The frontier of decentralized finance (DeFi) has taken off in recent years, galvanizing the ambitions of investors and coders as much as all-star football players. BlockchainShock.com, the premier source for the latest market sentiment analysis and technical breakdowns, understands the transformative potential of DeFi. This is because DeFi platforms operate outside the realm of centralized financial institutions. Perhaps most importantly, they provide people the ability to spend their dollars anywhere, on any purchase, I.O.U. or barter without requiring access to a centralized institution. DeFi’s stated mission is to remove third parties, like banks, from our financial ecosystem. This strategy reduces abuse and accelerates transaction times. DeFi heavily focuses on the idea of P2P financial exchanges. This allows two parties to securely and privately exchange cryptocurrency directly for goods, services, or even other cryptocurrencies without involving any third party.
Yet this thrilling new frontier does come with several hurdles to be leaped. In fact, one of the biggest modes of operation for hackers and thieves to steal your crypto dollars comes from exploits in DeFi applications. Though DeFi holds great potential for a more transparent and inclusive financial system, these smart contracts pose serious security threats. Just four years ago in 2019, digital assets locked into DeFi services represented under $1 billion. By November 2021, this figure surged to $236 billion. This article dives into the security risks that are built into DeFi. It addresses the risks and trade-offs between decentralization and security while providing recommendations on how to better navigate these risks in practice.
Understanding the DeFi Landscape
Decentralized finance, or DeFi, is transforming how we make financial transactions. It provides a decentralized peer-to-peer environment, removing the need for centralized institutions and third parties from the process, allowing for near-instant transaction settlements on the blockchain with total transparency through open-source smart contracts. Decentralization is a major tenet of DeFi. Because transactions are executed directly on secure blockchain networks such as Ethereum, no central authority maintains control, fostering a more open and transparent financial system. Unlike centralized platforms, DeFi applications allow you directly to interface with a blockchain. This architecture enables individuals to spend, lend, accept, receive, exchange and trade their money however they want—not reliant on the whims of a third party.
The Promise of Decentralization
Decentralization is one of the great pillars of DeFi, providing a number of strong benefits. By eliminating intermediaries through self-executing code, DeFi seeks to cut costs, improve efficiency, and foster financial inclusion. These transactions often occur on blockchain networks such as Ethereum. This design ensures that no single party can dominate the system, opening the door for a more transparent financial landscape. This translates to increased independence for end users and increased opportunities to develop other compelling financial products & services.
The Security Paradox
Decentralization introduces unique security challenges. In fact, one of the leading causes that hackers and thieves steal cryptocurrency is by exploiting vulnerabilities in DeFi applications. Despite the promise that DeFi holds in the direction of a more open financial system, it sadly comes with crucial security risks. The lack of traditional gatekeepers can leave DeFi platforms open to exploits and attacks. Transacting with anonymous parties on-chain is fundamentally unsafe and creates an enabling environment for nefarious actors to operate. Regulatory Uncertainty: DeFi’s lack of comprehensive regulation raises concerns around fraud and market stability.
Navigating the Security Risks in DeFi
DeFi has introduced a new frontier of security threats that both users and developers need to understand. Education is the first step toward mitigating that risk.
Smart Contract Vulnerabilities
Smart contracts build the infrastructure of DeFi applications, automating enforceable financial agreements and transactions. Yet, these contracts themselves can be highly elaborate and may house bugs or exploits that hackers could take advantage of. Such vulnerabilities increase the chances of funds being lost, prices being manipulated, and other nefarious actions occurring.
Impermanent Loss
Impermanent loss is a risk unique to liquidity providers in decentralized exchanges (DEXs). When users deposit liquidity into a pool, they assume an impermanent loss risk. The entire value of their deposited assets may fluctuate, leading to deep losses relative to simply maintaining possession of those deposited assets. Unlike other economic losses, this impermanent loss can be reversed if the price divergence corrects.
Governance Concentration
Despite the ultimate goal of decentralization in DeFi, most projects still operate with highly concentrated governance structures. Just a handful of people or organizations can dramatically shape the course of the project. This control can result in a tendency to make very user-unfriendly decisions that benefit their bottom line at the expense of others.
Balancing Decentralization and Security
The real question is whether decentralization and security can coexist in DeFi. Though the challenges are great, there are promising strategies and approaches that can help find the right balance.
Audits and Formal Verification
Third-party comprehensive security audits by recognized firms are essential in removing and/or addressing vulnerabilities in smart contracts. Formal verification, a more rigorous formal approach, employs advanced mathematical techniques to prove the correctness of smart contract code.
Insurance and Risk Mitigation Tools
Decentralized insurance protocols allow users to protect their investments. For one, they offer cover for losses due to hacks, exploits, and other unforeseen events. These protocols usually function on a decentralized, user-driven model where individuals can come together and pool their capital to better disperse their risk.
Decentralized Governance and Community Involvement
Support decentralized governance structures and lift up authentic community engagement. This method makes it harder for governance concentration to form and focuses which projects get developed on users’ interests. This might mean setting up systems for community members to vote on decisions, delegate their voting power, or enjoy a transparent decision-making process.
Dolomite's Approach to Security
Dolomite, a decentralized margin trading platform, offers a case study in how DeFi projects can prioritize security while maintaining decentralization.
Security Audits and Bug Bounty Programs
Dolomite brings in top firms to do frequent security audits of the platform. It manages a bug bounty program that rewards security researchers for discovering and responsibly disclosing vulnerabilities.
Risk Management Framework
Dolomite as an organization has embraced a strong risk management framework. This framework actively addresses impermanent loss, collateral risk and market manipulation.
Community Governance
Concrete dolomite takes its users’ rights very seriously with a community governance structure. This gives them the ability to introduce and vote on governance changes to the protocol, keeping the project continually focused on what benefits their interests the most.
The Coexistence of TradFi and DeFi
First, we have to accept that TradFi and DeFi are going to have to learn to coexist. This collaborative approach is necessary to enable a more inclusive and faster evolution of our financial ecosystem. This interesting blend of TradFi and DeFi provides truly inspiring opportunities. It has the potential to yield advantages including increased efficiency, more innovative financial products and improved transaction speed.
Overcoming Technological and Regulatory Barriers
Technological Barriers: Establishing interoperability between DeFi and TradFi systems requires advanced infrastructure and significant investment. Regulatory Uncertainty: DeFi’s lack of comprehensive regulation raises concerns around fraud and market stability.
Enhanced Efficiency and Innovation
By bringing DeFi’s tech into the TradFi world, we can make these processes faster and cheaper once the tools kick in. Enhanced Efficiency: Integrating DeFi’s technology into TradFi can streamline processes, reducing costs and improving transaction speed. DeFi’s stated goal is to remove intermediaries, including banks, from the financial ecosystem. This on-chain transaction alternative reduces costs dramatically and increases the speed of transactions.
The Future of Finance
In order to survive in tandem with decentralization, institutions need to change their compliance teams’ philosophy from risk-averse to innovation-first. In parallel, DeFi protocols need to create tools that allow vetted third parties to perform KYC and verify crypto wallet holders. None are insurmountable, and DeFi protocols can and should develop mechanisms to empower these trusted third parties. For instance, identity providers can take care of the KYC/AML process and make sure the wallet holders are verified. We know one of the most important advantages of DeFi is its borderless nature, accessible to anyone with an internet connection. By comparison, the world of traditional finance is still very centralized and constrained by local jurisdictions’ financial and anti-money laundering laws.
Practical Advice for DeFi Users
Here are some practical tips for users to protect themselves:
Do Your Research: Before investing in any DeFi project, thoroughly research the team, the technology, and the security measures in place.
Use Hardware Wallets: Store your cryptocurrency in a hardware wallet to protect it from online attacks.
Hardware Wallets
Ledger
Trezor
Diversify Your Investments: Don't put all your eggs in one basket. Diversify your investments across multiple DeFi projects to reduce your risk.
Stay Informed: Keep up-to-date with the latest security threats and best practices in DeFi.
Conclusion
While DeFi holds incredible promise to reshape our financial system for the better, it introduces new and daunting security risks. By understanding these risks and taking appropriate precautions, users and developers can help ensure that DeFi remains a safe and accessible space for innovation. Through decentralization, DeFi works to make our financial system more open. The act of transacting with unknown parties on-chain introduces risks and can embolden nefarious actors. Together, we need to forge ahead to innovate and work in concert to develop a safer and more resilient DeFi ecosystem.
