The DeFi ecosystem presents a complex array of risks, from built-in weaknesses in its decentralized structure to the ever-changing nature of threats as the space grows.
Inherent Risks in Decentralized Finance #
One of the defining features of DeFi is its decentralized nature, which removes the need for traditional middlemen like banks and brokerages. While this decentralization provides many benefits, like increased access and transparency, it also introduces unique risks that investors must know about.
Without a central authority watching over the DeFi space, the duty for doing due diligence and judging the safety of protocols falls completely on individual investors.
This lack of oversight exposes users to a higher risk of hacks, scams, and poorly designed projects.
For example, in August 2020, the DeFi protocol Yam Finance had a critical bug in its smart contract, resulting in a loss of over $750,000 in user funds.
This incident highlights the importance of thoroughly checking projects before investing, as even seemingly promising platforms can have hidden weaknesses.
Another built-in risk in DeFi comes from the permanence of smart contracts. Once deployed on the blockchain, these self-executing contracts cannot be easily changed or updated.
While this permanence is a key feature of DeFi, ensuring the trustless execution of agreements, it also means that any bugs or flaws in the code can lead to irreversible losses.
In the case of the DAO hack in 2016, a vulnerability in the smart contract allowed an attacker to drain about $50 million worth of Ether, showing the potential effects of permanent code gone wrong.
The high degree of composability in DeFi, which allows different protocols and applications to work together seamlessly, also increases systemic risk compared to the more separated nature of traditional finance.
A vulnerability in one protocol can quickly spread through the entire DeFi ecosystem, potentially starting a chain reaction of failures.
This was clear in the bZx flash loan attack of February 2020, where an exploit in the bZx protocol’s integration with other DeFi platforms led to the theft of nearly $1 million.
Lastly, the anonymous nature of many DeFi development teams and the current lack of clear legal frameworks for the space create extra risks for investors.
Without knowing the real identities of the people behind a project, it can be hard to hold them accountable in case of fraud or misconduct. Moreover, the lack of established legal ways to recover funds lost due to hacks or scams leaves users with limited options.
Evolution of DeFi Risks Over Time #
As the DeFi ecosystem has grown and matured, the nature of the risks associated with it has also changed. In the early days of DeFi, the most common threats were relatively simple, like basic smart contract hacks, rug pulls (where project creators suddenly abandon the project and take investors’ funds), and economic attacks like flash loan exploits.
However, as the DeFi stack has become more and more complex, with a growing number of connected protocols and applications, new attack surfaces and risk vectors have emerged. The rise of yield farming and liquidity mining, for example, has created new ways for bad actors to manipulate token prices and drain value from unaware users.
Moreover, the huge size of the DeFi market, with billions of dollars now locked in various protocols, has brought in more advanced exploits and institutional attackers looking to take advantage of any weaknesses they can find. In August 2021, the Poly Network, a cross-chain DeFi platform, was the victim of a major attack that resulted in the theft of over $600 million in various cryptocurrencies, showing the evolving nature of DeFi risks and the potential for large losses.
The development of cross-chain DeFi, which allows the flow of assets and data across different blockchain networks, has further widened the scope of risk considerations.
Investors must now deal with the security and reliability of multiple networks, as well as the bridges and interfaces that connect them.
The recent exploit of the Wormhole bridge in February 2022, which led to a loss of about $320 million, highlights the risks of cross-chain DeFi and the need for strong security measures.
Quantifying DeFi Risk Exposure #
Given the complexity and newness of the DeFi landscape, quantifying risk exposure can be a tough task. Traditional risk metrics, like Value at Risk (VaR) and liquidation levels, may not fully capture the unique risks of DeFi investments.
VaR, for example, estimates the potential loss an investment may have over a given time period based on historical market data.
However, this metric does not account for the risk of smart contract hacks or the impact of flash loan attacks, which are specific to the DeFi ecosystem.
Similarly, liquidation levels, which refer to the price at which a collateralized position is automatically closed out to prevent further losses, do not factor in the risk of sudden market manipulation or the failure of price oracles.
Modeling DeFi risks is especially difficult due to the lack of extensive historical data, the rapid pace of innovation, and the intricate web of dependencies between protocols. Investors must consider a wide range of risk factors, including smart contract risk (the possibility of bugs or exploits in the underlying code), economic risk (the impact of market volatility and liquidity on token prices), oracle risk (the reliability of external data feeds used by DeFi protocols), and governance risk (the potential for harmful or misguided changes to a protocol’s rules).
To illustrate the challenge of quantifying DeFi risk, consider the case of the Compound protocol’s governance token (COMP) manipulation in September 2021.
Due to an error in the protocol’s distribution mechanism, a bad actor was able to mint over $80 million worth of COMP tokens, causing major disruption to the platform’s economics.
Such incidents are hard to predict and account for in traditional risk models.
Despite these challenges, a growing number of tools and frameworks are being developed to help investors estimate risk levels and potential loss scenarios in their DeFi positions. On-chain risk monitoring platforms, like DeFi Pulse and DeFi Score, provide real-time data on the health and security of various protocols, allowing users to track key metrics and identify potential red flags.
Additionally, stress testing tools like Gauntlet and Dedge enable investors to simulate various market conditions and assess the resilience of their DeFi portfolios. By modeling different scenarios, like extreme price fluctuations or liquidity drains, these tools can help users better understand their risk exposure and make informed decisions about their investments.
According to a report by Gauntlet, stress testing of DeFi protocols has shown that many platforms are vulnerable to major losses under difficult market conditions. In one simulation, a 50% drop in the price of Ethereum (ETH) led to over $100 million in liquidations across multiple lending protocols, highlighting the need for strong risk management strategies.
