Cathy Ross, the finance and tech expert behind Fraud.net‘s AI-powered risk management platform.
Welcome to the Wild West of the financial world: decentralized finance. Known simply as “DeFi,” this ecosystem leverages blockchain to provide financial services to users without banks, brokers or traditional financial institutions. It promises greater inclusion, transparency and efficiency, but it is unfortunately vulnerable to significant risks.
This is something I’m seeing firsthand from founding and running a fraud and risk company that evaluates online transactions, and we provide services to payment companies, banks and exchange platforms. Most exchange and payment platforms come with very specific risks, and DeFi is no different, but its ever-evolving nature and changing regulations make it a little harder to risk manage.
Understanding Decentralized Finance
DeFi offers an alternative to traditional banking and financial services by using decentralized exchanges (or “DEXs”) that trade digital assets, lending platforms, yield farming and insurance protocols. These services are powered by smart contracts—self-executing contracts with terms directly written into code—which remove the need for centralized intermediaries and allow users to interact directly. Parties can negotiate their own interest rates and lend money via DeFi networks.
By eliminating middlemen, DeFi can lower costs and offer services to anyone with the internet, regardless of location or banking status. Its promise of democratizing finance has attracted investors, developers and entrepreneurs, but its decentralized nature also means there is no central authority to enforce security or provide recourse in case of fraud.
A Brief History
The possibility for a decentralized financial system began in 2009 with the launch of the first cryptocurrency, Bitcoin, followed by a second-generation blockchain in 2015, Ethereum. This contained smart contracts, allowing developers to create various decentralized apps.
In 2017, protocols such as decentralized exchanges began to emerge, contributing to the growth of initial coin offerings. ICOs gave individuals and non-institutionalized entities the power to fund a new type of financial project on a large scale.
Unfortunately, the pandemic caused a market implosion early in 2020. Later that year and in 2021, many factors contributed to restoring the ecosystem’s popularity until the “crypto winter” (bear market) that occurred in 2022 and 2023, which was partly caused by the collapse of FTX.
The Rise Of Fraud In The DeFi Ecosystem
As the DeFi space has grown, so too has fraud. While its decentralized nature aims to provide users with more autonomy, it also creates an environment where bad actors can thrive. Without traditional forms of oversight, criminals have found innovative ways to exploit the system, often with devastating consequences:
1. Market Manipulation: This commonly takes the form of a rug pull, one of the most common types of fraud in DeFi. This occurs when the developers of a DeFi project promote it aggressively and attract a large number of investors until abruptly pulling out, disappearing with the liquidity and leaving investors with worthless tokens.
2. Smart Contract Exploits: While smart contracts, a key part of DeFi, are considered secure and tamper-proof, they are not immune to vulnerabilities. Hackers can exploit flaws in the code to manipulate the system, draining funds from users or causing other types of financial loss. For example, in 2020, the DeFi platform YAM Finance suffered a rebasing contract bug that led to the crash of its market value. This highlighted the potential risks of relying on unaudited code. DeFi platforms that deploy unaudited or poorly written smart contracts make themselves susceptible to attacks.
3. Phishing Attacks: In the context of DeFi, phishing attacks can happen via email or take the form of fake websites that mimic legitimate DeFi platforms. Once an attacker gains access to a user’s private key, they can steal funds or manipulate transactions. New DeFi users may be targeted with schemes that exploit their lack of understanding about digital wallets and security.
4. Flash Loan Attacks: Flash loans, a unique feature of DeFi, allow users to borrow assets without collateral as long as the loan is repaid within the same transaction. In a flash loan attack, however, malicious actors borrow large sums of money, use the loans to manipulate the price of assets, and then profit from the manipulated prices. The result can destabilize entire DeFi markets.
Mitigating The Risks Of DeFi Fraud
There are several best practices to navigate the DeFi ecosystem more safely:
1. Conduct your due diligence. Before investing in any DeFi project, conduct thorough research. This includes reading whitepapers, examining the team behind the project, and checking for any independent audits of the smart contracts. Investors can consider using platforms that offer smart contract audits to help identify vulnerabilities.
2. Diversify. As with any investment strategy, diversification is key. By spreading investments across multiple DeFi projects, you can reduce your exposure to a single point of failure. And, of course, it’s wise to only invest what you can afford to lose, as the DeFi space remains highly speculative.
3. Use reputable platforms. Choose well-established DeFi platforms with a good track record. Projects with large user bases, established reputations and third-party audits are generally less risky than new or untested platforms.
4. Consider security best practices. Implement security best practices such as using two-factor authentication and hardware wallets to store private keys, and avoid sharing sensitive information. Regularly updating software and avoiding public wifi networks when transacting in DeFi can also reduce the risk of hacks.
DeFi Today
DeFi has seen explosive growth, fueled by increased scrutiny and technological advancements like artificial intelligence, which is helping make the ecosystem more secure. Current DeFi protocols incorporate better security measures, user-friendly interfaces and more robust governance structures. Platforms are increasingly integrating with traditional financial systems, expanding access to digital assets.
The rise of decentralized finance has enormous potential to reshape the global financial landscape by offering open and permissionless financial services. However, the lack of regulation, combined with the complexity of smart contracts and the prevalence of high-risk schemes, has made DeFi an attractive target. DeFi will likely see greater innovation in security and regulatory frameworks, but until then, understanding and mitigating risks associated with this growing ecosystem is crucial for investors and businesses looking to navigate the decentralized economy safely.
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