Complete DeFi Risk Guide
DeFi Risk Overview
DeFi offers high return opportunities along with various risks. The advantage of decentralization where "code is law" also means "mistakes cannot be undone."
Risk Categories:
- Technical Risks: Smart contracts, oracles, infrastructure
- Economic Risks: Liquidation, IL, liquidity, depegging
- Operational Risks: Team, governance, rug pulls
- Regulatory Risks: Legal, tax, sanctions
Technical Risks
Smart Contract Bugs
Description:
- Loss of funds due to code errors
- Unintended behavior
- Exploitable by attackers
Cases:
- DAO Hack (2016): $60M
- Wormhole (2022): $320M
Mitigation:
- Check audits
- Verify TVL and operating history
- Bug bounty programs
Oracle Risk
Description:
- Price feed errors/manipulation
- Incorrect liquidation triggers
- Arbitrage exploitation
Cases:
- Harvest Finance (2020): $34M oracle manipulation
Mitigation:
- Protocols using reliable oracles like Chainlink
- Multiple oracle references
Protocol Dependencies
Description:
- Using combinations of multiple protocols
- Cascading effects if one fails
- Double-edged sword of "money legos"
Examples:
- Problem with Curve that Yearn uses
- Lido issue in strategies using stETH
Mitigation:
- Understand dependency chains
- Be cautious with complex combinations
Frontend/Infrastructure Risk
Description:
- Website hacks
- DNS hijacking
- Malicious transaction inducement
Cases:
- BadgerDAO (2021): $120M loss from frontend hack
Mitigation:
- Verify addresses directly
- Use hardware wallets
- Check transaction details
Economic Risks
Liquidation Risk
Description:
- Forced liquidation when collateral value drops
- Collateral - Debt - Liquidation Penalty = Remainder (or 0)
Applies to:
- Lending borrowing
- CDP (DAI minting)
- Leveraged positions
Mitigation:
- Maintain conservative collateral ratio
- Monitor health factor
- Set up alerts
Impermanent Loss (IL)
Description:
- Loss from asset ratio changes when providing LP
- Greater loss with larger price movements
Applies to:
- AMM liquidity provision
- Especially volatile pairs
Mitigation:
- Choose correlated asset pairs
- Stablecoin pools
- Calculate IL before entering
Liquidity Risk
Description:
- Insufficient liquidity at withdrawal
- Large slippage
- Lending pool depletion
Cases:
- Aave/Compound withdrawal delays during high utilization
Mitigation:
- Check liquidity depth
- Have alternative routes for emergencies
- Avoid concentrating entire position in one place
Depegging Risk
Description:
- Stablecoin price deviation
- LST price deviation (stETH, etc.)
Cases:
- UST collapse (2022): $40B
- USDC SVB incident (2023): Temporarily $0.87
Mitigation:
- Diversify stablecoins
- Monitor depegging
- Have immediate response plan
Token Price Risk
Description:
- Reward token price decline
- Governance token value decline
- Unable to realize APY
Mitigation:
- Regular harvesting and diversification
- Analyze token fundamental value
- Be wary of excessive incentive dependency
Operational Risks
Rug Pull
Description:
- Development team steals funds and disappears
- Liquidity removal
- Backdoor exploitation
Types:
| Type | Method |
|---|---|
| Liquidity Rug | Withdraw LP tokens and flee |
| Minting Rug | Mint unlimited tokens and sell |
| Backdoor Rug | Exploit hidden admin functions |
Warning Signs:
- Anonymous team
- No audit
- Unlocked team tokens
- Excessive APY promises
- Unverified code
Mitigation:
- Be cautious of anonymous protocols
- Check audits
- Verify team token lockups
- Be careful with low TVL new protocols
Team/Key Risk
Description:
- Admin key loss/theft
- Internal team disputes
- Development abandonment
Cases:
- Multichain (2023): CEO disappearance, $125M+ loss
Mitigation:
- Check multisig
- Verify team transparency
- Prefer immutable contracts
Governance Risk
Description:
- Malicious proposals passing
- Centralization from token concentration
- Governance attacks
Cases:
- Beanstalk (2022): $180M governance attack
Mitigation:
- Check governance structure
- Verify token distribution
- Presence of timelock
Regulatory Risks
Legal Uncertainty
Description:
- Unclear legal status of DeFi
- Different regulations by country
- Sudden regulatory changes
Examples:
- US SEC token securities classification
- EU MiCA regulations
Sanctions Risk
Description:
- OFAC sanctioned address blacklists
- Forced protocol censorship
- Asset freezing
Cases:
- Tornado Cash sanctions (2022)
- Related address USDC freezes
Tax Risk
Description:
- Complex tax treatment
- Non-reporting risks
- Retroactive taxation possibility
Mitigation:
- Record all transactions
- Consult tax professionals
- Conservative tax planning
Risk Assessment Framework
DYOR Checklist
Protocol Basics:
- Audit completion
- TVL size and trends
- Operating period (minimum 6 months)
- Hack history
Team and Governance:
- Team disclosure status
- Team token lockup
- Governance structure
- Multisig status
Economic Model:
- Revenue source (real yield vs inflation)
- Token distribution
- APY sustainability
Dependencies:
- Other protocols used
- Oracle type
- Bridge usage
Risk Scoring
| Factor | Low Risk | High Risk |
|---|---|---|
| Audit | Multiple audits | None |
| TVL | $100M+ | Under $1M |
| Operating Period | 2+ years | Under 1 month |
| Team | Disclosed | Anonymous |
| Code | Immutable | Upgradeable |
Risk Management Strategies
1. Diversification
Fund Diversification:
- Less than 20% in single protocol
- Utilize multiple chains
- Mix multiple strategies
Stablecoin Diversification:
- USDC 40%
- USDT 30%
- DAI 20%
- LUSD 10%
2. Position Sizing
Rules:
- Only portion of total portfolio in DeFi
- Small amounts in high-risk protocols
- Only amounts you can afford to lose
3. Monitoring
Tools:
- Zapper, DeBank: Position tracking
- DeFi Saver: Automated management
- Telegram/Discord alerts
Check Frequency:
- Liquidation risk: Daily
- General positions: Weekly
- During market volatility: Constantly
4. Exit Plan
Determine in Advance:
- Stop-loss levels
- Exit routes (check liquidity)
- Emergency contacts
5. Insurance
Options:
- Nexus Mutual
- InsurAce
- Protocol's own insurance
Limitations:
- Doesn't cover all risks
- Premium costs
- Strict payout conditions
Risk Response Summary
| Risk | Probability | Impact | Mitigation |
|---|---|---|---|
| Smart Contract Bug | Medium | High | Check audits, diversify |
| Liquidation | Medium | Medium | Conservative collateral ratio |
| IL | High | Medium | Correlated pairs, calculate |
| Rug Pull | Low (if verified) | High | DYOR, avoid new protocols |
| Depegging | Low | High | Diversify, monitor |
| Regulatory | Medium | Medium | Track information, diversify |
Summary
DeFi risks are categorized into four types: technical (smart contracts, oracles), economic (liquidation, IL, depegging), operational (rug pulls, governance), and regulatory (legal, sanctions). While all risks cannot be eliminated, they can be managed through diversification, appropriate position sizing, continuous monitoring, and exit planning. Verify protocols through DYOR (Do Your Own Research), only invest amounts you can afford to lose, and remember that complex strategies mean complex risks.
Next article: Smart Contract Security - Causes and Defenses Against Hacks