Hacking of funds is a major risk of using DeFi

Risks of Decentralized Finance

March 5, 2021

When using Decentralized Finance there are many risks that could cause losses. We will explore ways to mitigate these risks and keep our crypto safe in future articles.

Hacking

Example: the vault you locked your coins in has an exploit allowing hackers to take the coins.

All decentralized finance contracts have potential vulnerabilities. There is no guaranteed safe investment on the blockchain. Even blue chip DeFi institutions have been hacked and lost millions of dollars. Hacking vulnerabilities could come from the blockchain, the smart contract, or other software used by services.

Loss of Principal

Example: the stablecoin you bought has a flaw in it's stability mechanism, printing huge numbers of coins and dropping its value to zero.

Cryptocurrencies are not guaranteed to hold their value, even stablecoins. When making an investment consider a plan to protect your principal - whether it's a stop loss price or simply write off the principal in expectation of enough income to cover the loss.

Bugs

Example: a smart contract version upgrade has gone wrong, locking the invested funds into the contract forever.

Funds could become lost or immobile due to unintended bugs in the contract code. The product may also not function as intended despite being formally audited.

Slippage and Exchange Rate Losses

Example: the price of Bitcoin doubles, wiping out your liquidity provider gains.

Many products are exposed to market fluctuations and can lose money due to volatile exchange rate changes. Trading sites like PancakeSwap will expose you to “impermanent loss” which affect assets which rise or fall significantly. Even more dangerous is when dishonest token operators perform "rug pulls" where they drain liquidity pools using worthless tokens.

Variable Interest Rates

Example: cryptocurrency interest rates drop, causing your advertised 30% rate to drop to a real 1% rate.

Advertised interest or reward rates will vary daily, and actual interest rates may be less than the best possible rates.

Counterparty Risk

Example: the protocol you invested in has gone bankrupt, and disabled withdrawls.

Risk that the website, service, company, or its suppliers go bankrupt and close. Many scammers exist in the crypto space, and many companies are exposed to significant risk if they work with them.

Losses Not Insured

Example: a large selloff in the cryptocurrency market drops the price of Bitcoin and Ether. The lending protocol becomes severely undercollateralized and suffers losses, which are not insured.

Crypto lending protocols offer savings rates and loans just like real banks. However, they are not insured by governments against loss.

Losing your keys

Example: your laptop breaks and you have not written down your seed phrase. The funds cannot be recovered.

If you lose your crypto wallet key or password, the funds are lost forever.

Irreversible Actions

Example: you mistype an address or an amount and the transaction is processed. On the blockchain, this is irreversible.

Many centralized institutions like banks and credit card companies exist because they let you correct mistakes. The blockchain offers returns and freedom- but in exchange, also the responsibility to not make a mistake with your funds.
US Tax Considerations

All cryptocurrency transactions in the USA are taxable. The majority of DeFi investments should be treated as capital gains, payable when you close the transaction or when coins return to your wallet. The change in value of all tokens involved in the transaction should be considered. Certain exotic crypto investments, which continually deliver tokens to your wallet, could be considered interest or some other type of income. This is not financial advice: please consult a tax adviser or lawyer if you have questions.