A Practical Guide for Non-technical DeFi Users to Understand DeFi Risks
For a second, imagine walking into a car dealership and noticing that the environment has no gates or security, nor do they have insurance on their cars, good infrastructure or qualified staff. This is a very risky business as several things could go wrong. This is exactly how financial instruments traded and held on the blockchain are vulnerable to attacks when the holder is not informed of the risks of participating in the ecosystem.
DeFi is evolving the world of finance and taking it to a new level, but it’s not without its risks. Understanding the risks involved in DeFi is crucial for non-technical users to properly navigate the Web3 ecosystem safely.
What is DeFi and Why Does It Matter?
Decentralized Finance (DeFi) is a prospering ecosystem that aims to provide financial services without the need for traditional intermediaries like banks. Unlike traditional systems, where costs are undertaken at the expense of users and funds are held indirectly, DeFi offers a custodial solution for users. This enables users to be in charge of their money, make investments, and influence decisions that interest them.
DeFi provides a wide range of new tools for using crypto assets. It offers opportunities beyond purchasing crypto on a centralized exchange or holding it in a decentralized exchange (DEX) wallet. It is a platform that limits no one and allows everyone to build a decentralized, custodial, and, when done correctly, secure lifestyle.
While DeFi offers many potential benefits, it also carries various types of risks that users should be aware of, and understanding these risks lessens the possibility of falling prey to one. The rest of this guide will break down the key risks in simple terms and provide practical tips for mitigating them, including leveraging products like Nexus Mutual for risk protection.
Simplifying DeFi Risks
DeFi risks often come in various forms. While many fall victim to some because it is inherent, many also victim to it because they don’t know how it works. Let us explore some of them.
Smart Contract Risks
Smart contracts are digital, self-executing agreements stored on blockchain technology. They automatically fulfill their terms when specific conditions are met without the need for intermediaries. They operate on a distributed ledger, ensuring secure and transparent transaction recording.
Smart contracts are classified under technical risks in DeFi and can be tricky beasts. There are a few ways they can go wrong that users should watch out for. Take reentrancy attacks, for instance. This happens when a function can be called repeatedly before its execution. It’s like someone cutting in line repeatedly at a bank teller — they could potentially drain an account before anyone notices. To avoid this, users should stick to well-known, audited protocols and be wary of any contract that handles funds in an unusual way.
Then there’s the issue of integer overflow or underflow. It sounds technical, but think of it like your car’s odometer rolling over to zero after hitting its max number. In smart contracts, this can lead to some weird behavior, like suddenly having a ton of tokens you shouldn’t. Users can protect themselves by using contracts that implement “safe math” libraries, which catch these problems before they happen.
Access control flaws are another headache. It’s basically when the bouncer at the club lets anyone in, even if they’re not on the list. In smart contract terms, it means functions that should be restricted are open to anyone. Users should always check that a contract’s functions are properly secured, especially when dealing with high-value assets.
Logic errors are like typos in the contract’s rule book. They can cause the contract to behave in ways nobody intended. While it’s tough for average users to spot these, sticking to contracts that have been thoroughly audited and battle-tested can help reduce the risk.
Timestamp dependence occurs because some contracts rely too heavily on block timestamps, which miners can slightly manipulate. For users, the best defense is to be cautious with contracts that make critical decisions based on precise timing, especially for high-stakes operations.
Front-running is like someone peeking at your poker hand and then betting before you. In the blockchain world, it happens when someone sees your transaction before it’s processed and jumps ahead of you. Users can protect themselves by using protocols with built-in protections against front-running, or by setting strict slippage tolerances in decentralized exchanges.
Some examples of high-profile smart contract exploits or hacks are:
- The DAO hack (2016): An attacker exploited a recursive call vulnerability in The DAO’s smart contract, draining approximately 3.6 million ETH (worth about $50 million at the time). This led to a contentious hard fork of the Ethereum blockchain.
- Parity wallet freeze (2017): A bug in the Parity multi-signature wallet contract allowed an attacker to take ownership and then self-destruct the library contract, permanently freezing over 500,000 ETH (worth about $160 million at the time).
- Poly Network hack (2021): An attacker exploited a vulnerability in Poly Network’s smart contract to steal over $600 million in various cryptocurrencies. Interestingly, the hacker later returned most of the funds.
- Wormhole bridge hack (2022): An attacker exploited a vulnerability in the Wormhole bridge smart contract, stealing approximately $320 million worth of wrapped ETH tokens.
- Ronin Network hack (2022): Attackers compromised validator nodes and exploited vulnerabilities in the Ronin bridge smart contract, stealing about $625 million worth of ETH and USDC.
These examples highlight the critical importance of rigorous smart contract auditing, formal verification, and ongoing security measures in blockchain-based systems. They also underscore the potential magnitude of consequences when vulnerabilities are successfully exploited. To minimize falling victim to these risks, users should:
1. Stick to well-known, audited protocols with a strong track record.
2. Be cautious with new or unproven contracts, especially those handling large amounts of value.
3. Use wallets and interfaces that provide clear information about transactions and their potential risks.
4. Stay informed about common vulnerabilities and best practices in the space.
5. Consider using additional security measures like hardware wallets for high-value transactions.
6. Be patient and avoid rushing into transactions, especially during periods of high network congestion.
Remember, in the world of smart contracts, if something seems too good to be true, it probably is. A healthy dose of skepticism and due diligence goes a long way in staying safe.
Navigating Liquidity and Impermanent Loss
Liquidity explains how easily users can trade one cryptocurrency for another on an exchange. Think of it like the oil that keeps the DeFi engine running smoothly. In the world of decentralized finance, liquidity is basically how easily you can buy or sell something without causing a big price swing. It’s important because, without it, users would be stuck trying to trade. Good liquidity means tokens can be swapped and trades made quickly without losing a lot of money in the process.
Now, impermanent loss! It’s a bit of a head-scratcher, but here’s the gist: When you provide liquidity to a pool, you’re essentially putting in equal values of two different tokens. The problem comes when those tokens’ prices start dancing to different tunes. If one token moons while the other tanks, you might end up worse off than if you’d just held onto your tokens. It’s called “impermanent” because, in theory, if the prices come back to where they started, investors are back to square one. However, in crypto waiting for prices to come back is not always guaranteed, hence the risk associated with crypto.
So, what are the practical ways to deal with this? Well, when it comes to managing liquidity and trying to dodge impermanent loss, there are a few tricks of the trade. First off, investors need to perform due research, such as checking if the platform has been audited, or the market cap of the token. It is not advisable to jump into just any liquidity pool because it promises juicy rewards. Looking for stable pairs or tokens that tend to move together. For example, stablecoin pairs or different versions of ETH tokens are often a good bet.
Another tip is to keep an eye on investments like a hawk. The crypto market moves faster than a cat chasing a laser pointer, so what worked yesterday might not work today. Users should take advantage of tools to track investment positions and be ready to pull out if things start looking sketchy.
Also, consider protocols that offer ways to mitigate impermanent loss. Some newer DeFi projects are devising clever ways to protect liquidity providers, such as insurance (Nexus Mutual) or rebalancing mechanisms.
Lastly, it is advisable to spread liquidity across different pools and protocols. This way, if one pool goes sideways, it’s not really a huge loss. Remember, in DeFi, there’s no such thing as a free lunch. High rewards often come with high risks, so investors should always be prepared for the possibility that things might not go as planned.
Decentralized Governance Risk
Decentralization is a big part of DeFi, so, of course, it makes sense that there are platforms for governance. Since the whole concept of DeFi is empowering users to handle their funds and make investments, governance is necessary to enable users to make pooled decisions that will advance their investment decisions.
Risks in decentralized governance manifest in multiple ways, and this presents significant challenges to the effective management and development of DeFi protocols. It is often tagged a procedural risk.
One primary concern is the potential for conflicts of interest among token holders with voting rights. In many DeFi governance models, individuals or entities with substantial token holdings can exert disproportionate influence over decision-making processes. This concentration of power may lead to decisions that benefit a select few at the expense of the broader community or the long-term health of the protocol.
Poor decision-making is another critical risk factor in decentralized governance. The complexity of DeFi protocols often requires in-depth knowledge to make informed decisions. However, not all token holders possess the necessary expertise to evaluate complex proposals effectively. This knowledge gap can result in the approval of potentially harmful changes to the protocol.
Voter apathy presents an additional challenge. In many cases, a significant portion of token holders do not actively participate in governance decisions. This lack of engagement can lead to decisions being made by a small, potentially unrepresentative group of active participants, potentially compromising the democratic ideals of decentralized governance.
Instances of vote buying and manipulation by large token holders, often referred to as “whales,” have also been observed in various DeFi projects. These actions can undermine the integrity of the governance process and lead to decisions that do not reflect the broader community’s interests.
Examples of high-profile governance-related issues in DeFi projects:
1. Maker DAO “Black Thursday” (2020): During a market crash, Maker’s governance system failed to respond quickly enough to extreme market conditions. This resulted in approximately 8.32 million worth of ETH being liquidated for 0 DAI, causing significant losses to the protocol and its users.
2. Compound token distribution error (2021): A bug in a governance-approved proposal led to the accidental distribution of approximately 160 million worth of COMP tokens. This incident highlighted the risks of implementing changes without adequate testing and the potential for costly errors in governance decisions.
3. Uniswap’s first governance vote failure (2020): Despite majority support, the inaugural governance proposal for Uniswap failed to meet the required 40 million vote threshold. This highlighted issues with voter participation and the challenges of achieving quorum in decentralized governance systems.
4. Beanstalk Farm's governance exploit (2022): An attacker used a flash loan to acquire enough voting power to pass a malicious governance proposal, draining the protocol of approximately 182 million. This incident exposed vulnerabilities in governance models that allow rapid accumulation of voting power.
5. Solend’s controversial governance vote (2022): The Solend protocol passed an emergency proposal to take over a large user’s account to mitigate liquidation risks, which was later reversed due to community backlash. This case highlighted the ethical concerns and potential centralization risks in DeFi governance.
To address these challenges, the DeFi community is exploring various improvements to governance models. Proposals include implementing quadratic voting systems (like that of Gitcoin)to reduce the influence of large token holders, introducing time-locked tokens and governance to ensure active members are the ones making decisions (like that of BanklessDAO), and developing more robust education and communication channels to inform token holders about the implications of governance decisions.
Counterparty and Custody Risks
Counterparty risk refers to the possibility that one party in a financial agreement may fail to meet their obligations. In some DeFi protocols, like lending platforms, there is a counterparty (borrower) involved. If the counterparty defaults or fails to repay their debt, it can result in losses for the lender or liquidity provider.
Now, centralized custodians in DeFi platforms are a whole other can of worms. It’s like giving your house keys to a stranger and hoping they don’t throw a wild party while you’re gone. These custodians hold onto your crypto, promising to keep it safe. However, this reintroduces the risk of mismanagement, hacking, or theft, similar to traditional financial institutions. It’s a bit of a tightrope walk between convenience and security.
In order for users to reduce the possibility of falling into this risk, it is advisable to:
- Spread investments across different protocols and platforms.
- Perform detailed investigations before jumping into a lending pool. This could include checking out the protocol’s track record, audit reports, and community feedback.
- For the custody issue, it is advisable to look for platforms that use decentralized custody solutions or those that allow users to retain control of their private keys.
- Users could also be self-custodians of their crypto. In this case, using hardware wallets ensures maximum security.
Regulatory Uncertainties and Extrinsic Risks
Decentralization, crypto, and DeFi are still fairly new terms regarding their emergence in the finance world. Many are still skeptical, thinking crypto is a scam, and most governments do not recognize the concept of crypto as evolution; rather, they recognize it as an entity that has come to take money and power out of their hands. Due to this and many other reasons, it is banned in many countries. The risk involved here is that when there is a ban by the government on crypto, users who participate in DeFi could lose their holdings or ability to actually participate in the ecosystem. There is also the possibility of arrests and fines due to a user using crypto protocols where it is not allowed, and users might not be able to gain from certain protocols due to regulatory restrictions.
Market volatility and economic conditions also pose significant external risks to DeFi protocols. The crypto market is notoriously volatile, with prices often swinging wildly in short periods. This volatility can severely impact DeFi platforms, especially those relying on collateralized lending or liquidity provision. For instance, a sudden market crash could trigger mass liquidations, potentially destabilizing entire protocols. Moreover, broader economic factors like inflation rates, regulatory changes, or global financial crises can indirectly affect DeFi by influencing investor sentiment and capital flows. These external factors are often beyond the control of individual protocols or users, making them particularly challenging to navigate.
Users need to stay informed to enable them manage regulatory and extrinsic risk by being proactive. First, it’s crucial to keep abreast of regulatory developments in personal jurisdiction and any countries where you’re considering participating in DeFi. Following reputable crypto news sources, joining relevant online communities, and consulting with legal experts can help. Secondly, diversification is key — not just in terms of assets but also in terms of the protocols and platforms you use. This can help lessen the impact of potential bans or regulatory crackdowns. Another helpful tip is to use privacy tools that can help provide an additional layer of security, however, it’s important to understand the legal implications of doing so. Finally, it is important for users to always maintain a skeptical mindset and conduct thorough due diligence before engaging with any DeFi protocol, particularly in terms of its regulatory compliance and risk management practices.
Composability and Oracle risks
Composability is a building block in DeFi. It is when users can interact with protocols in infinite combinations, assembling different activities within a system on top of one another like building blocks. Composability simply refers to the interoperability within the trading ecosystem. Because of composability, users can earn rewards after putting their money into lending protocols and various other activities.
Oracles function as essential intermediaries between blockchain networks and external data sources. These systems gather, authenticate, and deliver real-world information (off-chain) to smart contracts operating on the blockchain (on-chain).
While both these concepts hold immense benefits, a hack or a bug attack could lead to the loss of assets. This is because composability is basically different protocols depending on one another to execute transactions; if there is a problem with one of those “blocks” the others are affected. In the case of oracles, an attacker might decide to manipulate the price of assets off-chain which an oracle could pick up, allowing for the manipulation and stealing of assets on a protocol
It is important to be well-informed and trade only on tested and trusted platforms to minimize the possibility of this risk.
Introducing Nexus: A Solution for DeFi Risk Protection
Most problems have a solution, and the solution to many DeFi risks is Nexus Mutual. Nexus Mutual is a decentralized insurance company founded by Hugh Karp. The Nexus Mutual platform uses the Ethereum blockchain to create a mutual or shared risk pool with other users. This is achieved by members buying insurance coverage to protect them against any of the risks supported by the platform. This risk is then assessed in staking pools, in which experienced members can create and manage staked NXM tokens, underwrite risks and earn rewards. The final step in this process is for members to lend their staked NXM tokens to provide liquidity to risk experts who assess and underwrite risks. In return, members earn rewards when other members purchase insurance coverage (referred to as “cover”) from the protocol. It’s like the circle of life but for DeFI.
Nexus Mutual currently supports two cover products, which are:
- Protocol cover: with Nexus Mutual, crypto users can safeguard assets deposited into a particular protocol against various potential loss scenarios, such as hacking incidents, exploitation of vulnerabilities, failures in Oracle data feeds, liquidation process failures, and malicious governance attacks.
- ETH Slashing Cover: Downtime or service disruptions during validation can result in financial penalties through a process known as “slashing.” With Nexus Mutual, investors can acquire insurance coverage that safeguards validator nodes against the potential losses caused by slashing penalties
With over $18 million claimed, a bug program to catch vulnerabilities and a secure ecosystem, Nexus Mutual is the right platform to help protect against DeFi risks. Nexus Mutual offers a transparent, trustless, and accessible insurance solution tailored to the unique needs of the DeFi ecosystem by leveraging the power of decentralized finance and blockchain technology. With its flexible, dynamic, and transferable features and multi-event coverage, Nexus Mutual empowers users to confidently engage in DeFi activities while reducing the inherent risks associated with participating in the ecosystem.
Conclusion
In conclusion, the DeFi space is rapidly evolving and its different risks with it. Educating ourselves on the different risks, staying abreast of information and staying secure is necessary. The insurance of digital assets in DeFi is also becoming increasingly important. With platforms like Nexus Mutual, enjoying and protecting yourself in the DeFi space is as easy as ever. Enjoy your experience in the DeFi space, and don’t forget to always do your own research (DYOR).
