At first glance, decentralized finance, called DeFi for short, is the next big thing in finance, ready to replace traditional banks and financial services that have been around for centuries. What users have failed to realize is that without banks involved, the risk associated with doing business increases – a risk that rarely exists around the traditional banking sector. And while DeFi is surely promising and innovative as a whole, recent hacks and exploits resulting in millions lost are a prime example as to why the technology in the DeFi sector might still be too young and therefore too risky to invest too much capital into.
Introduction To DeFi Hacks, DeFi Exploits, And How To Avoid Risks In DeFi
The month of May 2021 was absolutely brutal in terms of the amount of total DeFi exploits resulting in millions of investors dollars in capital being flushed down the drain. Several DeFi protocols were hit with high-profile DeFi hacks that not only hurt investors in their wallets, but crushed the reputations of the protocols that were left vulnerable. In most cases the related LP token was the target, but in many cases ETH tokens were also taken.
The negative sentiment surrounding the exploits and the liquidity shock helped in part to cause the crypto market crash that took Bitcoin and Ethereum down by more than 50% per coin.
Fraud In The DeFi Ecosystem
In one example alone, a project admin account became compromised and along with it the private keys, and more than $80 million was stolen. The sum of funds stolen from DeFi exploits is increasing by the day, reaching millions stolen from DeFi exploits in 2020 and growing rapidly since.
Another example saw $45 million stolen where the compromise was to reissue new tokens to all affected users, making the original token worthless to anyone including the hacker. The same week, vulnerabilities in another DeFi software protocol saw a different kind of attack. These attacks range from flash loan attacks, to re-entry attacks, to the distribution of malicious code and more. The exploit means used depends on the DeFi protocol itself and the hacker’s motives and methodology, but the risks posed to DeFi users remains the same.
One project’s Ether pool was drained and more than $10 million in ETH tokens were stolen in the process as part of the hack, proving that regardless of the DeFi protocol. DeFi risks remain high.
Is DeFi Still Too Risky?
DeFi platforms are now abundant, and users are flocking to them without fully understanding the risks associated with the emerging technology and sector of the cryptocurrency asset class. Not only are there exploits, hacks, and more, but there are fake projects popping up left and right with only the intention of scamming users with an unexpected rug pull. The problem is growing as more capital flows into the category, and is a problem worth solving to build a brighter future of decentralized finance.
A Guide To Risks In DeFi
Before connecting your cold storage or hot wallet to the hottest DEX like Uniswap to lock up your tokens in smart contracts to earn an APY on coins, access flash loans, and more, be certain to understand all the various DeFi risks and how to avoid them if possible. Let the following guide act as a reference tool for the many security risks and loopholes associated with DeFi.
Types Of DeFi Risks And The Most Popular Hacking Methods
Let the following list act as a reference tool for the many security risks and loopholes associated with DeFi.
- Smart Contract Risks. Smart contracts are lines of code added to crypto token transactions but are highly prone to attack, errors, bugs, and more that can result in capital loss. Fees associated with erroneous transactions are not refundable, and over time can add up to large losses as the price of cryptocurrencies increase. Front-running, insufficient gas griefing, integer issues, reentrancy and other highly technical buzzwords plague smart contract problems.
- Hardware Risks. Hardware risks refer to the risks associated with the cold storage wallet being used to access any DeFi protocols or networks. Incompatibility issues, power outages, glitching, and worse are associated with hardware wallets.
- There are also risks associated with hardware wallets that crypto investors wouldn’t see coming. For example, a wallet company leaked the details and personal addresses of users who bought cold storage wallets, potentially creating risk of personal harm or safety issues due to the leak.
- Software Risks. Software risks are also highly technical and the security or a protocol matters the most here. A DDoS attack, injection, or overflow can be crushing to these decentralized software systems, as these exploits have shown.
- Injection Risks. Injection risks are often the worst associated with DeFi, as it happens when a user can access and manage data using the command line or SQL database to access vulnerabilities that allow the attacker to change data in ways with unpredictable outcomes.
- Financial Risks. The financial risks are a lot more obvious when it comes to DeFi, and we don’t mean losing money due to scams, hacks, exploits and otherwise. Financial risks are a very real risk associated with the price difference of locked tokens being offered up for liquidity provisioning. When a user goes to withdraw tokens from a DeFi protocol, if the price per token has dropped while being locked up, they’ve suffered a loss due to the financial risk associated with DeFi. The risk versus reward is typically in favor of DeFi protocols due to high APYs and other features, but there’s no denying the risks are real.
- Procedural Risks. Procedural risks in DeFi focus specifically on how users could be manipulated into using the protocol in ways that could hinder security efforts and bring vulnerabilities to light. Ensuring a reputable platform like Uniswap is selected, two-factor authentication is enabled, and software is fully up to date are ways that users can protect against these hidden procedural risks.
- Technical Risks. Technical risks are associated with smart contracts, software, and hardware, however, there are more ways the technical process of connecting to DeFi protocols can also lead to further risk. For example, if a user doesn’t know what they’re doing and finds themselves on a fake version of a popular DEX, it could result in coins being stolen or being sent to a destination that’s unintended. Without extensive technical skills, DeFi might not be right for everyone.
How To Manage DeFi Risks
Managing DeFi risks involves being ultra selective in which platforms to do business with and connect to. It is also important just like any type of investment to never invest more than one can comfortably afford to lose. DeFi’s products and services mimicking traditional banking services like loans and interest accounts all without the need for detailed verification methods makes for a very appealing system. However, it gives the investor the illusion of the same type of safety and security that banks provide.
When something goes wrong at a big bank, there’s a branch manager to talk to and an 800 line to call for support. At a decentralized exchange, if you get scammed, hacked, or send your funds to the wrong place, it is only you who suffers and there’s no one you can turn to for help.
Keeping a backup of any private keys, and ensuring they cannot be compromised must be of the utmost importance. Strong personal operational security and a tight lip also might be considered. Simply put, never disclose to anyone ever that you hold any crypto, especially not DeFi tokens or you could inadvertently make yourself a target for hackers and scammers.
DeFi tokens have been soaring in value for over a year now, bringing tons of new participants to the crypto industry and to the DeFi sector itself. Buzz surrounding the subsection of the industry has become even more popular than Bitcoin or Ethereum itself, and is part of what’s driving up the value per ETH token also.
However, as time has proven, DeFi is still too risky at this point in time, especially when dealing with unproven decentralized protocols. With crypto working best without a third-party, it is rare to believe that in any scenario, working with banks is the safer option. Instead, searching for a reputable centralized platform to access DeFi protocols instead can make or break an investor’s bottom line.
Strategy managers do battle to rise the ranks and gain the most followers, in which they’ll earn a cut of the profit share of successful copied trades. Followers get to sit back and let the strategy manager do the technical analysis and footwork for them. All they have to do is pick and choose which strategy managers to follow.
DeFi Risks FAQ: Commonly Asked Questions About Risks in DeFi And How To Avoid
Because DeFi is still such a new technology and requires some technical expertise to get involved, users that are interested but are novices tend to have a lot of questions. Here’s a list of the most frequently asked questions associated with DeFi and the risks involved.
Why Is DeFi So Popular?
DeFi is so popular due to how inclusive it is, and the permissionless environment. This means that there are no verification methods like credit checks required to access flash loans on crypto assets.
Is There Risk In DeFi?
DeFi is very promising but at this time recent events transpiring across crypto have shown that the technology is still too risky, until more reputable brands begin rolling out their DeFi products.
Can DeFi Be Hacked?
Any DeFi service is potentially vulnerable to hacks, exploits, scams, errors, or worse. The technology is still too new, untested, and users themselves are the beta testers and their money is at stake at all times.
What Are DeFi Hacks?
DeFi hacks range in variety and in scale. Some result in only a few tokens taken, while others result in millions of DeFi tokens stolen through various attack vectors.
