Overview of DeFi Security Challenges and Best Practices to Overcome Them

Given that crypto assets have long been a tempting and lucrative target for fraudsters worldwide, the DeFi space has witnessed zillions of scams and hacks, which have put DeFi security at risk.

According to the 2023 Crypto Crime report by Chainalysis, in 2022 the number of DeFi frauds was on the rise, and DeFi protocols accounted for 82.1% of all cryptocurrency stolen by hackers, up from 73.3% in 2021. The statistics look really daunting, and, at the time of writing, the lost DeFi funds amount to a total of around $4.26 billion (ouch!).

But how can the situation be reversed, and what can DeFi users actually do to protect their crypto assets and stay safe in this ever-changing world of decentralized finance?

Read on to find out more about the most pressing DeFi security challenges and check out which practices and approaches can help overcome them.

What are the most widespread DeFi security challenges?

In recent years, DeFi apps have faced numerous hacks and breaches that have compromised their security and led to huge financial losses for users. The majority of these attacks have been the result of DeFi security challenges related to smart contract vulnerabilities, rug pulls, the absence of adequate regulatory frameworks, heavy reliance on some centralized components, oracle manipulations, and simple human error.

Now let’s take a closer look at each DeFi security challenge.

Smart contract vulnerabilities

Smart contracts are regarded as the cornerstone of decentralized finance applications. They make it possible to automatically carry out transactions and facilitate lending, borrowing, margin trading, and many other processes related to financial software development.

Still and all, smart contracts are vulnerable to lots of different hacks and exploits that come from codebase weaknesses and errors made by developers at the early stages of the app’s development. In the long run, hackers take advantage of those code imperfections and loopholes and manipulate the DeFi protocol so as to steal users’ funds and assets.

For instance, the recent Deus DAO hack was due to a basic implementation error in its token contract. As a result, the DeFi protocol lost over $6 million.

Rug pulls

Rug pulls have been another commonplace DeFi security challenge.

In this type of scam, hackers, aka fraudulent developers, invite users and businesses to invest in their “upcoming” DeFi projects, and push up the price of the project’s token to create hype and buzz around their campaign and make it look trustworthy.

However, once unsuspecting users have invested in the scam, fraudsters delete all traces of their involvement and leave the project, fleeing with investors’ funds.

Unfortunately, in spite of users being fully aware of DeFi rug pull scams, they still swallow the bait and transfer their funds to fraudsters. For example, it was recently reported that a Cronos-powered algorithmic lending protocol managed to steal around $600,000 from users before deleting all of its social media pages.

Absence of adequate regulation

Despite the fact that a lot of time has passed since DeFi rose to prominence, it still does not have sufficient all-encompassing regulatory frameworks. This imposes certain security risks, making DeFi security more vulnerable to malicious activities and financial manipulation, and allowing fraudsters to find legal loopholes and come up with ways to drain users’ funds.

Another problem related to regulatory aspects is that the existing DeFi regulations differ across international jurisdictions and lack certain regulatory coordination and unity. This proves rather bewildering for DeFi investors as they do not have clear and concise rules to follow.

In addition to this, given that the majority of DeFi applications are based on permissionless blockchains, it is difficult to tax and report transactions executed with digital currencies. In May 2022, it was even reported that the Internal Revenue Service may be missing out on more than $50 billion a year from crypto traders not paying their taxes.

So, even those DeFi users who are striving to do everything right and in accordance with the law may face regulatory obstacles due to the lack of clear DeFi regulation.

Heavy reliance on some centralized components

As paradoxical as it may sound, decentralized finance is still reliant on some centralized components such as price feeds and liquidity pools. Moreover, the centralization concept itself, ironically, is often considered one of the main problems of DeFi security.

According to a report published by the CertiK blockchain security firm, in 2021 centralization was the most widespread security problem faced by 1,737 audited decentralized projects and resulted in around $1.3 billion in user funds stolen from DeFi protocols.

Oracle manipulations

In DeFi, oracles are responsible for providing relevant external information, such as price feeds, to blockchains. They leverage APIs to gather price data from different decentralized exchanges (DEXs) and send it to the chain.

And even here hackers have their wits about them. They swiftly manipulate and exploit token price information received from external sources, resulting in system failure and theft.

Bad actors normally execute oracle manipulation attacks by leveraging large amounts of crypto to rapidly boost the trading volume of the tokens of the targeted DeFi protocol. As a result, the price of those tokens goes up, yet it does not reflect the real market picture and fraudsters simply exchange those inflated tokens for ones with greater value elsewhere.

The Mango Markets case of 2022 is one of the most famous DeFi oracle manipulation attacks. This Solana-based DEX saw $110 million in assets drained from the protocol. However, US law enforcement later arrested and charged the hacker for orchestrating the artificial manipulation of the price of the perpetual future.

Human factor

It is not just hackers to blame for DeFi safety scams. Users themselves sometimes make blunders and fail to follow some simple security practices to keep their assets and funds safe.

Decentralized finance applications require users to manage their funds and keys themselves. But some individuals do not operate DeFi apps properly and correctly. Some users can also be inattentive and make errors such as sending finances to the wrong addresses or coming up with weak passwords, which lead to their funds being stolen and security being put at huge risk.

What are the best DeFi security practices?

Even though it is not that easy to ensure 100% safety when dealing with decentralized applications, there are certain proven and efficient DeFi security practices that are worth considering. These include high-quality and timely smart contract audit and testing, bug bounty programs, development and introduction of robust DeFi regulations, enablement of two-factor authentication on a wallet, and adoption of different risk management strategies.

High-quality and timely smart contract audit and testing

Smart contract audit must be part and parcel of any DeFi project striving to deliver a high level of security and establish trust among users.

During the audit process, it is essential to execute a thorough review of the source code against all known vulnerabilities, assess and optimize gas usage, analyze the business logic of the smart contract, and produce recommendations on how to avoid risks.

Smart contract audit will empower you to ensure that your DeFi application will function as intended, spot potential vulnerabilities, boost project credibility and trust, solidify the app against scams and hacking, remediate potential issues, enhance your code performance, and, as a result, prevent millions of dollars being lost through hacking.

To ensure high-quality auditing and testing of your smart contracts, it is essential to partner up with a professional smart contract audit agency that will establish an efficient smart contract audit framework targeted at helping you eliminate risks and secure your project. So, take your time to find the best and most reliable tech partner (or look no further, as you have already found them 😏).

Bug bounty programs

Another efficient way of achieving a high level of DeFi security within the entire landscape and protecting users’ funds is to use and contribute to the wider adoption of the so-called bug bounty programs. These initiatives provide financial rewards to ethical hackers who identify and report bugs, errors, and vulnerabilities to the DeFi app’s developer.

In the long run, all parties involved reap the benefits of bug bounty programs. DeFi users and businesses enjoy better protection, security, and enhanced vulnerability detection, while ethical hackers stand to enjoy substantial financial rewards for their active participation in noble causes.

Development and introduction of robust DeFi regulations

As we have mentioned before, regulatory compliance remains a tough issue for DeFi security.

However, the introduction of robust and concise DeFi regulations is not a matter of if, but when. Regulators the world over are hard at work mapping out relevant crypto, compliance, and enforcement regulations.

For example, the Council of the European Union reached an agreement on markets in crypto assets (MiCA) proposal while the USA issued its Lummis-Gillibrand Responsible Financial Innovation Act that covers core components such as oversight of centralized service providers, consumer protection, and stablecoins.

Two-factor authentication for wallets

To sell, buy, and simply manage DeFi digital assets, users will need to install a specialized wallet. To boost the security and enhance the protection of their funds, businesses are strongly advised to implement two-factor authentication (2FA) on their wallets. By doing this, you will add an extra layer of protection which will make it much more difficult for fraudsters to access the user’s wallet and assets, even if they manage to get hold of the password.

Above all, remember that forewarned is forearmed. Since the DeFi landscape is far from being totally secure and no one can guarantee the security of any assets, you should encourage your users to take all the measures they can to prevent their funds from being stolen. Users should come up with a complicated password, be careful with online service providers, and back up and encrypt their wallets.

Prevention is better than cure — so take some preventive measures and do what is within your reach to stave off unnecessary troubles and protect your users.

Risk management strategies

It is a well-known fact that crypto assets are regarded as one of the most high-risk investment classes since their prices are volatile, their behavior and tendencies are totally unpredictable, and the underlying blockchain technology is somewhat difficult to comprehend.

With regard to this, it is advisable to incentivize your users to give due consideration to DeFi portfolio diversification and adopt sound risk management strategies to minimize their exposure to risks.

You could suggest that they follow, or at least consider, risk management strategies such as:

• The 1% rule which implies that users should not risk more than one percent of their total capital on DeFi investment.
• A stop-loss order sets a specified price for a DeFi asset at which the position will automatically close.
• Portfolio diversification and hedging, by which a user will need to invest in different assets and coins.
• Do Your Own Research (DYOR) which entails a user carrying out thorough research on their own and double-checking the asset and its potential profitability before investing in it.

Closing thoughts

Decentralized finance will continue gaining wider traction and piquing the interest of many more individuals and businesses worldwide. However, to be here to stay, the entire DeFi landscape needs to evolve further and become more secure so that it can ensure the greatest level of protection for users’ funds.

We at PixelPlex are proud that we are doing our best to contribute to the development of a secure web3 space, and helping our clients enhance trust in their DeFi projects, by providing professional DAO development and smart contract audit services.

Our experts leverage industry best practices, techniques, tools, and standards, cover multiple domains and use cases, comply with all industry standards, and work with EVM-compatible and substrate-based blockchains along with other popular protocols to deliver a stellar result and enable you to reach your business goals.

Drop us a line and get a quote on your smart contract security audit today!