DeFi Risks & DeFi Risk Management Strategies
17 May 2022 by Marlo Pluto
Reading time 14 min
DeFi Risks and DeFi Risk Management Strategies - any crypto investor should be aware of DeFi risks and DeFi risk management strategies. Without this, it will be difficult for him to maximize his income.
The appearance of blockchain technology radically transformed the digital space and gave rise to many applications. One market segment that is experiencing rapid growth as a result of blockchain innovation is the industry of decentralized financial services, or DeFi. DeFi is a collective term for peer-to-peer financial services carried out on public blockchains. The purpose of DeFi platforms is to provide comprehensive financial products to everyone, without relying on middlemen such as centralized banks or credit institutions. By cutting out intermediaries from processing financial operations, DeFi makes transactions cheaper, faster, and automatic thanks to the implementation of blockchain-powered smart contracts.
DeFi enables developers to build financial solutions such as decentralized lending and borrowing, decentralized insurance, decentralized money markets, and decentralized asset management firms. This makes DeFi a serious competitor to the legacy banking system with its high entry barriers, slow and cumbersome processes, and extortionate transaction costs.
Despite the great promise and innovation behind DeFi, this space does have some downsides, too. Hacker attacks or faulty smart contracts leading to the users’ funds being stolen, frozen, or misused indicate that the technology still lacks security and transparency and, therefore, might be risky to consider DeFi as a wise investment.
Knowing the risks associated with DeFi and the ways to manage them can help facilitate the mainstream adoption of DeFi services and improve their investment attractiveness. In this article, we will highlight potential vulnerabilities related to DeFi and strategies that can lessen them in order to encourage better utilization of DeFi solutions.
Types of DeFi Risks
- All risks that DeFi economy is exposed to can be divided into several large groups:
- Technical risks,
- Procedural risks,
- Financial risks,
- Governance risks.
Let’s dive deeper into each category of existing DeFi risks and how to deal with them.
Technical Risks in DeFi
Technical risks in the sector of DeFi mainly revolve around issues with the protocol, underlying blockchain, as well as the implemented software and hardware. The threat of technical risks cannot be underestimated because the malfunction of a single technical constituent can destroy the platform’s functionality. Different factors may trigger technical risks in DeFi, including the failure to ensure the platform’s adequate scalability, lack of proper use cases testing, errors in writing the code lines of a smart contract, etc.
On the protocol level, DeFi platforms are subject to two types of risks. The first is intrinsic protocol risks that are by default embedded in the protocol’s design and affect the normal functioning of the platform. If inherent, protocol risks can unintentionally facilitate incorrect or even illegal behavior of the DeFi system and hamper the conduction of audits from authorities. For example, if the development team of some DeFi project uses a poor source of randomness, this can potentially render the users’ private keys vulnerable to hackers.
The second type is exogenous protocol risks referring to the external situations that alternate the protocol’s coded behavior. Hackers, who take advantage of potential vulnerabilities and bugs detected in the open-source smart contract logic, are a prominent example of exogenous protocol risks.
Underlying Blockchain Risks
The infrastructure of DeFi protocols heavily depends on the underplaying blockchain. If some aspect of the blockchain is compromised – for example, its consensus mechanism is manipulated – it can result in vulnerabilities in all DeFi protocols that are hosted on that blockchain. A vivid example of this can be the erroneous behavior of validators in Proof-of-Stake (PoS) networks. If a group of validators misbehaves (for instance, validators aren’t online as they always must be to verify blocks, or they repeatedly make errors in the validating procedures), their stake may be partly or fully eliminated to counterbalance the losses incurred from their mistakes. The functioning of a DeFi protocol with a corruptive consensus algorithm cannot be effective.
Did you know that you are able to extract data from API into Microsoft Excel using the in-built Power Query feature?
Smart Contract Risks
Another notable issue that emerges among technical risks in the DeFi landscape refers to weaknesses in the protocol’s smart contracts. Smart contracts are essentially strings of computer code that are written into each transaction that takes place on a given DeFi platform.
- As smart contracts are designed by programmers (say humans), they may be prone to human-factor mistakes as well as system bugs, and external attacks, which may eventually materialize into the losses of user funds. A fee paid for an erroneous transaction cannot be refunded and can lead to large losses over time as the price of the cryptocurrency rises. Some examples of notorious smart contract problems include:
- Unauthorized transfers: it is when the smart contract contains features that allow a user to bypass the established authorization patterns for sending tokens from an account,
- Self-destruction: it is a situation when a smart contract comes with a function that allows a user with a privileged role to remove a token contract from the blockchain and destroy all tokens generated by the contract,
- Uncontrollable minting: the smart contract contains functionality that enables a user with a privileged role to artificially enhance a token’s circulating supply,
- Transaction order dependence: the smart contract allows for asynchronous transaction processing, which can be exploited for profit or protocol correctness by reordering mempool transactions (the mempool is a place where all unconfirmed transactions are stored waiting for the confirmation by the network).
The next important addition among technical DeFi risks points towards the physical equipment employed by the DeFi platform to support its operation and provide its decentralized services. Typical hardware breaches associated with a decentralized economy belong to power issues, incompatibility, glitching, and sensitivity. A separate hardware risk related to DeFi comes from the cold storage wallets that are used to open access to the DeFi protocols or blockchains. For example, if a hardware wallet company has not properly secured the personal details and addresses of their users, this theoretically creates a risk of data leakage and, consequently, the threat of capital losses.
Another top entry among DeFi technical risks refers to software issues that may seriously compromise the DeFi network’s security if left unattended. Common examples of software DeFi risks encompass DDoS attacks, injection, overflow, and uncontrolled format strings. These risks can be crushing to the DeFi platform’s normal functioning.
They are often the worst risks associated with DeFi systems. An injection in this context is a situation when a hacker can access and manage the protocol’s data by entering a malicious code through the command line or SQL database to take advantage of vulnerabilities. This allows the attacker to alter critical data, which may lead to unpredictable outcomes.
Procedural risks in DeFi space relate to how users can be manipulated into using the protocol in a way that could interfere with security measures and expose existing vulnerabilities of the protocol. The most common procedural hazards in DeFi look like the following:
It is a trick wherein a malicious actor creates a fake website or service that looks identical to the well-known DeFi platform to dupe unsuspecting individuals into sharing their personal information. Phishing is frequently performed through emails that a user believes to be sent by a genuine DeFi provider. Once the individual opens the link contained in the email, they are redirected to a counterfeit website that looks like a real thing. Sensitive information derived from phishing hacks can be leveraged by hackers to steal user funds, perform illegal transactions, or commit other activities, while the user is never wise about them.
This user manipulation technique is also nicknamed “bait and switch.” It resembles phishing to some extent, but instead of concocting a fake website, a wrongdoer places an ad banner on some website. Clicking on that banner will redirect a person to a page infected with malicious software. This malware will automatically download to the user’s device without their knowledge and provide the attacker with full access to the device’s systems.
It is an advanced form of phishing that targets specific individuals or organizations. General victims of spearfishing are employees working in finance or IT departments of an organization, those who may have access to sensitive information, or at least the ability to inadvertently grant access to such information.
Quid Pro Quo
This malicious technique resembles baiting, yet the attacker pretends to offer a lucrative incentive if the victim agrees to do what the hacker asks.
It is another risk in DeFi, where those in higher positions are targeted to expose their real locations.
It is when a malicious agent poses themselves as a trusted individual (a DeFi company representative, a user’s family member, a work-mate, a healthcare provider, or any other authority) to convince a victim to share their sensitive information. A pretexting hack may be arranged through emails, phone calls, or even-in-person communications, and it often looks like an emergency to cause a panic in a victim and make them do what the hacker wants.
It is a variation of a phishing attack in which information obtained from the victim is used to convince a mobile operator to add a new SIM card to the user's existing account. With full access to the victim's smartphone, a hacker can steal funds from any wallet app on the device and gain access to multiple authentication applications that can be used to hack into sensitive accounts and steal valuable assets.
The segment of DeFi is also rife with financial risks wherein a user is exposed to monetary losses not because of intrinsic protocol vulnerabilities or external fraudulent activities, but because of the ever-changing economic situation. Since decentralized finance systems are all about operating with digital assets, they much depend on the market trends, just like traditional stocks. The market risk that plagues DeFi space is associated with holding and speculating with virtual assets, whose price can spike or drop against the US dollar as market circumstances shift.
It is important to realize that the market is highly sensitive to different types of events occurring in the world. The change of political regimes, civilian riots, military conflicts, natural disasters that ruin objects of infrastructure and even public statements of celebrities – anything can affect the price of a specific token the DeFi platform employs.
But DeFi financial risks do not stop at that. Poor investment decisions may also translate into capital losses. The nature of most cryptocurrencies that constitute the DeFi industry is extremely volatile. The exception is, perhaps, stablecoins that are programmed to be pegged to the price of a real-world asset like USD or EUR.
A given crypto coin may drastically sag within a short period, and there is a real risk that the coin will never reach or surpass its all-time high again. To protect their investments, a user needs to perform a fundamental and technical analysis of the asset of interest. It is also vital to do research regarding the DeFi platform’s technology, current performance, history, and perspectives before pouring hard-earned money into the DeFi project.
A unique characteristic of DeFi systems is that they are generally controlled and managed by DAOs, decentralized autonomous organizations that decide on the protocol’s parameters, modifications, and further direction. Ill-thought decentralized governance proposals may badly affect the behavior of a given DeFi platform, potentially leading to the loss of investments.
But poor internal governance decisions are not the only danger a DeFi platform may suffer from. National governments of countries are constantly clamping down on cryptocurrencies, trying to take this sphere under total control. Politicians adopt laws and regulations that either restrict the use of DeFi networks in a region or enhance the centralization of the governance model of such DeFi protocols.
How to Avoid Risks in DeFi
The key trait of DeFi systems is that they eliminate the participation of trusted intermediaries by introducing programmable, self-executing smart contracts to conduct financial transactions. While DeFi holds a huge promise, the sphere is also plagued with new types of risks that have not been seen in capital markets.
Clever risk management strategies that elevate the security of digital assets and ensure the robustness and immunity of the protocol will promote the institutional adoption of DeFi and make it attractive for investors. Here are some recommendations that help to mitigate risks that are evident in today’s DeFi environment.
Trustworthy Platforms and Services
Avoiding DeFi risks starts with being ultra-selective when it comes to choosing a platform to deal with and connect to. Users should do their due diligence and thoroughly review the DeFi system and services it offers before investing money in it. Just like with any type of investment, it is also important to never invest more than one can safely afford to lose.
Multi-factor authentication is a powerful security tool, especially when coupled with strong verification methods. Email verification, SMS code confirmation, and multi-signature authentication are some of the best DeFi risk management practices.
Security for Digital Assets
Maintaining a backup of private keys and ensuring they cannot be compromised should be of paramount importance. Strong personal operational security and non-disclosure of any information concerning personal crypto holdings can also be considered.
A user should never let anyone know that they own any cryptocurrencies, especially DeFi tokens, otherwise, such an individual may become an unintentional target for hackers and scammers. To safeguard personal digital funds, it is recommended to use cold crypto wallets that enable offline storage of electronic assets, making it hard for a malicious agent to gain access to them.
Regular backups and software updates are also among the top recommendations for minimizing the risks associated with DeFi. Enterprises are implementing new updates and introducing advanced features to improve DeFi security. Therefore, systematic DeFi software updates can mitigate the risks of new vulnerabilities.
Diversification means that investors add the most promising, undervalued, and non-overlapping DeFi coins to their investment portfolios. Such an approach helps to balance the risk of the portfolio losing significant value because of a single asset.
It is possible to identify promising tokens by calculating the relation of their market capitalization to the total value locked (TVL). Tokens with the lowest correlation of these values can be considered undervalued. This means that there is reason to expect that these assets will “catch up” with others in their valuation and grow. Therefore, by buying these cryptocurrencies, investors stabilize their portfolios in the medium and long term.
Another tactic to diversify the DeFi investment portfolio is to choose projects that are hosted on different blockchains, such as Ethereum or Binance Smart Chain. Diversification can also be done by including a DeFi insurance project into the investment portfolio as the demand for capital protection in the decentralized finance ecosystem is growing. Having insurance tokens in your portfolio will allow you to significantly offset an adverse event should it happen.
Staking & Investing in Stablecoins
Staking is also among safe options to lower DeFi risks and avoid value losses. Many DeFi companies allow users to profit from just holding the specific tokens within the platform for a certain period. For example, the popular cryptocurrency exchange CEX.IO lets its participants earn up to 16% APY for storing tokens. Profits from staking can only increase if the price of the token locked goes up.
To protect the portfolio from severe fluctuations, a user can invest in stablecoins, too, that offer staking, such as DAI. Thus, passive income from staked tokens can both increase the overall return on investment in the DeFi sector, and offset potential losses in the event of a sharp market drop.
The idea of hedging revolves around methods to reduce financial risks. There are many ways to hedge in the sphere of DeFi. Hedging offsets possible portfolio value losses with profits from an opposite position. For example, when a user buys an asset on the exchange, they can immediately open an opposing position on the linked derivative. Such derivatives may be futures, binary options, or CFDs.
Buying options is one of the popular hedging strategies in DeFi economy. Options are a type of derivative contract that gives buyers the possibility to buy or sell an asset at a stated price within a set time frame. This allows investors to protect their portfolio by going short in the event of a downswing in the market.
It is also possible to manage DeFi risks by measuring an acceptable risk score based on DeFi Score’s rating. The DeFi Score, created by ConsensYs, is a single, consistently comparable value for assessing DeFi platform risk. Their model captures the market’s risk attributes for smart contracts, centralization and financial risk, and provides 0–10 scores for each asset used within a particular platform.
Choose More Robust Governance Models
Many DeFi protocols establish their unique governance models that allow the network’s participants to have their say on the project’s future development and performance parameters. It is critical to pick a DeFi system with a transparent governance structure that is organized in such a way that the DeFi protocol is truly decentralized with fair distribution of rewards, and it takes robust measures against voting result manipulations.
Understanding the risks of DeFi clears the way to eliminate them. While the DeFi landscape is free of most inefficiencies that are omnipresent in the traditional banking system, it is too early to assume that DeFi does not pose any risks. Handling DeFi risks will facilitate the effective adoption of DeFi products and services. In the long run, DeFi may become the main source of available financial services. Thus, private investors, businesses, and governments can learn more about the effectiveness of DeFi by becoming familiar with the associated risks.