What are the risks of DeFi?

DeFi, which stands for Decentralized Finance, opens up exciting possibilities in the world of finance. It lets developers create new financial products and services without relying on traditional banks or intermediaries. This means you can exchange assets without having to trust a middleman.

But just like any new technology, DeFi comes with its own set of risks. To make DeFi safe and reliable for users and institutions, we need to address these risks. Without doing so, DeFi will remain something experimental and won’t be as useful or popular.

Here are the main risks in simpler terms:

1. Smart Contract Risk: Think of smart contracts as digital agreements. If these agreements have flaws or are exploited, it can lead to problems.
2. Governance Risk: Governance is like the rules that control how DeFi platforms work. If these rules aren’t fair or are easily manipulated, it can cause trouble.
3. Oracle Risk: Oracles provide data to DeFi. If they give bad data or are compromised, it can mess up transactions.
4. Scaling Risk: Imagine DeFi as a busy highway. If it gets too crowded, transactions can get slow and expensive.
5. Exchange Risk: When you swap one asset for another in DeFi, there can be issues like high fees or not getting a fair deal.
6. Custodial Risk: Sometimes, people trust their assets with DeFi services. If those services aren’t secure, you might lose your assets.
7. Regulatory Risk: Governments have rules about finance. If DeFi doesn’t follow these rules, it can get into legal trouble.

To make DeFi better, we need to find ways to manage and reduce these risks so that more people can use it with confidence.

Smart Contract Risk

Over the past ten years, there have been instances where crypto-related platforms, mainly cryptocurrency exchanges, were hacked. These hacks were often due to weak security measures, but they highlight a crucial point: software, which is the foundation of these platforms, can be vulnerable to attacks and errors made by developers.

Unlike traditional financial systems, which rely on banks and intermediaries, DeFi (Decentralized Finance) is built on computer code, like a set of digital rules. This code can be viewed and used by anyone once it’s deployed on the blockchain. While this transparency is a strength, it also creates a new risk known as “smart contract risk.”

So, what is smart contract risk in simpler terms?

Imagine smart contracts as computer programs that handle financial transactions in DeFi. They are relatively new in mainstream technology, and best practices for creating them are still evolving. Recent hacks of projects like DForce and bZx have shown that smart contract programming can be fragile and prone to errors.

Smart contract risk can take two forms:

1. Programming Errors: Just like any software, smart contracts can contain bugs or mistakes in the code. For example, imagine a smart contract designed for a lottery that accidentally tries to transfer more tokens than it actually has due to a small error. These errors can “lock” funds within the contract, making them inaccessible.
2. Economic Exploits: In some cases, there may be no obvious code error, but attackers can manipulate the contract to their advantage. For instance, they might use a less popular exchange’s price information to influence the contract’s pricing, then make profits by trading on a more popular exchange.

Economic exploits become even trickier with something called “flash loans.” These allow anyone to temporarily borrow a large sum of cryptocurrency for a single transaction, making it easier for attackers to manipulate markets within a short time frame.

One famous smart contract attack happened in 2016 with a project called “The DAO.” It attracted a significant amount of cryptocurrency but had a critical code flaw that allowed hackers to drain funds. This incident led to a debate in the Ethereum community about whether to rewrite the blockchain’s history to undo the hack.

Similar incidents, although smaller, have occurred in the DeFi space, showing that smart contract security is still a work in progress. Until these risks are addressed, people may be hesitant to fully trust and use DeFi applications with their money.

Governance Risk

Programming risks in the world of technology have been around for a long time, dating back to the early days of modern computing, which began over half a century ago. These risks involve the possibility of errors or vulnerabilities in computer code that can lead to problems or vulnerabilities in software systems.

In the context of DeFi (Decentralized Finance), programming risk is a significant concern. Some DeFi protocols, like Uniswap, rely entirely on computer code (smart contracts) to operate autonomously. However, many other DeFi applications involve more than just code; they depend on a human-controlled governance process. This process actively manages and adjusts the protocol’s parameters to ensure its stability and effectiveness. This introduces a new type of risk called “governance risk,” which is specific to the DeFi landscape.

Governance risk relates to how changes are made within a DeFi protocol. It involves mechanisms that allow users and investors to participate in decision-making. To take part in governance, individuals must acquire tokens that grant them the right to vote on changes to the protocol’s rules and future development. These governance tokens are often traded on the open market. While these tokens usually have a fixed supply, which makes it harder for any single entity to acquire a majority, they still pose a risk of being controlled by malicious actors.

While there haven’t been many actual governance attacks in practice, some new projects, like Automata, enable users to buy governance votes directly, which could increase the risk of malicious or hostile governance.

In traditional fintech companies, founders typically hold significant control, reducing the risk of external parties influencing the company’s direction or product. In contrast, DeFi protocols are vulnerable as soon as their governance systems launch. This means that anyone with enough resources can acquire a majority of governance tokens and take control of the protocol, potentially leading to funds being stolen.

An example of a governance attack occurred on March 13, 2021, involving True Seigniorage Dollar. In this case, the attacker gradually acquired a significant portion of the governance tokens, proposed changes to the protocol, and exploited it to create and sell a massive amount of tokens, resulting in significant financial harm.

While we have not witnessed a successful governance attack on any Ethereum-based DeFi project so far, there is a growing concern that financially motivated adversaries may attempt such attacks if the potential profits outweigh the costs of the attack. This highlights the importance of robust governance mechanisms and security measures in the DeFi space.

Oracle Risk

Oracles are a crucial but challenging aspect of DeFi (Decentralized Finance). They serve the essential purpose of providing off-chain data to DeFi protocols in a secure and reliable way. In simple terms, oracles help answer the question: How can we bring real-world data, like asset prices, into the blockchain world so that DeFi applications can use it?

Without oracles, blockchains operate in isolation and don’t have access to information beyond what’s recorded within the blockchain itself. However, many DeFi protocols need external data, such as cryptocurrency prices, to function correctly. Relying on these data feeds introduces a risk called “oracle risk.”

Oracle risk is a significant concern because if an attacker can profit more from manipulating the oracle than it costs them to do so (the Cost of Corruption is less than the Profit from Corruption), the oracle becomes a tempting target for manipulation.

There are three main types of oracle solutions used in DeFi:

1. Schelling-point oracle: This type relies on token holders voting on event outcomes or reporting asset prices. Examples include Augur and UMA. While they maintain decentralization, they can be slow to provide data.
2. API oracle: These oracles are centralized entities that provide data in response to requests. Examples include Provable, Oraclize, and Chainlink. DeFi systems using API-based oracles must trust the data provider to be accurate, which introduces centralization risks.
3. Custom, application-specific oracle: Protocols like Maker and Compound use this type of oracle. It’s designed to meet the specific needs of the protocol. For example, Compound uses a single data provider controlled by its team to supply on-chain price data.

The problem with oracles as they currently exist is that they pose significant risks to DeFi protocols. They are vulnerable to front-running, where opportunistic traders manipulate prices before transactions are executed, causing losses. Moreover, even well-known oracle services like Chainlink and Maker have experienced severe outages that had a cascading impact on the DeFi ecosystem.

Until oracles become native to blockchains, highly secure, and proven to be resilient, they remain the most significant systemic threat to DeFi. This means that DeFi projects must carefully consider how they use oracles and work towards developing more robust solutions to mitigate these risks.

Scaling Risk

Ethereum, like many other blockchain systems using the “Proof of Work” consensus mechanism, grapples with a significant challenge in terms of scalability. Scalability, in this context, pertains to the number of transactions a blockchain can effectively handle within a given timeframe. Presently, Ethereum operates with a fixed block size, meaning that every miner on the network must process all the transactions within a block. This limitation poses difficulties for Ethereum when dealing with a high volume of simultaneous transactions.

To provide some perspective, Ethereum can process a maximum of around 15 transactions per second (TPS). In contrast, a payment network like Visa can handle over 65,000 TPS. This highlights that Ethereum can only process a small fraction of the transaction volume that Visa can manage. This scalability issue poses a significant challenge for DeFi (Decentralized Finance) because most DeFi applications operate on the Ethereum blockchain.

Efforts are currently underway to address this scalability problem through two primary avenues:

1. New Consensus Algorithms: One active solution involves adopting a new consensus algorithm known as “Proof of Stake” (PoS). PoS replaces the traditional mining process with staking, where users lock up assets as collateral to validate transactions and create new blocks. PoS aims to be more energy-efficient and scalable compared to PoW (Proof of Work). It relies on the premise that a malicious actor would need to control more staked assets than the rest of the network combined, which is highly improbable.
2. Scaling Approaches: There are two general approaches to increasing blockchain throughput: vertical scaling and horizontal scaling. Vertical scaling consolidates transaction processing onto a single powerful machine, reducing latency but centralizing control. Horizontal scaling divides the work among multiple chains, preserving decentralization while increasing throughput through parallel processing. Ethereum 2.0 is adopting the horizontal scaling approach, known as sharding, in combination with PoS. This is expected to significantly enhance Ethereum’s transaction processing capacity.

Ethereum 2.0, although experiencing delays, holds the potential to achieve much higher transaction throughput, potentially reaching up to 50,000 TPS, through horizontal scaling. It’s important to note that the full implementation is still in progress, and challenges remain.

Another approach to tackle scalability issues involves the development of Layer 2 solutions. These solutions are built on top of the Ethereum blockchain and utilize cryptographic techniques and economic incentives to maintain security while increasing transaction throughput. However, many existing Layer 2 solutions lack support for smart contracts and decentralized exchanges.

One promising Layer 2 solution is Optimistic Rollup, which aggregates transactions off-chain and periodically submits a digest to the main Ethereum chain. While this approach can enhance scalability, it also comes with its own set of challenges, including the need for fraud proofs and increased transaction costs.

In summary, addressing scalability issues is a top priority for the DeFi space. Various approaches are being explored, including new consensus algorithms, scaling techniques, and Layer 2 solutions. However, no single solution has emerged as the clear winner yet. Until the scalability problem is adequately resolved, DeFi applications will continue to face limitations in terms of their potential impact and ability to handle high transaction volumes.

DEX Risk

In the world of DeFi (Decentralized Finance), things are getting pretty close to what we’re used to seeing in traditional finance. DeFi is all about digital versions of things like trading, taking risks to potentially make more money, and even playing around with make-believe assets. Out of all these activities, trading is the big winner when it comes to what people are actually doing in DeFi.

Now, what’s really interesting is how DeFi has given birth to a bunch of new digital exchanges. These are like the places where you can swap one digital thing for another. Imagine it like a digital stock exchange, but instead of buying and selling company shares, you’re trading digital assets.

In the world of DeFi exchanges on Ethereum (that’s one of the popular blockchains), there are two main types: Automated Market Makers (AMMs) and order-book exchanges. They’re different in how they work and the risks they come with.

AMMs, which are super popular, let you swap assets without having to trust anyone. They use smart contracts to handle everything, so you don’t need to worry about a middleman running off with your money. Uniswap is one of the big names in this category.

But, there’s a catch with AMMs. People who provide liquidity to these platforms can earn some extra crypto by staking their assets. It sounds good, but it’s not all roses. There’s something called “impermanent loss,” which means if the assets you’ve staked move around a lot in price, you might not make as much as you hoped. Some AMMs try to solve this issue, but it’s still a problem.

On the other hand, order-book exchanges work a bit differently. They’re more like traditional stock markets where buyers and sellers come together, and prices are determined by their interactions. However, these DEXs also have their challenges. They can be slow and vulnerable to some clever trading bots that might jump ahead of your trades.

Plus, they often have wider gaps between buying and selling prices, making it less attractive for users. In traditional finance, big players like Jump and Virtu help keep these gaps tight, but in the DeFi world, there’s usually just one market maker for each asset pair.

Some DEXs try to avoid these problems by moving most of their stuff off the blockchain, keeping only the essential things on the chain. This helps them avoid the slow-downs and clunkiness of on-chain DEXs. However, it also brings up some legal concerns.

Despite all these challenges, things are improving. As technology gets better and people get smarter about DeFi, these risks will likely become less of a big deal. So, while it’s a wild world out there, it’s also a world full of possibilities and innovations.

Custodial Risk

When it comes to safeguarding their cryptocurrency assets, individuals and institutions have several options, each with its own set of benefits and risks.

1. Self Custody:

• Hardware Wallet: One option is to take full control by self-custodying their assets. This often involves using a hardware wallet, which is like a secure flash drive that stores the private keys offline, away from the internet. This approach offers high security because it’s not connected to the web, making it extremely difficult for hackers to access the private keys.
• Web Wallet: Some users opt for web wallets like MetaMask, which store private keys in a web browser. While convenient, it’s important to use this option cautiously as web browsers can be vulnerable to malware and phishing attacks.
• Desktop Wallet: Desktop wallets are software applications installed on a computer, providing control over private keys. They are more secure than web wallets but still require vigilance to protect against malware.
• Paper Wallet: A paper wallet involves printing the private key and keeping it offline. It’s one of the most secure options as it’s immune to digital hacking. However, it carries the risk of physical loss or damage.

The primary risk with self-custody is the possibility of losing or locking the private keys. There have been instances where individuals forget their password or lose access to their hardware wallet, resulting in the loss of substantial cryptocurrency holdings.

2. Custodial Wallet:

• Another approach is to use a custodial wallet, where a trusted third party holds and manages the private keys on behalf of the user.
• Examples of custodial wallet providers include Coinbase and Binance. These platforms offer user-friendly interfaces and additional features like trading and staking.
• The advantage is that users don’t need to worry about managing their private keys, which can be complex and risky. However, it means placing trust in the custodial service.

Custodial wallets are not immune to risks either. If the exchange or custodian gets hacked, there’s a potential for the loss of user assets. While many exchanges implement security measures, there is still a history of security breaches, even if they have improved over time. Some exchanges, such as Coinbase, offer insurance to mitigate losses resulting from security breaches.

It’s important to note that most high-profile cryptocurrency exchange hacks have occurred on centralized exchanges, where large amounts of assets are stored in one place. Decentralized exchanges (DEXs) have also faced their share of attacks, but they operate differently, with assets stored in smart contracts rather than on a central server.

In summary, the choice between self-custody and custodial wallets comes down to a trade-off between control and convenience. Self-custody provides the highest level of control and security but requires users to take responsibility for safeguarding their private keys. Custodial wallets offer convenience but involve trusting third parties to secure assets, which comes with its own set of risks. Regardless of the chosen approach, it’s crucial for users to be aware of potential risks and take appropriate security measures.

Environmental Risk

Environmental risk in the context of DeFi (Decentralized Finance) refers to the potential negative impact that blockchain and cryptocurrency technologies, particularly those associated with DeFi projects, can have on the environment. While DeFi offers innovative financial solutions and decentralized systems, its underlying technologies can raise environmental concerns. Here are some key aspects of environmental risk in DeFi:

1. Energy Consumption: DeFi platforms and blockchain networks, especially those using the Proof of Work (PoW) consensus mechanism (e.g., Bitcoin and some Ethereum components), require substantial computational power. PoW mining consumes a significant amount of electricity, leading to a high carbon footprint. The energy-intensive nature of PoW blockchains can contribute to greenhouse gas emissions and environmental degradation.
2. Carbon Footprint: The energy consumption associated with mining and processing transactions on PoW blockchains results in a substantial carbon footprint. This has raised concerns about the environmental impact, particularly in regions where the electricity used for mining is generated from fossil fuels.
3. Electronic Waste: Hardware components used in cryptocurrency mining, such as specialized mining rigs (ASICs) and graphics cards (GPUs), have a limited lifespan. As they become obsolete or inefficient, they contribute to electronic waste, which can be challenging to recycle or dispose of responsibly.
4. E-waste Pollution: The improper disposal of electronic waste, including obsolete mining equipment, can lead to soil and water pollution, posing health risks to communities and ecosystems.
5. Blockchain Scalability: Some blockchains used for DeFi, like Ethereum, are exploring solutions to improve scalability, such as transitioning from PoW to Proof of Stake (PoS). PoS is considered more energy-efficient, but the transition process and network upgrades can have environmental implications.
6. Resource Intensive Operations: Smart contract executions and complex DeFi protocols can require significant computational resources. While this may not directly contribute to energy consumption like mining, it still places demands on the infrastructure that powers these operations.
7. Environmental Awareness: DeFi projects and blockchain communities are increasingly recognizing the environmental risks associated with their activities. This has led to initiatives to reduce the carbon footprint of blockchain networks and promote sustainable practices.
8. Alternative Approaches: Some blockchain projects are exploring alternative consensus mechanisms, such as PoS or delegated proof of stake (DPoS), which aim to reduce energy consumption and environmental impact. These approaches prioritize energy efficiency and sustainability.

It’s important to note that not all blockchain technologies and DeFi projects have the same environmental impact. Some newer blockchains and DeFi platforms are designed with environmental sustainability in mind, using energy-efficient consensus mechanisms or operating on eco-friendly networks. Additionally, there is a growing awareness within the crypto and DeFi communities about the need to address environmental concerns and adopt more sustainable practices.

Environmental risk in DeFi underscores the importance of responsible development and the adoption of eco-friendly solutions within the blockchain and cryptocurrency space. As the industry evolves, there is a potential for DeFi to contribute positively to environmental sustainability through innovative approaches and conscious decision-making.

Regulatory Risk

As the DeFi (Decentralized Finance) market grows in size and influence, it is increasingly coming under regulatory scrutiny. This heightened attention from regulators is not surprising given the potential impact and risks associated with DeFi. Here are some key points regarding the regulatory landscape for DeFi:

1. KYC/AML Compliance: Regulatory bodies, including the Commodity Futures Trading Commission (CFTC), have started to enforce Know Your Customer (KYC) and Anti-Money Laundering (AML) compliance on major centralized spot and derivatives exchanges. Decentralized exchanges (DEXs) are also likely to face similar regulatory demands in the future. Some decentralized derivatives exchanges have already restricted access for U.S. customers due to regulatory concerns.
2. Regulatory Uncertainty: The noncustodial and decentralized nature of DEXs creates a legal gray area with uncertain regulatory implications. While DeFi projects aim to provide decentralized financial services, the lack of centralized intermediaries complicates the application of traditional financial regulations.
3. Impact of Regulation: Regulatory pressure can have significant consequences for DeFi projects. An example is the shutdown of the algorithmic stablecoin project Basis in December 2018 due to regulatory concerns. This illustrates the challenges that DeFi projects may face when trying to navigate regulatory requirements.
4. Anonymous Protocol Founders: In response to regulatory pressures, some DeFi projects have opted for anonymity among their founders. This anonymity can make it challenging for regulators to identify and hold accountable the individuals behind these projects.
5. Governance Tokens: Many DeFi projects release governance tokens, and these tokens have attracted regulatory scrutiny. The U.S. Securities and Exchange Commission (SEC) is evaluating whether some of these tokens should be classified as securities. Some DeFi projects have structured their tokens to avoid being categorized as securities to comply with SEC regulations.
6. Cryptocurrency Taxation: The taxation of cryptocurrencies is an evolving regulatory issue. The IRS draft proposal, as of December 31, 2020, requires reporting of various cryptocurrency transactions, including receipts from airdrops or hard forks, cryptocurrency exchanges for goods or services, purchases or sales of cryptocurrency, and more. Clear guidelines on cryptocurrency taxation are still being developed.
7. State-Level Regulation: While some cryptocurrencies have been classified as commodities by federal regulators like the CFTC, individual states, such as New York, have implemented their own regulations targeting brokerages facilitating cryptocurrency transactions. DeFi protocols and their users may face a patchwork of state-level regulations.
8. Market Outlook: The regulatory landscape for DeFi remains uncertain, with many existing challenges and issues yet to be resolved. As the DeFi market continues to evolve, it is likely to face increasingly specific and nuanced regulatory measures aimed at addressing its unique characteristics and potential risks.

In summary, the DeFi space is navigating a complex and evolving regulatory environment. As regulators take a closer look at DeFi activities, projects in this space will need to adapt to comply with existing and emerging regulations while striving to maintain the decentralization and innovation that define the DeFi ecosystem. The future of DeFi regulation remains uncertain, and market participants will need to stay informed and adapt to changing regulatory dynamics.

Conclusions

Decentralized finance (DeFi) offers a range of significant advantages over traditional finance, including decentralization, increased access, efficiency, interoperability, and transparency. Decentralization ensures that financial products are collectively owned by the community, reducing the risks associated with centralized control. Providing access to these innovative financial products for all individuals is crucial for preventing wealth inequality.

In contrast to traditional finance, which often includes inefficiencies and unnecessary intermediaries, DeFi’s contractual efficiency returns value to the average consumer. DeFi’s shared infrastructure and open interfaces enable unparalleled interoperability, fostering innovation and collaboration. Furthermore, DeFi’s public nature enhances trust and security in a traditionally opaque industry.

DeFi projects like Compound and Uniswap have demonstrated the ability to distribute value directly to users through governance tokens and yield farming. Yield farming, in particular, has attracted substantial capital to DeFi in a short period, incentivizing innovation and community growth.

While each DeFi use case offers varying degrees of these benefits, they also come with their own drawbacks and risks. Scalability and smart contract risks are two significant challenges that must be overcome for DeFi to achieve mainstream adoption. Scaling issues could limit DeFi’s benefits to only the wealthiest participants, while smart contract risks require ongoing diligence and best practices to mitigate vulnerabilities.

The future of DeFi holds transformative potential, but it is not without its challenges. Proper due diligence, security measures, and risk management are essential for the sustainable growth of the DeFi ecosystem. As traditional finance firms gradually integrate with DeFi, they have the opportunity to adapt and thrive in a changing landscape. Startups like Dharma are paving the way for broader consumer access to DeFi, albeit with added layers of inefficiency. The DeFi protocols that establish strong liquidity networks and offer superior utility will play a vital role in mainstream adoption.

In essence, DeFi represents a groundbreaking transformation of finance, offering accessibility, efficiency, and inclusivity. It is a complete rebuild from the ground up, democratizing finance and creating a level playing field for all participants. DeFi’s potential is vast, and it holds the promise of reinventing finance in the decade ahead.