Main Issues and Risks in DeFi Smart Contracts

Decentralized Finance (or DeFi) is one of the hottest areas in the crypto universe and traditional finance area.

DeFi (AKA Open Finance) refers to financial services using digital assets and smart contracts, protocols, and decentralized applications (DApps); usually built on Ethereum Smart contracts (the protection of which is provided by best blockchain auditors) are essential for DeFi as they allow us to trade anything of value digitally without the need for mediators like banks or lawyers. Although the DeFi market has certain advantages, it contains numerous risks. For example, its members have acted outside the existing regulatory framework or, in some jurisdictions, in violation of current regulations.

The 5 Main Risks in DeFi Smart Contracts

DeFi as a new economy sector continues to develop, which means it carries certain risks for investors. The main risks of DeFi when working in the markets are:

1. Smart contracts risks
2. Oracle risks
3. Illegal activities
4. Management risks;
5. Information Security.

#1 Smart Contract Risk in DeFi Protocols

Smart contracts define the technological features of crypto assets. Therefore, any vulnerability or bug in the code of a smart contract that controls or interacts with a crypto asset, if discovered or exploited, could adversely affect any crypto asset issued, tracked, or held by a smart contract logic and may permanently disrupt the function and value of the crypto asset.

Many projects are started by copying another developer’s code; while open copying of proven software has certain advantages, distributing bad code can have negative consequences. As DeFi protocol and systems are subject to upgrades and upgrades, there will always be smart contract risks of bugs in the code.

#2 Oracles

There may be risks when using oracles. Thus, centralized oracles are vulnerable to malicious behavior by the provider of information (for example, about the dollar exchange rate) and errors in coding, attacks, or manipulation by others.

Attackers use oracle attacks to profit, for example, by initiating liquidation of a position based on inaccurate or erroneous information. Even in the absence of errors or misconduct, the provision of certain data by the oracle may be delayed in time, leading to the delivery of outdated information to the smart contract. This may cause adverse effects for those still using the smart contract, even though the market conditions have long since changed.

#3 Legal Side DeFi Risks

Despite the philosophy behind the name of the financial industry, the real situation is quite different. Over the past three years, the DeFi market has shown significant growth. But unfortunately, as the industry develops, so does the pressure from government regulators.

Another problem with DeFi has to do with the increasing level of centralization. This makes financial transactions more transparent and allows government agencies to track down unscrupulous market participants and apply sanctions against them.

The DeFi market’s decentralization is the industry’s main advantage compared to other institutions. Decentralized markets are a new page in the global economy, but they try to regulate it with old norms. And the higher the level of centralization, the more the industry will fall under the regulator’s sanctions. This, in turn, will provoke transformations within the industry, and DeFi investors will lose its main distinctive features.

#4 Risk Management

While many DeFi applications claim to be decentralized, some protocols retain leadership groups or other entities, such as selected professional investors or venture capitalists, the right to vote, the right to decide governance issues, or keep some ultimate control, including terminating the protocol.

Therefore, with such governance of DeFi protocols and smart contracts comes several unique risks. The two main areas where risks arise are the control of administrative keys and the rules for the operation of protocol control structures.

#5 DeFi Security Information

Cybersecurity risk management policies and procedures are core elements of the traditional system regulating securities and capital markets. However, perhaps due to the developing and permissionless nature of DeFi, protocols and smart contracts have become susceptible to hacker attacks. Hacks can lead to the leakage of confidential information and loss of funds, often without the possibility of recovery. Therefore, the “audit” smart contracts industry began to take shape.

Saving an administrative key by an individual allows you to disable or change the smart contract or the protocol itself. But storing the administrative key also comes with risks. In some cases, its owner has limited control over users’ funds or private keys. As a result, there are risks such as loss or theft of a key, insider theft of crypto assets stored in a smart contract or protocol, and other cybersecurity issues (for example, ransomware or third-party hacking and flash loan attacks). There is also a risk that the smart contract or protocol will be unexpectedly disabled or changed by the administrator in DeFi ecosystem.

Сonclusion

Some of the risks are inherent in the very nature of blockchains. The other part is related to the interaction of DeFi with the real financial sector, which operates under the laws of a particular jurisdiction. Finally, part of the risks is associated with the impact of the human factor, including fraud and cybercrime. These risk groups make it impossible to say that DeFi today is a peer-to-peer environment without centralized control.

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