In the previous article from Lenous Protocol titled “What is DeFi?“, we became familiar with decentralized finance. Decentralized Finance (DeFi) represents a revolutionary concept in the financial world, built on blockchain technology. It aims to make financial services accessible to everyone by eliminating the need for traditional intermediaries such as banks and financial institutions. The primary goal of DeFi is to create an independent and transparent financial ecosystem free from regulatory influence and human error.

Key Components of DeFi

1. Software and Smart Contracts

Smart contracts, which form the backbone of Decentralized Finance, are self-executing contracts with the terms of the agreement written in code. These contracts automate processes, minimizing the possibility of fraud and errors. Developers typically choose the Ethereum network, but DeFi services are also available on other platforms such as EOS, Waves, Tron, NEO, Polkadot, and Binance Smart Chain.

2. Decentralized Exchanges (DEX)

Decentralized exchanges allow users to trade cryptocurrencies without having to trust third parties with their funds. This is achieved through automated algorithms and smart contracts that provide liquidity and secure transactions. DEXs do not require users to provide personal information, making them safer and more anonymous compared to centralized exchanges.

3. Stablecoins

Stablecoins are cryptocurrencies whose value is pegged to real-world assets, such as the US dollar or gold. They provide stability and reduce the risks of volatility commonly associated with most cryptocurrencies. An example of a stablecoin is Tether (USDT), which is used for trading and storing value within the DeFi ecosystem.

4. Liquidity and Lending

In DeFi, users can provide their assets for lending in exchange for interest rates. This creates new investment opportunities and income generation. Platforms such as Aave and Compound allow users to earn interest on their deposits and borrow funds against collateral.

5. Community Participation

A key aspect of DeFi is the active involvement of the community in project governance. Many platforms utilize decentralized autonomous organizations (DAOs), where token holders can vote on changes to protocols and project management.

Advantages of DeFi

Accessibility: Decentralized Finance opens financial services to people worldwide, especially in regions where traditional banks are unavailable.

Transparency: All transactions are recorded on the blockchain, ensuring complete transparency and auditability.

Security: The use of smart contracts reduces the risk of fraud, as the terms of the agreement are encoded and executed automatically.

Low Fees: DeFi platforms generally charge lower fees compared to traditional financial institutions.

Innovation: DeFi is continually evolving, offering new financial tools and earning opportunities.

Risks of Decentralized Finance

Despite its many advantages, Decentralized Finance also faces several significant risks:

1. Smart Contract Vulnerabilities

Smart contracts may contain bugs or vulnerabilities exploitable by malicious actors. Several major attacks on DeFi protocols in the past have demonstrated how easily funds can be lost due to coding errors.

2. Market Volatility

While stablecoins provide some stability, other tokens can experience significant price fluctuations. This poses risks for investors, especially in highly volatile conditions.

3. Regulatory Risks

As DeFi gains popularity, regulatory interest also increases. Uncertainty regarding legislation may create challenges for users and developers, particularly if new restrictions are introduced.

4. Lack of User Protection

Unlike traditional financial systems, which have mechanisms for consumer protection, Decentralized Finance lacks such tools. This means users bear full responsibility for their funds and must exercise caution when selecting platforms.

Future of Decentralized Finance

Decentralized finance has enormous potential for further growth and development. As blockchain technology matures, we can expect the emergence of new solutions and improvements in security, performance, and user experience.

1. Integration with Traditional Finance

As institutional investors and financial institutions show increased interest, we may witness closer integration of Decentralized Finance with traditional financial systems. This could lead to the creation of new financial instruments and services that combine the best aspects of both systems.

2. Development of Regulatory Norms

Over time, regulators may develop new rules and standards for Decentralized Finance, making it safer and more accessible to a broader audience. This could include requirements for compliance with security and transparency standards.

3. New Innovations

DeFi will continue to evolve with the introduction of new technologies and concepts, such as decentralized identifiers (DIDs) and oracles, which can enhance platform functionality and security.

4. Education and Awareness

With the growing interest in DeFi, there will be a need for more educational resources for users. Training on the risks and opportunities of DeFi will help a wider audience understand how to engage safely with this new financial ecosystem.

Increased User Responsibility

The downside to this independence is that the token holder is responsible for their security. If one forgets or has the wallet key stolen, all access to the assets is gone forever. It is this aspect of Decentralized Finance that really impresses on users the importance of rigorous security practices: using hardware wallets, activating two-factor authentication, staying current with security updates, and so on.

Finally, Decentralized Finance engagement requires advanced competence—from understanding smart contracts to the basics of information security. They must be in a position to realize possible vulnerabilities of being phished or socially engineered for sensitive information; crypto space is a hotbed for these activities.

Also, none of the participants are responsible for any actions within the system; technical support from their part in traditional banking is absent. All troubles should be coped with by a user independently. This might look dauntingly overwhelming in case one is fresh in the ecosystem.

Moreover, since these platforms are decentralized in nature, users should be wary of the projects they invest in, for there are no regulating bodies that would recommend the validity of a token or protocol. One needs to ensure that adequate research is done at one’s end, right from the whitepaper all the way to community feedback and team credentials.

In other words, the very elements of Decentralized Finance that celebrate freedom and the like actually put a very high level of burden on users with respect to security and due diligence, thereby placing a premium on education and awareness while treading through this fast-changing landscape.

Infrastructure Failures and Smart Contract Hacks

The proportion of funds stolen from cryptocurrency platforms through DeFi protocols has been steadily increasing since early 2020. As of mid-2022, DeFi protocols accounted for 97% of stolen cryptocurrency, totaling approximately $1.68 billion. Experts believe that a majority of these funds have fallen into the hands of hacker groups linked to governments.

When a critical error occurs in any protocol, there is a risk of vulnerability throughout the entire system, allowing access to any point in the chain. For instance, on August 10, 2021, a major hack targeted the Poly Network, resulting in the theft of $611 million. This incident is currently regarded as the largest theft in the history of decentralized finance.

Additionally, the growth of DeFi transactions presents new technical challenges for cryptocurrency researchers and compliance teams, as the decentralized protocols and applications they use generate difficult-to-trace transactions, more complex than those in traditional centralized services.

Regulatory Uncertainty Surrounding DeFi

The decentralized architecture of Decentralized Finance makes it nearly impossible for governments to regulate it in the same manner as traditional centralized finance (CeFi). Nevertheless, DeFi is an established phenomenon, and governments inherently take on the responsibility of preventing money laundering and terrorism financing through any new financial instruments.

For example, the Russian Ministry of Finance closely monitors the developments in DeFi, partly due to the high risk of financial bubbles that could harm the national economy.

In Russia, Law No. 259 of July 31, 2020, “On Digital Assets” (CFA), stipulates that, starting January 1, 2021, only tokens issued by entities registered with the Central Bank of Russia are allowed for issuance and circulation. Trading platforms must also obtain similar approval from the Central Bank. There are additional restrictions, such as maximum purchase amounts for tokens by unqualified investors.

However, Decentralized Finance tokens operating on public blockchains do not fall into the category of CFAs defined by law, as their developers are unlikely to register with the Central Bank of Russia, leaving them in a “grey area.”

On February 18, 2022, the Ministry of Finance submitted a draft law to the Russian government regarding the regulation of cryptocurrencies, titled “On Digital Currency.” This draft states that the use of digital currencies as a means of payment within Russia will be prohibited. Under the proposed regulation, digital currencies are considered solely as investment instruments.

Currently, there is no specific regulation for the Decentralized Finance sector in other countries either, as even the status of cryptocurrencies is still poorly defined in many places. In countries with regulation and taxation of crypto assets, such as Japan, Australia, the USA, and some EU countries, income from Decentralized Finance is treated within the framework of existing legislation.

Fraud

In 2021, criminals stole over $10 billion through investments utilizing decentralized finance (DeFi) technology. Fraudsters create worthless tokens and lure investors with promises of extremely high returns, a scheme known as a “Rug Pull.” In a typical Rug Pull scenario, fraudsters wait for trading in a liquidity pool to “heat up,” causing the token price to surge, only to withdraw all liquidity and disappear with the funds.

In June 2021, the ISO 23195:2021 standard, titled “Security Objectives of Information Systems of Third-Party Payment (TPP) Services,” was published. This standard defines TPP providers as services that enable merchants to accept online payments without requiring a merchant account. However, the presence of intermediaries increases the risk of fraud during payment processing.

ISO 23195 includes an internationally agreed-upon list of terms and definitions, two logical structural models, and a list of security objectives. To ensure maximum relevance, the logical structural models, assets, threats, and security objectives in this document are based on real-world practices.

Given that TPP service providers continually strive to reduce fraud risks during payment transactions, this standard serves as a valuable complement to existing security measures.

Low Performance of DeFi

By nature, blockchains operate more slowly than their centralized counterparts. Consequently, as the volume of transactions increases, the performance of DeFi protocols significantly declines.

Disorder in the DeFi Ecosystem

As a growing sector, the DeFi ecosystem has yet to fully mature. Therefore, finding the most suitable, reliable, and secure application can be quite challenging. However, DeFi services are actively evolving, aiming to simplify the use of this technology and address its shortcomings, including security issues.

Conclusion

The success of DeFi lies in its accessibility and independence: anyone can participate in creating and using DeFi products, regardless of citizenship or residence, as the protocols and economic models of the services are open for verification and auditing. However, the increasing investments in DeFi attract the attention of more hacker groups, exacerbated by the technical complexity of the field, the often insufficient qualifications of users, and the lack of effective regulatory oversight.

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