The tendency for criminals to exploit the pseudo-anonymity of cryptocurrencies is one of the elements that is slowing down mainstream adoption. So far, many centralized exchanges have grown past the limitations of early crypto days in order to avoid falling victim to hackers in the process. The advent of DeFi and its associated decentralized exchanges seems to be reopening the old wounds of rampant stealing of tokens and cryptocurrencies.
The major limitation around these breaches is the inability of the community to track transactions of the criminals. This is because all DeFi infrastructure are natural mixers. Therefore, every transaction on DeFi protocols has the ability to become easily anonymized. Although this is one of the fundamental properties of decentralization for purposes of privacy protection, it is also a property that can be exploited by bad players in the industry.
Jess Davis, CEO of Uberstate acknowledges the full extent of this problem. However, he believes that a solution would eventually emerge through the implementation of certain other robust protocols. These are protocols that would allow for further stability and liquidity in the industry.
As Q day draws near (date of the start of Quantum Computing) everyone’s binary private keys are vulnerable to unencryption from hackers. Our limited encryption is no match for AI on the quantum scale. The benefits of community oriented staking on the returns and rewards side will mitigate some of the risks. Banks taking custody of crypto currency and new institutions like special purpose deposit institutions will allow loan origination and insurance products against these portfolios of digital assets as we are starting to see with Tether and Forex platforms as well as equity derivatives. In this case the value of assets under management in cold storage supply, could act as a buffer to hacking the original pool of liquidity and further protect the end consumer from unsustainable losses. Deposit insurance offered on deposits in stable coin would alleviate many of these concerns as it would allow further stability and liquidity and increase the reputation of the industry.
The Complexity of Smart Contracts
The CEO of Radix, Piers Ridyard explains to Coinstituency that this is a risk that is majorly contained in the smart contracts that make up DeFi infrastructure. He describes them as complex pieces of code that could have unexpected outcomes. When this occurs, it is possible for it to have negative effects. When tackling this issue, developers have a few tools at their disposal such as audits, using open-source code that has been battle tested, and reactive feedback from the community.
Ridyard acknowledges the current situation as an existing challenge. According to him, this challenge is as a result of the fast pace in the DeFi space, where there is often a race to market new DeFi products, many of which feature groundbreaking innovation. This can often mean developers are put in the awkward situation of either potentially missing their launch window by waiting for time consuming audits, or to go live and risk security issues. Neither are great choices.
He explains that this is one of the reasons why his company is using a different approach. This approach will help developers create secure code by using finite-state-machines rather than turing complete smart-contracts. He notes that often security issues with smart contracts are not caused by bad actors, but from unexpected outcomes in the code.
Solution Comes With Maturity
Ridyard believes that DeFi is experiencing rapid innovation, similar to when cryptocurrency first emerged into the world. In the early crypto years, technology, fast releases, and products were leading the charge. This growth and pace certainly gained a lot of attention, however, it wasn’t until later (and as the industry matured and gained traction) that both experts in the field and legal/regulator opinions started to surface about the best way to conduct business.
In much the same way, he believes that as the DeFi industry matures and gains adoption, the businesses operating in the space will mature with it and adapt to regulatory or legal consideration.
While there are still risks associated, Ridyard is of the opinion that decentralised applications offer a key benefit in that users maintain control of their private keys throughout. Unlike a centralised exchange, when you use a DeFi application such as Uniswap, your funds are sent directly to a smart contract and the swapped tokens immediately come back to your own wallet – you do not need to “deposit” funds. This significantly reduces the risks of losing funds because the central entity gets hacked.
With this set-up, there are still risks with the smart contract itself. While audits can help give reassurance to the security of a smart contract, fundamentally they are very complex pieces of code.
On the issue of tracking, Ridyard says;
In a decentralized system all transactions are visible on-ledger and as a result, the complete trail of transactions can be followed. As we have seen with centralized exchanges, KYC and AML processes have been put in place to help mitigate bad actors using the system, and it is likely that DeFi products will incorporate similar safeguards in the future.
In conclusion, he notes that the overall fast pace of development and innovation in DeFi is creating new and exciting ways for users to interact with cryptocurrency and replicate many of the traditional financial services in more efficient and user friendly ways. As with all innovation, there will inevitably be some bumps in the road. However, the benefits of DeFi will continue to see user demand force the industry to mature into a place where we see businesses operate safe, secure products.
The Marriage Between Innovation and Risk
Justin Newton, CEO at Netki believes that the DeFi innovation comes with both ups and downs. He explains that the magic of public blockchains and digital assets is that these networks are platforms for open and permissionless innovation. This he describes as a very close parallel to how the Internet came behind traditional phone networks and led to a wave of inclusion, innovation and value creation. He expects a similar trend to unfold with financial networks.
Newton notes that any new platform has new risks and it is important that as we learn about those platforms and the actual risks they create, and also consider that it is important that we build and deploy tools to control those risks. This is happening first in the centralized world because regulators are forcing it to happen. That said, regulators are looking closely today at both unhosted wallets as well as DeFi platforms to see the risks there, both to consumers, but also from a money laundering and terrorism financing perspective.
He continues by pointing out that smart platform operators will understand that most consumers actually want a system that has protections and guard rails in place. “Once you let bad actors into your system, they likely won’t be contained to a single kind of bad activity, and are likely to try and exploit the other actors on your platform, driving away legitimate users”, says Newton.
There Needs To Be Control
Newton emphasized that it is critical that these controls are built, so that we don’t simply emulate what was done before on centralized financial networks. That would be like saying we should have the same safety rules in cars as we have in trains since they both move people.
We need to recognize that unlike legacy financial networks, digital asset networks were designed with innovation at its core and as a result, the default behavior needs to be to permit an activity at the core protocol layer, and ensure that enforcement can happen at the application layer where regulated entities or service providers can enforce risk based controls that are appropriate for the activity occurring.
Like centralized exchanges, Newton believes that various platforms will proceed at different paces in order to find a solution to this problem. He notes that even in the more centralized world there are various levels of AML policies in place at different companies as some have chosen to “jurisdiction hop” to avoid regulation while others have considered compliance and consumer protection as a core feature that they invest in, market and promote. “The same thing will happen in DeFi, says Newton. “Although the pressures will likely come in different ways, such as riskier platforms losing the ability to transact with the more reputable centralize services”.
In conclusion, Newton thinks that DeFi will have a short term negative impact on mass market adoption due to scandalous stories that will come out scaring people away. However, he believes that it will be a long term benefit as DeFi is a part of the path of innovation that is the core reason that digital assets and public blockchains even exist, open and permissionless innovation.
Iyke Aru is a seasoned author and educator in the blockchain and cryptocurrency industry. He has been in the business of crypto content writing for many years with thousands of his articles across several platforms on the internet. Iyke is based in Nigeria where he stands out as one of the most informed and credible figures in the cryptocurrency industry. Outside blockchain and crypto, you will most likely catch Iyke playing or discussing football with friends and family.