authentication like Google Authenticator helps prevent unauthorized wallet access even if your password is compromised.
When reviewing transactions, always double-check the recipient address, amount, and any additional requested data or permissions. Don’t hesitate to cancel and investigate if something seems suspicious.
