How to stay safe in DeFi
DeFi, short for decentralized finance, is a growing sector of the crypto industry that is revolutionizing the way people access financial services.
Unlike traditional finance, which relies on intermediaries such as banks and service providers, DeFi operates based on a transparent set of rules programmed into smart contracts and public blockchain technology.
Leveraging these innovative features, DeFi can provide much higher degrees of transparency, immutability and security.
However, this innovative and rapidly evolving landscape also comes with its fair share of risks and uncertainties.
The allure of high yields, decentralized applications and permissionless access can often overshadow the importance of safeguarding one's assets and data.
To enjoy the benefits of DeFi while minimizing the risks, it's essential to equip oneself with knowledge, tools and best practices that will enable you to navigate this digital frontier safely.
What are the main risks of using DeFi?
The often technical nature of DeFi, with its reliance on smart contracts and decentralized exchanges, brings unique challenges and potential vulnerabilities for all users.
Smart contract risks
Smart contracts lie at the heart of every DeFi protocol. They are what allow DeFi services to operate autonomously — without the intervention of any middleman.
However, these pieces of software can be susceptible to vulnerabilities or flaws in the code. While the smart contract may be able to operate without any human intervention, it is still only as reliable as the human that created it. In some instances, smart contract bugs can lead to financial losses or even a complete loss of funds.
People with programming experience may be able to audit and review the smart contract code themselves. However, for most users that don't have this technical knowledge, it's advisable to only use platforms that have been independently audited by reputable individuals or companies.
Without the technical expertise to verify the functionality of a smart contract themselves, many still need to place trust in the developers that create DeFi applications to operate in the way they’re advertised to. Using DeFi platforms that highly specialized blockchain audit agencies have reviewed is one way to minimize the risk of smart contract vulnerabilities in DeFi. But this should not be relied upon wholly.
The decentralized nature of DeFi creates potential opportunities for scammers to exploit unsuspecting users. Honeypot scams, fake accounts, and other deceitful tactics are prevalent.
These scams typically involve scammers reaching out to victims on social media channels (Telegram, Discord, X, etc) and trying to build a relationship of trust. They may ask for help to send a transaction (honeypot scam) or direct you to use a fraudulent site (phishing scam).
While these scams are nothing new and are hardly limited to the world of DeFi, they are unfortunately common. Without human intermediaries to monitor for scams, DeFi scammers are able to operate with little restriction.
Users must exercise caution when interacting with unknown projects, verifying the credibility of the development team and conducting thorough research before investing in or participating in DeFi protocols.
When providing liquidity to a pool, such as supplying assets like SOL and USDC to a SOL/USDC pool, the relative value of those assets can change over time. This can result in impermanent loss for liquidity providers.
This shift in relative asset values is known as impermanent loss because the loss is only realized if the liquidity provider withdraws their assets at that time. Impermanent loss occurs because liquidity providers take on the risk of market fluctuations while providing the liquidity needed for trading on decentralized exchanges.
Despite impermanent loss, liquidity providers may still profit in the long run.
Many DeFi platforms offer yield farming or liquidity provider (LP) tokens that allow users to earn additional returns in the form of interest fees. These interest fees can sometimes help to offset the impermanent loss and potentially lead to overall profitability for liquidity providers.
A rug pull refers to an exit scam where the developers of a DeFi project create liquidity pools by pairing their own newly-created tokens with popular cryptocurrencies. These pools attract investors looking to earn profits through trading or providing liquidity.
Once a significant amount of funds is locked in the pool, the scammers manipulate the liquidity by selling their newly-created tokens and withdrawing the base tokens, such as Ether (ETH) or Polkadot (DOT).
This leaves investors with worthless tokens and significant financial losses.
There are several common tactics used by rug pullers. One tactic is retaining a large portion of the total token supply after it is first offered to the public. This provides centralization control over the asset, allowing the project’s founders to control the market and manipulate prices.
They often generate hype and enlist social media influencers to attract more investors, creating a false sense of legitimacy.
Once the pool is sufficiently filled with investor funds, the scammers dump their project tokens into the pool, causing the value to plummet before making a swift exit with the base tokens.
Collapses in decentralized finance (DeFi) projects can lead to significant financial losses for investors and users. It is crucial to thoroughly research projects before investing in or interacting with them to identify potential signs of trouble and reduce the risk of such collapses.
One major red flag to watch out for is a lack of transparency in the project's team. It is essential to know who is behind the project and their experience in the blockchain and cryptocurrency industry. Look for information about their development team, their track record, and their involvement in other successful projects.
Paying attention to a project's token distribution plans is also important. If a large portion of the tokens is held by a small number of individuals or there are no clear guidelines on token distribution, it could indicate potential issues with the project's governance or fairness.
The mechanisms of the underlying DeFi protocols may also be susceptible to manipulation, creating opportunities for malicious actors to crash the project.
An infamous example of this type of risk is the Terra Luna collapse of 2022.
When researching a project, it's important to look for a single point of failure or dependency in order to avoid this sort of situation.
Any single point of failure could create systemic issues down the line that ultimately compound until there is a collapse.
At its core, DeFi refers to a set of financial services that are provided by applications built upon blockchain technology. These services are self-operated and do not rely on intermediaries like banks or traditional financial institutions.
Think of any financial service that currently exists in the traditional financial market; be it loans, mortgages, or insurance products. Now imagine if, instead of insurance brokers and traditional banks acting as the gatekeepers to these services, everything was automated based on a transparent set of rules laid out by a computer program.
Instead of waiting days for bankers to approve a loan, or insurance providers to pay out a claim, developers could write a computer program that would instantly provide these services as soon as certain predefined conditions are met.
Developers can build these programs to follow a conditional logic, such as “if a valid certificate is provided, the smart contract will automatically process a life insurance pay out — based on the terms that have already been set.”
DeFi leverages the decentralized nature of blockchain networks to provide these types of financial services in a transparent and autonomous manner. Unlike traditional finance, where centralized institutions control and oversee all transactions, DeFi relies on smart contracts to automate processes and enforce agreements.
Removing middlemen from these services not only saves time and money, but also makes them more accessible for people around the world. As long as people meet the predefined conditions established in the smart contract, there's no need for intermediaries to be involved in intrusive processes like credit checks and storing personal identifying information.
Using these decentralized platforms, anyone — not just those who have been granted exclusive access — can lend or borrow funds.
For example, a person in the United States could lend funds to a person in India using DeFi services. To secure the loan, the smart contract may first require the borrower to deposit an amount of collateral. If a borrower defaults, the smart contract itself can automatically liquidate the collateral and fully reimburse the lender. No intermediary needs to be involved in any step of this process.
Since the agreement is based on a series of clearly defined terms, there is less potential for unexpected outcomes or manipulation. These terms can be defined and mutually agreed upon ahead of time between the individuals entering into the agreement. Facilitating truly peer-to-peer financial services is the true innovation of DeFi.
Tips to stay safe on DeFi
It is vital that crypto users take precautions when using DeFi protocols and stay informed about best practices to protect their funds.
Do you own research — thoroughly
Research is a critical step in staying safe while participating in the world of DeFi.
When exploring a DeFi project, start by examining its website. Look for comprehensive information about the project's goals, features, and use cases. Pay attention to whether the project has a clear roadmap and well-defined token distribution plans. Additionally, review the white paper, which provides insights into the project's technical details, underlying technology, and potential risks.
Don’t simply rely on what a friend told you, or what you heard from an influencer on social media. When it comes to crypto, it is important to verify, not just trust.
Another important aspect to consider is the listed developers or founders of the project. Research their backgrounds, experiences, and contributions to the crypto community. Established and experienced developers can sometimes provide confidence in the project's legitimacy and the team's capabilities.
It is important to note that conducting thorough research does not guarantee the legitimacy of a project or its likelihood of success. However, doing thorough research can help to minimize the risk of falling victim to scams or fraudulent schemes.
If it seems too good to be true — it probably is
While the allure of earning a large reward from minimal effort is appealing to everyone, “there is no such thing as a free lunch,” as the saying goes.
Nearly every financial activity carries some degree of risk, and anyone that insists otherwise should be viewed with a degree of skepticism.
Slowing down and asking yourself if this could potentially be simply too good to be true can be one way to spot something that is simply a fraud.
Two-factor authentication (2FA)
Two-factor authentication (2FA) plays a vital role in securing DeFi accounts and adding an extra layer of security. This allows you to have a second layer of protection beyond your password when signing into certain online platforms.
With the increasing prominence of decentralized finance, it has become crucial for users to take measures to protect their crypto assets.
After enabling 2FA, users are required to enter a verification code in addition to their password when logging into their DeFi accounts. This code is generated through an authentication app, such as Google Authenticator, or it can be sent via a mobile text message. You can also even use a hardware device such as a YubiKey to serve as a form of 2FA.
Even if a user's password gets compromised, the presence of 2FA makes sure that unauthorized individuals cannot gain access to their accounts without the verification code.
By implementing 2FA, users significantly reduce the risk of unauthorized access to their DeFi accounts.
Use a hardware wallet
Using a hardware wallet is important for keeping your DeFi assets secure. These crypto wallets provide an additional layer of security by storing your private keys offline, making it extremely difficult for hackers to access and steal your funds.
Unlike software wallets or online wallets, which are connected to the internet and vulnerable to online attacks, hardware wallets keep your private keys offline on a secure device. This means that even if your computer or smartphone gets hacked, access to any DeFi assets held in cold storage will remain safe.
It's important to understand the advantages and tradeoffs that different types of crypto wallets offer.
You can learn more about the different types of crypto wallets that exist in our Kraken Learn Center article, What are custodial and non-custodial crypto wallets?
Investigate a community
When getting involved in a decentralized finance (DeFi) project, investigating the community surrounding it can sometimes help signal whether a project is trustworthy or not. However, this process shouldn't be relied upon entirely.
Some best practices many people take while investigating a DeFi project’s community include:
1. Check community activity: Look for forums, social media groups, and discussion channels related to the project. Analyze the level of genuine activity and engagement within these platforms. More active communities may indicate a higher level of trust and support provided by users, but be mindful of bots or fake engagement.
2. Evaluate user feedback: Pay attention to conversations and feedback within the community. Read through posts, comments, and reviews to understand the experiences and opinions of other users.
3. Assess transparency and communication: Evaluate how the project team interacts with the community. Transparent and consistent communication from the development team builds trust and makes sure that users are well-informed about any updates or changes.
Disconnect your wallet after each session
It's recommended that all DeFi users should disconnect their crypto wallets after each session when using DeFi platforms. By disconnecting, you prevent other Web3 apps from accessing your wallet details and token balances, reducing the risk of unauthorized access and potential loss of funds.
When you connect your wallet to a Web3 app, it grants access to your wallet's private keys or seed phrase. This authentication allows you to interact with the DeFi platform, but it also means that the app can potentially access your wallet details and token balances even after you have closed the session.
Therefore, disconnecting your wallet is essential to maintain the confidentiality and security of your crypto assets.
Never invest more than you can afford to lose
One of the most important principles to remember when making any investment decision is to never invest more than you can afford to lose. While DeFi offers opportunities to earn rewards, it's especially fraught with risks and you may lose all your invested capital.
Therefore, it's essential to be mindful of the amount of crypto you deploy in these protocols.
Why is safety in DeFi important?
While the DeFi market presents exciting opportunities, it's important to exercise caution.
By being aware of the risks and completing rigorous due diligence, you can help mitigate some of these risks.
Get started in DeFi with Kraken
Now that you have learned more about how to manage the risks of DeFi, are you ready to get started?
Kraken makes it easy to participate in the decentralized financial economy.
Whether you are looking to purchase cryptoassets before using them in a DeFi protocol or looking to convert your crypto holdings back into cash, Kraken makes it easy.
Kraken offers trading on the most popular DeFi assets as well as the most popular cryptocurrencies in the market today.