Risk in DeFi is always present
Despite the high profitability and potential of DeFi, investing in DeFi has risks. The most significant risk and fear for investors is to lose their capital, so many people refrain from investing in DeFi. “Is DeFi dangerous?” – you may ask. If you invest correctly and carefully, and have your own DeFi risk management stratefy, the answer is: “Not so much”. DeFi platforms themselves are not inherently dangerous, but the crypto exploits that are directed at them are. In 2022, hackers stole about $4.3 billion; 97% of this amount they stole from DeFi, mainly through exploits of smart contracts. On the graph below, you can see the biggest DeFi hacks of 2022.
You may not know, but when you invest in a DeFi platform, you transfer your funds directly in the platform’s smart contracts. In exploits, it is the smart contract that is under attack. Why are crypto smart contracts sometimes so vulnerable to exploits?
Why do crypto exploits happen?
Taken from Elliptic Connect
The problem with crypto exploits lies in the smart contracts themselves. There are two reasons why exploits happen.
First, a smart contract can contain a mistake made by a developer while programming the smart contract. Interestingly, a smart contract with such a mistake can function correctly. Of course, until a hacker discovers this mistake and exploits it. Human mistakes are the most common reasons for crypto exploits. One of the best examples is the exploit of Scream.sh. Due to human mistake, the price of some stablecoins was hardcoded as $1. When those stablecoins temporarily de-pegged from $1, hackers exploited the smart contracts of the platform. Scream.sh lost a lot of money because of this crypto exploit. You can read about it here.
Second, a smart contract can be perfectly written and have no mistakes, but it is programmed in such a way that leaves it vulnerable to potential DeFi exploits. For example, let’s take an exploit on Aave. Hacker’s scheme was to borrow 40 million CRV tokens, bring the value of CRV down, and profit from the millions of dollars in short positions on the token. As a result, leaving Aave with a bad debt. Although Aave stated that all borrowing was covered by the liquidation procedure, $1.6 million were still unpaid. You can read about it here.
Well, you probably already understood that it is impossible to completely avoid the risk of exploits. Investors can only hope that hackers will not be interested in the platform where they keep their investments. “Is it possible to protect yourself from an absolute loss of investment?” – you may ask. If you carefully think through your investment approach and diligently choose the platform you are investing in, then you can minimize the DeFi risk. Let’s review some steps for efficient DeFi risk management.
What is crypto insurance?
Crypto insurance is an important tool of DeFi risk management that provides protection for your investment. If a hacker steals your DeFi investment from a specific platform, the insurance provider will partially compensate your loss. But insurance has a cost and purchasing one often reduces the maximum possible return on your investment. This is where the choice has to be made. You either accept a lower profitability or risk losing your investment entirely. But the choice is up to you.
If the platform in which you hold your investments suffers an exploit, there is a high probability that you will lose your funds. Of course, you can expect the platform to come up with the funds to return your investment. As often happens in such cases, the exploited platforms tend to make a lot of promises that never materialize. The solution to this problem is to buy an insurance.
Diversify your portfolio
While insurance can be a solution for some, it doesn’t guarantee full recovery of lost capital. A lot of crypto insurances will only cover a part of the amount lost. In some cases insurances can be very expensive. The general wisdom says that diversification is the key to minimize the risk. If you keep all your eggs in a single basket, and eventually, someone steals your basket, then all your eggs are gone.
Therefore, diversify your portfolio! Diversifying your portfolio is a key component of successful DeFi risk management. It is better to keep your eggs in different baskets and keep those baskets in different places. Then the risk that someone will steal all your capital at the same time is very low. Implementing a well-rounded DeFi risk management approach includes spreading your investments across different platforms and blockchains.
Conduct a research of your potential DeFi investment
You can quickly lose your DeFi investment if you don’t understand all the details behind the platform you are investing in and the tokens you use and if you don’t follow the rules of DeFi risk management. Therefore, you need to analyze the platform where you are looking to invest and conduct specific crypto research. To do this, you must carefully and thoroughly analyze the available information about the platform. Proper research is an essential part of DeFi risk management. You probably are not fully aware of what exactly you should pay attention to, so you may have a logical question: “Where should I start my crypto analysis?”
How to do a crypto research?
Here are 5 steps to follow while conducting a crypto research to improve your DeFi risk management strategy.. You are welcome to use them as the basis for your own research.
1. Familiarize yourself with the platform where you are planning to invest
Analyze the user interface of the platform and check its documentation. See how professionally it is designed and implemented. If everything is well-done, it increases the chances that the team knows what it is doing. Find out who is behind the platform and who the founders of this platform are.
Check when the platform was created. If the platform is brand-new and was created just a couple of months ago, then the risk that it might be exploited in the future is higher.
2. Search for crypto exploits in the past
If the platform did have exploits in the past, there is a good chance that it might happen again. The important thing would be to see how they handled the exploit and whether they actually compensated those who suffered. You can search for information on whether there were some problems with the service online.
For example, you might type “ApeSwap exploit” if you are searching for information about ApeSwap, you will see that nothing comes up. On the other hand, if you type “Cream Finance hack”, you will see some information that Cream Finance did have exploits in the past. The formula to follow is: “Service name” + “issue”/ “problem”/ “exploit”/ “hack”.
3. Verify audits
As we know, most exploits come from human mistakes. The best way to prevent a mistake while you are writing a letter, for example, is to let someone else review it. Everything works in the same way with crypto smart contracts. There are companies that provide crypto audit services and review smart contracts to make sure there are no exploitable mistakes in the code of the smart contract. Among them are CertiK, Paladin, Hacken and others.
On their websites you can verify whether a platform you want to invest in was audited and what is the current status of the audit. If the results of the audit are good and necessary remediation work was completed, the risk of your DeFi investment is lower.
4. Analyze the risk score
There are services that keep track of various parameters associated with a platform and calculate the risk score for it, which they make available on their website. You can check the risk score of the platform you want to work with on one of these services. The best services that show you this risk score are DeFi Safety and RugDoc.
5. Check the native token
It is always a good idea to check the native token of the platform if the protocol issues one. This includes analyzing its historical performance, volume and circulating supply. You can find all needed data on CoinMarketCap and CoinGecko.
The first thing you can do is look at when price history begins. You can use a max time period on the chart for this. This will give you information about how long this token exists.
Next, you can focus your attention on the chart for the last 12 months (if data is available), especially how it correlates to the overall market. If the price of the token performs significantly poorly than the overall market, you might be a bit cautious, especially if you are expecting to collect DeFi rewards in this token. If the token is showing unusually strong performance compared to the overall market, there is a big chance that it is a freshly issued token of a brand-new DeFi platform. In this case, the DeFi risk of a smart contract exploit is higher.
How to further protect your DeFi investment?
As we have stated before, it is impossible to completely avoid the DeFi risk. DeFi platform and its crypto smart contracts where you made an investment might get exploited or tokens you are holding your investment in might significantly drop in value. So what can you do about it?
1. Subscribe to social media
If you cannot prevent an exploit from happening, then you at least want to be the first one to find out about it, so you have more time to act. In order to accomplish this, once you have made an investment, you can subscribe to a social media channel (Twitter, Discord, Telegram, Reddit, Medium) of the platforms and tokens involved in your portfolio.
2. Configure Google Alerts
You may also configure Google Alerts, so the news with relevant keywords would be delivered to you as soon as they come out. The relevant keyword might be a combination of the name of the platform and a keyword indicating a potential issue. For example, it could be “Aave loss” or “Scream exploit”.
It is important to analyze the value of your investment and its rewards as the time goes by. It gives you an opportunity to see how your investment is performing and whether any portfolio optimizations are necessary. However, it is difficult to collect and manage all relevant information manually. So, you probably need to use a crypto dashboard for this. For example, you might start from the dashboard we offer here at Chainfulness. Using it, you will be able to analyze the real P&L of your investments, the historical performance of your individual DeFi investments, and other important information, which is needed for competent DeFi risk management.
Conclusion
Every year, the number of hacker attacks on DeFi platforms is decreasing, but the amount of funds which hackers steal from these protocols is constantly growing. This means that hackers commit attacks more rarely, but their actions are successful in most cases.
Ordinary investors should adopt a reliable DeFi risk management strategy, considering the risks of possible exploits. But the risk of a potential exploit should in no way discourage you from taking advantage of various DeFi opportunities! Moreover, you can adopt a competent DeFi risk management by using three essential strategies: buying crypto insurance, doing thorough investment research, and diversifying your portfolio, while regularly monitoring its performance and reviewing relevant news.
We hope this article has lowered your fears around DeFi investments. Stay tuned for our new articles. We wish you only safe smart contracts without mistakes on your investment path.
Invest wisely!