Key Takeaways:
- Security is your responsibility. Use hardware wallets, verify dApps, and never share your seed phrase/private keys.
- Market volatility affects everything and everyone. Prices can swing fast, impacting trade, loans, and liquidity. Have a risk management plan.
- Not all DeFi projects are trustworthy. Watch out for scams, rug pulls, and unaudited protocols. If it sounds too good to be true, it probably is.
DeFi is powerful and risky. Knowing these risks is just as important as knowing these different protocols and the rewards they give. Let’s break down the key dangers and how to stay protected.
💡New to DeFi? Know the basics of DeFi in this guide
The Biggest Risks in DeFi & How They Impact You
DeFi brings financial opportunities, but it’s not without its pitfalls. From security flaws to market manipulation, understanding risks is crucial before diving in. Below are some of the most common risks in DeFi and how they can affect you.
1. Smart Contract Risks
Smart contracts make it easier to execute digital agreements. DeFi runs on smart contracts—automated code that executes transactions. If these contracts have bugs, vulnerabilities, or security flaws, they can be exploited by hackers, leading t o massive losses. Once funds are drained from a protocol, they’re often gone for good. Be sure to use well-audited, well-known, and battle-scarred platforms.
How It Can Go Wrong
- Bugs and Vulnerabilities: A poorly written smart contract can have hidden flaws that hackers can exploit. Small errors can be detrimental.
- Exploits and Hacks: Attackers actively scan DeFi projects and platforms for weaknesses. If they find one, they can drain liquidity pools, manipulate prices, or bypass security measures.
- Irreversible: Unlike traditional banking measures, transactions in DeFi (and crypto in general) are irreversible. Once an exploit happens, your funds are often lost permanently.
🔍 Examples
- The DAO Hack (2016): Vulnerability in Ethereum’s DAO smart contract led to millions of dollars lost.
- Nomad Bridge Hack (2022): A smart contract bug let anyone copy transactions and drain over $190M.
- The Bybit Hack (2025): Hackers exploited vulnerabilities in the platform’s security infrastructure, resulting in the theft of approximately $1.5B worth of ETH.
What You Can Do
- Stick to Audited Projects: Choose platforms with reputable third-party audits.
- Check for open-source code: Transparency allows security experts to verify contract safety.
2. Liquidity Risks: When There’s Not Enough to Trade
Liquidity is the lifeblood of DeFi and crypto—it ensures smooth trading, borrowing, lending, and more. When liquidity is low, things can go wrong fast.
How It Can Go Wrong
- High Slippage: When liquidity is low, large trades can drastically impact prices, leading to worse-than-expected trade execution.
- Failed Transactions: Insufficient liquidity can cause transactions to fail, resulting in wasted gas fees and missed opportunities.
- Exit Difficulties: Withdrawing assets from a low-liquidity protocol can be challenging, often requiring acceptance of substantial losses or delays.
🔍 Examples
- Celsius Network Liquidity Crisis (2022): The crypto lending network Celsius faced severe liquidity issues leading up to its bankruptcy filing in July 2022. The platform paused all customer withdrawals due to “extreme market conditions”, leaving users unable to access their funds.
What You Can Do
- Keep an Eye on Total Value Locked (TVL): High TVL means a protocol has strong liquidity.
- Be Cautious of High-Yield Pools: Some protocols offer unsustainable rewards to attract liquidity, but once incentives dry up, liquidity can disappear overnight.
- Monitor Trade Volume: Active markets reduce the risk of failed trades, be sure to check the available data.
3. Oracle Manipulation: When Data Turns Deceptive
Oracles act as bridges between blockchains and real-world data, providing essential information like asset prices to DeFi protocols. However, when these data feeds are tampered with, it can lead to significant losses.
How It Can Go Wrong
- Wrongly Priced Trades: Manipulated oracles can provide incorrect asset valuations, leading users to execute trades at unfavorable rates.
- Erroneous Liquidations: DeFi lending platforms rely on accurate price feeds to determine collateral values. If an oracle is compromised, users may face unwanted liquidations.
- Arbitrage Exploits: Attackers can create artificial price discrepancies across platforms, exploiting these “gaps” for profit.
🔍 Examples
- Mango Markets Exploit (2022): An attacker manipulated the price of the MNGO token on the platform, inflating its value and using it as collateral to drain approximately $117M from the protocol.
What You Can Do
- Cross-Reference Data Feeds: Relying on multiple oracles can help validate the accuracy of information. Read more here.
4. Regulatory Risks: When Governments Step In
DeFi and crypto operates in a rapidly evolving legal landscape. Regulatory actions can significantly impact the accessibility and functionality of DeFi platforms, introducing uncertainties for users and developers.
How It Can Go Wrong
- Access Restrictions: Governments may impose bans or restrictions on DeFi and crypto platforms in general, limiting user access.
- Compliance Burdens: New regulations can require different DeFi platforms to implement compliance measures, increasing the learning curve for users and increasing operational burden.
- Legal Ambiguities: Unclear regulatory frameworks can lead to legal challenges for DeFi projects, affecting their stability and user trust.
🔍 Examples
- US Legal Actions Against DAOs (2024): A judge ruled that venture backers of Lido DAO could be liable for selling unregistered securities, highlighting the legal risks associated with decentralized organizations.
What You Can Do
- Stay Informed: Keep track of regulatory developments in your area that may affect DeFi activities.
- Understand Legal Obligations: Be aware of legal responsibilities, such as tax requirements, when participating in DeFi.
5. Front-Running & MEV: When Bots Beat You to the Punch
In the DeFi world, front-running and Maximal Extractable Value (MEV) refer to tactics where bots or validators exploit the transaction ordering system for profit, often at the expense of regular users.
How It Can Go Wrong
- Transaction Hijacking: Bots monitor pending transactions and insert their own to capitalize on anticipated price movements.
- Sandwich Attacks: A bot places a buy order before and a sell order after a user’s transaction, profiting from the price impact caused by the user’s trade.
- Increased Costs: Users may end up paying higher prices or receiving fewer assets than expected due to these manipulative tactics.
🔍 Examples
- “jaredfromsubway.eth” Bot: The notorious MEV bot monitored by the community for large trades. Upon detecting a significant transaction, it would swiftly execute its own buy order ahead of the user’s trade and sell immediately after, profiting from the price movement induced by the user’s transaction.
- Uniswap V2 Sandwich Attacks: On the Uniswap V2 platform, bots frequently executed sandwich attacks by detecting large pending transactions. They would front run the user’s trade with a buy order, and immediately a sell order after the user’s transaction is finished.
What You Can Do
- Study Slippage Tolerance: Define your acceptable slippage limits to prevent significant losses from unexpected price movements during the transaction.
6. Liquidation Risks: Navigating the Volatility
In DeFi lending platforms, users can borrow assets by providing collateral. However, due to crypto’s volatility, value of collaterals can fluctuate rapidly. This fluctuation of assets can make the platform liquidate assets to maintain system stability, which may lead to a significant loss to the borrower.
How It Can Go Wrong
- Market Volatility: Sudden price drops can swiftly decrease the value of collateral.
- Oracle Failures: As specified in previous sections, inaccurate price feeds can misrepresent collateral values, leading to unwarranted liquidations.
- Network Congestion: High transaction volumes can delay user actions to add collateral or repay loans.
🔍 Examples
- Aave’s CRV Token Liquidation (2022): A user borrowed approximately $40M worth of CRV tokens using USDC as collateral. A sudden price drop in CRV led to a liquidation event, causing Aave to incur bad debt.
What You Can Do
- Over-Collateralize: Provide more collateral than the minimum requirement to buffer against market volatility.
- Monitor Positions: Regularly check the health of your loans and be prepared to add collateral or repay portions to avoid liquidation.