Decentralized Finance is subject to significant risk, learn more about potential risk factors in order to mitigate the impact.
Phishing attempts & Private Keys
Your private keys¹ and seed phrase² are the keys to your wallet and anybody who has these keys can get in, these are for your eyes and your eyes only. No customer support will ever ask you for your private key or seed phrase. Be aware of social engineering and phishing attempts to obtain your private information or download malware into your devices, avoid clicking links from unreliable sources and never download files from strangers. Only use reputable exchanges and products to mitigate risk of scams and trojan attack vectors.
Learn more: Common Scams on Mobile Devices, Binance Academy
Smart Contract Exploit
Smart contract exploits happen when a bad actor takes advantage of an existing code for their own benefit. In DeFi, it's important to understand how exploits happen and know how to defensively protect yourself from the impact of potential exploit. The strongest ways to mitigate smart contract risk are only using reliable protocols, using a hardware wallet, and revoking approvals.
Learn more: What is Smart Contract Risk?, Coinmarketcap Alexandria
Be aware of potential volatility when buying tokens on DEXs, providing liquidity and staking in protocols. Price volatility is directly related to impermanent loss incurred in liquidity pools. Use single sided asset pairings and highly correlated pairs to avoid impermanent loss, avoid staking with high volatility tokens.
Black Swan Events
A black swan refers to an unpredictable, low probability event that results in catastrophic consequences, the term was popularized by Nassim Taleb in The Black Swan: The Impact of the Highly Improbable. Taleb's interpretation of black swan theory as it applies to any event contains three components: Rarity, Results in Severe Consequences, Rationalized Post-Occurrence.
Learn more: Black Swan Theory, Wallstreet Prep
An example of a recent black swan event in the crypto industry is the depegging³ of UST and collapse of Terra Luna, resulting in a $60 billion dollar wipeout on the market. Black swan events are often not isolated to the event that causes them, but continue to create ripple effects in aftermath. In the months following the collapse of UST and Terra Luna, we saw the subsequent collapse of CeFi⁴ lending platforms Voyager and Celsius, as well as the fall of Su Zhu & Kyle Davies' Three Arrows Capital. It is important to keep in mind that contagion⁵ often follows black swan events in crypto. Popularized methods of mitigating risk for black swan events include portfolio, protocol and wallet diversification, don't put all your eggs in one basket.
Learn more: Unstable Stablecoin: How Cryptos Crash Broke the Buck for Terra's UST, Forbes - Crypto Broker Voyager Digital Files For Chapter 11 Bankruptcy, Forbes - Bankrupt Crypto Lender Celsius Receives US Grand Jury Subpoena, Bloomberg - 3AC Founders Su Zhu & Kyle Davies Have Vanished, Like Terra LUNA CEO, Be in Crypto
Regulation & Censorship
DeFi is a new branch of blockchain technology, as such it is subject to heavy scrutiny by regulators and subsequently, centralized entities. When interacting with DeFi it is important to be aware of potential regulatory changes and ways they may affect you.
A recent example of sanctions and regulations on DeFi, directly impacting users, is the Tornado Cash sanctions by the Treasury Department and OFAC. Tornado Cash is a well known privacy mixer, used to facilitate private transactions; the primary purpose of Tornado cash is to obscure the sender from the recipient, breaking the trail from the origins of the assets.
Learn more: What are Coin Mixers and How do They Work?, Decrypt
In 2022 the Treasury Department and OFAC issued sanctions on Tornado Cash and all wallets that had interacted with the protocol, resulting in several DeFi front ends⁶ (subsequently attempting to remain compliant) blacklisting wallets that had interacted with the Tornado Cash protocol.
It is however important to note that while a front end can blacklist a user from an interface they can not blacklist a user from a decentralized protocol. Meaning, if there is more than one front end, a wallet will still have access to the protocol. This is not true when dealing with centralized entities, such as USDC Circle, who have the ability to blacklist with finality.
Learn more: Trust, Intermediaries and Censorship, The Defiant - Tornado Cash Sanctions By U.S. Treasury Draw Outrage, Suits From Community, Forbes
¹Private Keys are address agnostic, meaning they allow access into a single generated wallet address, single chain or EVM compatible.
²Seed Phrase refers to the keys to your entire wallet, every chain and address generated on a Metamask or hardware wallet.
³Depegging refers to when a token deviates from its intended price peg. Meaning, the tokenomics tie to the price of an external asset, when the token price deviates from the price of the external asset, it is depegging. Tokens with price pegs include stablecoins, which are intended to hold a 1:1 ratio with the US Dollar, as well as other tokenized assets, such as gold. In this example, UST was a stablecoin, with a $1 peg. Learn more: TerraUSD Collapse & Reasons for Failure, Blockhain Education Network
⁴CeFi is Centralized Finance, essentially, the concept of DeFi with yield returns and lending services, but with funds held through a third party custodian. At of the time of writing, every trusted CeFi product has gone bankrupt; due to this we won't go too far into them. Learn more: DeFi vs. CeFi: Comparing decentralized to centralized finance, Cointelegraph
⁵Contagion is a spread of market disturbances, this is the ripple effect of downside on financial markets in response to a macroeconomic shock - an unexpected event that has a large scale impact on the economy, or in this case a black swan.
⁶DeFi front ends are front end interfaces used to interact with decentralized protocols. The DEX websites you visit are front ends, whereas the code is decentralized. Be aware of the potential for "Front End Exploit", in which the interface can be compromised; stay up to date on social media for team updates.
You just finished a crash course in Decentralized Finance.
You should be proud that you took the time out to learn something new.
These resources will remain free & publicly available, so return anytime :)
Looking for more updates on DeFi? Join my Telegram broadcast channel.
Don't worry - I won't spam you, this channel is for important updates and AMAs only.
These resources are intended for general guidance and educational purposes only. I am not an investment or financial advisor, and make no representation regarding the advisability of investing.
For convenience only, this website may provide links or pointers to third party sites. While all information is provided in good faith, I make no representations about any other websites that may be accessed from this website. If you choose to access any such sites, you do so at your own risk.
Decentralized Finance is subject to significant risk, including risk related to smart contracts.