Why self-custody alone is not enough to protect your assets in DeFi.
Decentralized finance (DeFi) has garnered significant attention in recent years as a new way to access financial services without the need for traditional intermediaries. While DeFi has the potential to revolutionize the financial industry, it also comes with its own set of risks that users should be aware of.
In this blog post, we will explore the different risks associated with DeFi and discuss how to minimize your exposure to these risks.
Smart contract vulnerabilities:
Smart contracts are self-executing contracts with the terms of the agreement between buyer and seller being directly written into lines of code. While smart contracts can be a powerful tool in DeFi, they are also vulnerable to errors or malicious attacks.
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In 2022, the collapse of the Terra project highlighted the dangers of smart contract vulnerabilities. Terra’s entire ecosystem was reliant on LUNA maintaining its price, or at least, not suffering severe price depreciation. Well aware of this vulnerability, the Luna Foundation Guard (LFG) started bolstering the UST peg with Bitcoin in tandem with LUNA support.
The weakness in the model was already visible in February 2022. An Anchor community member going by the moniker “N3m0” asked LFG to bolster Anchor reserves with $450M to shore up declining revenue. Anchor’s stablecoin yield was so high (up to 20%), that it became unsustainable without the constant broadening of the pyramid’s bottom.
Critics branded this business model a classic Ponzi scheme. In Terra’s governance forum, N3m0 forecasted that Anchor would run out of stablecoin yields in November. It turned out the fall came much sooner.
When LUNA started tumbling during the bear market in the spring, many investors withdrew funds from the Terra ecosystem, led by Anchor. This cascaded into a classic bank run, deepening the broader selloff across crypto.
Within less than a week, from May 5 to May 11, LUNA’s price cratered to fractions of cent from $65. LUNA collapsed.
Liquidity risks:
Liquidity refers to the ability to buy or sell an asset quickly and at a stable price. DeFi protocols often rely on liquidity pools, where users can provide liquidity in exchange for a share of the fees generated by the pool. While liquidity pools can provide an opportunity to earn passive income, they also come with liquidity risks. If the value of the assets in the pool drops significantly, the liquidity provider may be unable to exit the position without incurring significant losses.
“To minimize your exposure to liquidity risks, it is important to diversify your portfolio and only provide liquidity to well-established and reputable liquidity pools.”
Market fluctuations:
Like any asset class, the value of cryptocurrencies and other assets in the DeFi ecosystem can fluctuate significantly. While market fluctuations can present both opportunities and risks, they can also be difficult to predict. To minimize your exposure to market fluctuations, it is important to diversify your portfolio and not invest more than you can afford to lose.
Other risks:
In addition to smart contract vulnerabilities, liquidity risks, and market fluctuations, there are a number of other risks to consider when operating in the DeFi ecosystem. These risks may include, but are not limited to:
- Cybersecurity threats, such as hacking or phishing attacks
- Operational risks, such as issues with the underlying infrastructure or service disruptions
- Regulatory risks, as the DeFi ecosystem is still in its early stages and regulatory frameworks are still being developed
The limitations of self-custody in protecting against DeFi risks
To ensure the safety of your assets in the decentralized finance (DeFi) ecosystem, it is important to follow best practices for asset protection. These may include:
- Researching and understanding the risks associated with each DeFi protocol or platform
- Only using reputable and well-vetted protocols
- Diversifying your portfolio across multiple protocols and assets
- Keeping assets in a secure, self-custody wallet
- Using strong, unique passwords and enabling two-factor authentication
In conclusion
In conclusion, self-custody, or the act of holding one’s own assets in a personal wallet rather than relying on a third party to hold them, is an important component of asset protection in the decentralized finance (DeFi) ecosystem. By taking self-custody of your assets, you can reduce the risk of third-party theft or loss. However, self-custody alone is not enough to protect your assets in DeFi. There are a number of other risks associated with DeFi, including smart contract vulnerabilities, liquidity risks, and market fluctuations, that self-custody does not protect against.
To maximize the safety of your assets in DeFi, it is important to follow best practices for asset protection, such as researching and understanding the risks associated with each DeFi protocol or platform, using reputable and well-vetted protocols, diversifying your portfolio, and using strong, unique passwords and two-factor authentication. By understanding the risks and following best practices, you can minimize your exposure to risks in DeFi and maximize the safety of your assets.
However, it is important to note that no risk management strategy is foolproof, and there is always a level of risk inherent in any investment. As such, it is important to only invest what you can afford to lose.
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About Author
Hi, I’m Innocent, a Web3 content writer with a background in computer engineering and distributed systems. I’ve been writing about blockchain technology and decentralized applications for the past few years, and I’m passionate about helping people understand the potential of Web3 and how it can shape the future of the internet.
I have a degree in Computer engineering from Olabisi Onabanjo University and have worked on a number of Web3 projects. My focus as a writer is on helping people learn about the technical and philosophical foundations of Web3, as well as exploring the practical applications and implications of this emerging technology.
You can find more of my writing on my website Medium page or connect with me on LinkedIn. Feel free to get in touch with any questions.
