The decentralized finance (DeFi) market is a rapidly growing segment in the evolving crypto ecosystem. The impressive performance of DeFi solutions in recent years has shifted users’ perception of digital assets. These defi protocols seek to address specific pain points in the traditional finance markets.
With decentralization at its core, DeFi offers numerous benefits by removing the ‘middleman,’ including improved accessibility of financial services, lower transaction fees, and higher interest rates. Due to these perks, DeFi exploded in popularity in 2020, with an increasing number of investors joining the emerging market.
The total value locked (TVL) in DeFi assets crossed the $1 billion mark in early 2020, and before the end of the year, the number exceeded $20 billion. As more protocols and decentralized applications (dApps) joined in, the TVL shot through the roof, smashing ATH after ATH. At its current peak, the market recorded over $274 billion in TVL.
Ironically, the element that fueled DeFi’s growth also makes it risky. Without a centralized authority, DeFi users are on their own, which has exposed investors to countless vulnerabilities that risk the safety of their assets. This article will provide an in-depth look at the different types of DeFi risks and strategic ways investors can remain safe while navigating the high-risk, high-reward realm of DeFi.
Understanding the Different Risks of DeFi
The issue of DeFi security remains one of the most discussed topics among crypto enthusiasts, as the rise of DeFi-related crime in recent years has fueled the demand for increased security within the sector. Here are some of the most significant security risks in the DeFi ecosystem.
Smart Contract Vulnerabilities
Smart contracts are essential to the DeFi ecosystem as they eliminate the need for third parties. However, these smart contracts are programming codes; thus, even a seemingly minor mistake can result in a vulnerability that could lead to the loss of millions of dollars worth of digital assets. In the first four months of 2022, the DeFi space lost over $1.6 billion due to exploits, exceeding the total amount stolen in 2020 and 2021 combined.
Vulnerabilities in a protocol’s smart contracts can create a loophole that allows hackers to exploit the platform and steal users’ funds.
Another well-known DeFi attack was the Poly Network hack in 2021, where hackers detected and exploited vulnerabilities in the protocol’s smart contracts. This resulted in the loss of over $600 million worth of cryptocurrencies. While the attackers later returned the funds, the experience proves how vulnerable investors’ assets are, as hackers can steal them anytime.
Flash Loan Attacks
Flash loan attacks are exploits that allow crypto users to misuse a feature called flash loans in DeFi protocols. Flash loans let investors instantly borrow crypto assets without providing any collateral. However, the loan must be repaid within the same transaction, which temporarily gives the users access to a large amount of money.
In a flash loan attack, the attacker borrows a significant amount of funds and uses them to manipulate assets’ prices or exploit weaknesses in a DeFi protocol. They do this by making multiple transactions quickly, typically within seconds.
Flash loan attacks are very lucrative, and attackers can amass hundreds of millions of dollars per exploit. In 2022, the DeFi project Beanstalk lost over $180 million to hackers in a massive flash loan attack.
Rug pulls are one of the most popular DeFi attack vectors. It is a situation where the developers of a DeFi project abandon and disappear with the investors’ funds.
The perpetrators usually drive attention to their DeFi project using various means to attract liquidity, some tactic is to offer a very high interest. After that, they remove most of the liquidity from the platform, leaving investors with worthless tokens.
One of the most enormous rug pulls in the short history of defi was the BTC pool of the Africrypt project, which resulted in the loss of over $3.6 billion.
Phishing attacks are fast becoming one of the most popular ways hackers drain investors’ wallets. The attackers often try to replicate the websites of popular DeFi platforms or even claim to be their customer support representatives.
The attacker mainly aims to access investors’ sensitive data, including secret recovery phrases. Most phishing attacks are so sophisticated that users could compromise their wallets by simply clicking on a malicious link. In 2022, a phishing scam stole over $1 million from various DeFi users in under 24 hours.
Best Practices for Staying Safe in DeFi
While there is still no guaranteed method to eliminate risks in the DeFi space, there are some steps investors can take to protect their assets.
Use a Hardware Wallet (But it’s not enough)
Hardware wallets are often regarded as the best option for safekeeping crypto assets, as they securely keep private keys in offline storage, making them inaccessible to hackers.
Make sure to choose a hardware wallet compatible with your defi operations. The most popular wallet is Metamask, which supports Trezor and Ledger hardware devices.
As always, for securing any non-custodial wallet, remember never to store your recovery phrase on your PC, or cloud, as that will defeat the entire purpose of using a hardware wallet in the first place.
It is worth noting that while hackers can only exploit your wallet if they have access to your physical hardware device, they could also lure you into confirming malicious smart contract transactions that could drain your wallet, even when your funds are stored on your HD wallet.
One example of such a malicious transaction is the “set approval for all” command, which gives the attacker the right to transfer user’s NFTs to the attacker’s wallet. Also, interacting with a malicious smart contract will not protect your assets even if you use a hardware wallet.
Interact Only With Reputable DeFi Platforms
The DeFi industry’s fast-paced growth has resulted in hundreds of DeFi projects, including those with credibility and those without. To ensure that you do not fall victim to malicious projects and end up losing your assets, it is vital to only use reputable DeFi platforms.
Before performing any action and interacting with any platform, ensure you have carefully researched the project and its credibility. Never interact with any project you are not sure about. Make sure the dApp is listed on defi aggregators like DappRadar.
Often Check Granted Access and Revoke
While interacting with a dApp, users often approve the protocol’s access and allowance to make use of some / all of the tokens in their wallet. This access is necessary to interact with the platform.
However, if the dApp is malicious or compromised, hackers can exploit the access rights and steal users’ funds.
Users must also regularly check the dApps they are giving access to their wallets and update the list, removing those that are no longer in use. Use tools like Revoke Cash in order to check which platforms you had given access to, and terminate any unnecessary access.
Phishing Scams and How to Avoid
Phishing scams are becoming notoriously challenging to curtail within the DeFi space. As such, investors must know about phishing scams and how to avoid them.
Don’t click on random links, and never click on crypto-related Google Ads, as they can be used to drain your wallet after interacting with a malicious smart contract.
Be aware that sometimes the official social networks of legitimate projects can get compromised and publish malicious phishing websites, as happened back when the BAYC Instagram account got hacked.
Always bookmark the website for the DeFi protocols you use often. Never share your seed phrase, no matter what.
Code Audits: Better, But Not 100% Guaranteed
Code audits became a market standard for defi protocols to get a stamp that their code has no code errors that can lead to exploits. Check the project’s website for the audit mark, it should lead to the report by the auditing company.
However, even audited protocols can get exploited. Team Finance exploited for over $14M despite being audited by Certik.
Keep your Software Up to Date
As always, with security, it is vital to keep your software and operating system, especially your browser, up to date.
Hackers love to exploit software vulnerabilities. Regularly updating your software will help reduce the chances of malicious actors accessing your account details via system vulnerabilities.
Do your Due Diligence
Carefully research a project before investing money into it. Learn about the project’s team, track record, and past experiences.
One instance is the pseudonymous founder of Azuki NFTs, Zagabond, who revealed that he had previously been involved and profited from about three of his failed NFT projects. The value of the Azuki NFTs quickly plummeted after he made the revelation.
Check for any reports about the projects on reputable media outlets in the crypto space. Still, remember that media coverage and celebrity endorsement do not guarantee the project’s safety. For instance, the Squid Game token rug pull of 2021 also received a lot of positive media coverage from major media outlets before the scam was discovered.
Additionally, most celebrities get paid (sometimes with no disclosure) to endorse fraudulent DeFi projects. So don’t invest in any project simply because your favorite star hypes it up.
Use Anti-Fraud Tools
Using anti-fraud tools like Blockfence as a DeFi investor offers enhanced security, fraud detection, and prevention. Blockfence and similar tools provide timely security alerts, conduct smart contract analysis, ensure privacy protection, and offer a user-friendly experience.
By leveraging these tools, you can have peace of mind knowing that your transactions and interactions within the DeFi ecosystem are actively safeguarded, and potential risks are mitigated effectively.
The DeFi market has continued to make great strides. While the 2022 crypto winter wiped out most of the sector’s 2021 gains, the DeFi space is still thriving.
The nascent industry is giving the traditional financial sector a run for its money. With a broad range of innovative solutions emerging in the DeFi ecosystem, malicious actors continue to devise new sophisticated methods to exploit the systems and steal investors’ assets.
While inherent ecosystem risks like smart contract vulnerability, phishing attacks, and rug pulls exist, investors can take practical steps to secure their assets.
Ultimately, education is the most outstanding protection against exploitation in the DeFi market. Therefore, investors must continue learning about new DeFi risks and how to secure their assets. They also need to stay updated with the latest developments in the space.