5 DeFi Risks

I just finished a 2 hour readthrough of Nic Carter's & Linda Jeng's 'DeFi Protocol Risks: The Paradox of DeFi' for the Ethereum Audible Podcast. They point out 5 key risks - which have all come true over the past year.

Here's a brief summary of the 36 page article and 5 risks.

DeFi is growing and is quickly on its way to becoming a new financial paradigm. But...there are financial risks in DeFi that manifest in new ways that we haven’t seen in the traditional financial system. The 5 risks pointed out are:

1. Interconnections with the traditional financial system
2. Operational risks stemming from underlying blockchains
3. Smart contract-based vulnerabilities
4. Other governance and regulatory risks
5. Scalability challenges.

Let's look at each.

1. Interconnections with the traditional financial system:

Stablecoins are the main connection to the existing financial system. They're pegged to fiat, but also via custodian banks. Stablecoins are one of the killer apps for crypto, but offer a centralization risk. Lyn Alden covers stablecoin centralization risk in her article: "Proof-of-Stake and Stablecoins: A Blockchain Centralization Dilemma" (did a readthrough of that a few weeks ago: https://open.spotify.com/episode/3cTMt0friaFdmWwJvbDtmX?si=2MYAbps7Ra-fq50oEbCmUg)

1. Operational risks stemming from underlying blockchains

Consensus failures (aka what happened to SOL recently), protocol changes, changing security assurances (PoW or PoS) all can be risk vectors for any protocol built on top.

1. Smart contract-based vulnerabilities

All the bugs you can imagine that allow draining of funds. Most famous of which - the DAO hack, but also most recently the Wormhole hack. Oracle attacks also are a vulnerability vector (https://www.theverge.com/2022/2/3/22916111/wormhole-hack-github-error-325-million-theft-ethereum-solana)

1. Other governance and regulatory risks

These risks include bad regulation or multi sig management - aka Axie's Ronin hack. Flash loans can be used to sway governance as well - a new risk unique to DeFi, aka the Beanstalk attack last week.

1. Scalability challenges

Inelastic block space can lead to high fees, irregular execution or transactions that don't go through at all - which lead to unexpected edge cases.

To bring it all together, DeFi is developing super fast, bringing more innovation to the financial world than any time since the 1800s. But it comes with new sets of risk. We're in heading west, as they like to say on Bankless!

For the full readthrough (~2 hours) you can give it a listen on @EthereumAudible podcast or read the entire paper here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3866699.

Enjoy!