Decentralized finance (DeFi) is an emerging ecosystem of alternative blockchain-based financial systems. They help users to engage in different traditional financial transactions and have the potential to revolutionize the financial market.
However, like any innovation, the first steps are tenuous and full of mistakes and lessons learned.
Just like any other booming industry, DeFi has also attracted its fair share of scammers and bad actors, who seek to lure investors into bogus projects.
And the risks aren't just based on scams. Fatal code bugs and exploits are among the biggest threats associated with using DeFi protocols.
SOFTWARE RISKS
Smart contracts are indeed a crucial aspect of DeFi as they replace the role of conventional centralized financial institutions. However, they are just code. Therefore, any compromise in the algorithm can lead to the loss of users' funds.
You must assume that if you invest in a DeFi protocol and hackers steal your investment funds, your money will disappear.
Smart contracts are an if-this-then-that type of software that is immutable and self-executing, meaning it cannot be changed or cancelled.
Let's say they are "dumb" in the sense that they will do what you asked them to do, not what you thought you asked them to do. If the terms are wrong, they cannot be corrected in time. In some cases, this means that assets locked in contracts that contain errors may never be paid out, as the contract may never be executed.
RUG PULLS AND PONZI SCHEMES
Another very common example of a security risk in DeFi refers to Rug Pulls. This mechanism works as follows:
A developer creates a DeFi project and a token. So there is some hype around it, attracting investors mainly via Twitter and Telegram. It lists the asset on a decentralized exchange (DEX) like UniSwap or PancakeSwap, usually paired with another popular token like ETH or BNB.
Once investors have allocated enough capital to the project, the malicious developer withdraws ETH or BNB, for example, from the liquidity pool, leaving only the token worthless. Then there is the withdrawal of resources and subsequent abandonment of the project, occurring the rug pull, or “pull of the rug”.
These designs are usually slightly modified replicas of other protocols.
COMMITTED PRIVATE KEYS
Private keys are basically the PIN code you need to access transactions sent to your public key address. Therefore, many of the prominent DeFi risks arise from the possibility of private keys being compromised, through theft or leakage of information.
There are several possible ways of leaking or stealing private keys.
One is through a compromised MetaMask interface. Another way refers to the loss or theft of the opening phrase. The seed phrase or mnemonic phrases provide an easier way to remember private keys.
FUNDS CONCENTRATED BETWEEN FEW HOLDERS
If large amounts of tokens are in the hands of a few holders, they are likely to be wallets in disguise.
The concentration of tokens allows for easy price manipulation at the expense of unsuspecting investors.
For example, if a few wallets control 60% of the supply of a given token, they can easily sell them all in one go and bring the token price down.
If a token only has a few holders and is not actively traded on multiple platforms, it is possible that it is a scam. Tools like Etherscan and CoinGecko can help in analyzing the distribution of a token.
As a general rule, a non-project team wallet should not contain more than 5% of the token supply.
51% ATTACKS
51% attacks are one of the most common threats in blockchain security. In them, attackers gain control over a large part of a network's computing power and as a result they are easily able to exploit security risks in a DeFi protocol, altering the contents of the distributed ledger and also opening up possibilities for double-spend attacks.
TWO OF THE MOST FAMOUS SCAMS
BITCONNECT
BitConnect stole around $2 billion through a fake project.
After the crash, in January 2018, its founders launched BitConnectX – a second rug pull.
SQUID GAME TOKEN
The Squid Game token was one of the more recent examples of a scam. The scam capitalized on the hype surrounding the hit Netflix series “Squid Game”. The price of the SQUID token has gone up over 230,000% in less than two weeks, however the ability to sell the token has been disabled and on November 1, 2021 the developers withdrew around $3.4 million from investors when the token dropped from $2,861 to $0.01 in just five minutes.
RECOMMENDED PRACTICES FOR DEFI SAFETY
While there are several risks in DeFi, you can turn to some best practices to improve security when interacting with these protocols.
If you are interested in a DeFi project, look into researching the development team and also looking at the technical aspects that leave projects open to exploration.
Read the documentation. One of the warning signs of a scam is vague documentation. Review the whitepaper and thoroughly research the project to learn more about the token holders/holders.
Check what percentage of the token supply is in the control of the developers. A large percentage means they can manipulate the market more easily.
If you have programming knowledge, see the project code. For most projects, the source code is publicly available. Review code to verify functions that have been flagged as dangerous by independent auditors.
Review Github, whitepaper and social media channels.
Before investing in a DeFi protocol, make sure you know how long it has been operating and the size of your total deposits.
It is fair to say that a DeFi protocol that has been operating for over a year and has more than $1 billion of total value locked into the protocol is likely to have less software risk than a DeFi protocol that was released two months ago and has $100 million of total value locked in the protocol.
COMMON SIGNS THAT SOMETHING IS NOT RIGHT IN A SUPPOSEDLY LEGITIMATE DEFI PROJECT
THE PROJECT APPEARED OVERNIGHT
Fraud projects often appear out of nowhere, while legitimate DeFi projects take a long time to develop. These fake projects are often accompanied by a lot of hype and capitalized on through memes. If a project that aims to revolutionize the DeFi world appeared overnight and looks too good to be true, it's probably a scam.
DEVELOPERS ANONYMOUS
Although Bitcoin, the first and largest cryptocurrency, was developed by a pseudonymous developer, anonymous developers should be a big warning that something could be wrong. The most successful projects today, like Ethereum, have a team of well-known developers.
If developers choose not to associate their name with the project and prefer to stay in the shadows, they may have good legal reasons for doing so, and you should avoid this token.
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