DeFi Scams Uncovered: What You Need to Know and How to Stay Safe

Imagine you're exploring the world of decentralized finance (DeFi) with high hopes of tapping into its immense potential. You’re excited about the possibilities — autonomy, transparency, and the chance for high returns. But as you navigate this rapidly growing ecosystem, you realize that with great opportunity come great DeFi risks. DeFi is revolutionizing financial markets, but it’s also attracting a new breed of sophisticated scams that could catch even the most seasoned investors off guard.

In this article, we'll delve into the risks that lurk in the DeFi landscape. But more importantly, we'll show you how you can protect yourself from falling victim to these schemes. Read our detailed guide and learn how to navigate the DeFi space safely.

New Forms of Cybercrime in DeFi

The rapid rise of DeFi has not only disrupted traditional finance but also given birth to new forms of cybercrime. With criminals constantly evolving their tactics, DeFi relies on users being more vigilant than ever. The decentralized nature of DeFi industry, while empowering, also makes it a fertile ground for scams. Law enforcement struggles to keep up with the pace of innovation and protect users, and the lack of regulatory oversight means that, often, you're on your own. Understanding these risks is the first step toward safeguarding your investments.

There is the lack of technical expertise regarding the specific features of the malicious activity being committed, as well as the absence of proper regulatory framework and established forensic models for investigating digital financial crimes.

According to statistical data from August 2024, the decentralized finance market capitalization had reached an impressive $69.76B. The growing scale in which DeFi operates can be attributed to the inherent advantages of distributed ledger blockchain technology over centralized finance, the wide array of potential digital projects, the rapid innovation and the unique structure of relationships between users in crypto markets, absent in traditional finance.

In essence, DeFi embodies a new philosophy of financial systems that eliminates vertical control and the reliance on centralized intermediaries inherent in the traditional financial system and fiat currency. Users enjoy greater autonomy within the framework of these new financial applications, with DeFi space serving as a means to facilitate the selection of optimal client strategies. The anonymity of transactions, low transaction costs, the lack of geographical constraints, a sense of independence, stable value, and the potential for higher returns, including speculative trading of crypto assets further enhance the appeal of DeFi protocols among users.

Researchers have identified several common risks associated with the DeFi ecosystem. Chief among these are the inherent vulnerabilities of DeFi protocols, the high volatility of cryptocurrencies, the complex design of inter-network bridges DeFi platforms rely upon, the unique format of peer-to-peer relationships between ecosystem participants, and the lack of clear integration between centralized and decentralized finance.

Additional key risks include operational risks, such as the loss of private keys, update and management challenges, and composability risks. Technical vulnerabilities and technology risks including smart contract risk, miner-related risks, transaction risks, and oracle-related risks, also pose significant threats. Financial vulnerabilities of new business models, encompassing liquidity risks, market risks, and credit risks, further compound the issues. Lastly, legal and regulatory risks, stemming from a lack of comprehensive oversight or, conversely, overly restrictive regulations, create uncertainty and undermine deterrence mechanisms.

The DeFi applications' technological vulnerabilities make it too easy for malicious actors to bypass protection measures and orchestrate large-scale cyberattacks. Moreover, the absence of robust legal regulation effectively eliminates the operational and procedural deterrents that could mitigate DeFi-related criminal activities.

A Case Study: The Euler Finance Hack

DeFi crimes have come a long way from the early days of simple phishing attacks. Today, hackers are deploying sophisticated methods that exploit the very technology meant to protect us. Take the infamous 2023 Euler Finance hack, where a vulnerability in the DeFi lending protocol led to the theft of $196 million in crypto assets. What’s alarming is that this protocol had undergone extensive testing and multiple security audits, yet the attackers still found a way in.

The breach occurred through the exploitation of a vulnerability in the DonateToReserve function, which caused an imbalance between the eToken (representing collateral) and the dToken (representing debt). This vulnerability was initially discovered by a certain "white hacker" in July 2022. He informed DeFi platform’s developers about the "first deposit error," which allowed for the artificial inflation of quotes and the withdrawal of all assets. While the DeFi service team addressed this issue, the fix led to the emergence of another vulnerability that the attacker was able to exploit.

The perpetrator utilized funds from the BNB Chain, converting BEP-20 tokens to ERC-20 through a cross-chain bridge before executing the deliberate attacks on the Euler Finance protocol in six transactions.

After the Euler Finance CEO announced a for information leading to the identification and arrest of the attacker, the perpetrator contacted the project team and negotiated the return of the stolen digital assets. Between March 25 and April 4, the hacker returned most of the stolen assets to the protocol.

This incident serves as a reminder that no system is completely secure, and even the most well-audited DeFi protocols can fall prey to malicious actors. It also highlights the difficulty in maintaining anonymity on the blockchain, as the Euler Finance team was able to track down and negotiate with the attacker.

Common Risks in DeFi

Think of DeFi as a high-tech playground where innovation runs wild — but so do the risks. From cryptocurrency theft to smart contract vulnerabilities, the dangers are real and diverse. It’s like building a house out of the most advanced materials but with the threat of a storm always looming. To protect yourself, you need to understand these risks inside out.

Cryptocurrency Asset Theft

Recent research paints a concerning picture of the state of cryptocurrency theft in the decentralized finance ecosystem. Cybercriminals have made DeFi-related crimes a leading form of digital asset theft, ranking high in both the frequency of incidents and the magnitude of financial losses incurred.

This surge in DeFi investing-targeted theft can be attributed to a few key factors. First, the growing mainstream interest and investment in DeFi platforms and services has provided bad actors with a larger attack surface to exploit. Additionally, the inherently open and interconnected nature of these decentralized financial platforms introduces vulnerabilities in their underlying network communications that criminals can leverage.

One of the most prevalent techniques employed by DeFi thieves is the utilization of flash loans, also known as instant loans. These are unsecured digital asset loans that have no restrictions on borrowing — DeFi participants can obtain funds and repay them all within a single transaction. If the borrower fails to fully repay the loan, the smart contract automatically cancels the transaction and returns the money to the lender. This rapid, unrestricted access to capital allows malicious actors to quickly obtain the resources needed for short-term price manipulation schemes in the crypto markets.

Flash loan attacks process typically unfolds as follows: the loan provider transfers the requested assets to the user, who then leverages the borrowed funds to interact with other DeFi smart contracts. After completing their intended operations, the user is expected to return the full loan amount to the provider; if they fail to do so, the provider immediately cancels the transaction. Criminals frequently abuse this flow of flash-borrowed capital to artificially inflate or deflate the prices of various cryptocurrencies across different DeFi platforms. Their ultimate objective is to gain control over a smart contract or protocol, alter its underlying code, and then siphon out the available liquidity.

An even more sophisticated tactic employed by some DeFi thieves is to directly manipulate the contract code itself, recording a full loan repayment even when only a partial or no repayment has actually occurred.

The "Exploit Code" Model

One of the most sophisticated and dangerous methods used by cyber criminals to target DeFi platforms is the use of exploit code — specialized programs designed to identify and take advantage of vulnerabilities in smart contracts and other DeFi services. These exploits allow bad actors to bypass security measures withdrawing funds from user wallets and platform reserves.

In some cases, the perpetrators will even combine the use of exploit code with automated trading bots to amplify the impact of their attacks. This lethal one-two punch gives them the ability to rapidly seize control of the situation and make off with millions in stolen funds before platforms can react.

Hacking model

In the DeFi ecosystem, where traditional intermediaries are absent, hacking involves the unlawful alteration of smart contracts or their underlying protocols. As the duration of a service's operation increases, its security often improves, as developers work to address and rectify vulnerabilities.

However, the greatest susceptibility to hacking in DeFi arises from the utilization of cross-chain bridges. These bridges maintain custody of a substantial volume of tokens, and their protocols are typically open-sourced. While this openness can demonstrate the transparency and integrity of the organizers, it also facilitates easier access for attackers to obtain private keys and transaction details of such services, compared to the security measures employed by centralized exchanges.

Investment Model

The rapidly growing DeFi ecosystem has unfortunately become a breeding ground for fraudulent activities, largely due to the increasing capitalization and investment appeal of these platforms. Criminals have devised a range of methods to perpetrate scams within the DeFi space.

One common tactic employed by fraudsters is the "investment model". Unscrupulous individuals will contribute funds to a liquidity pool, attract new investment funds, and then artificially inflate the price of a virtual asset. They then use this inflated value to pay off initial liquidity providers, while withdrawing the assets using malicious smart contract coding, leaving later investors with significant losses.

A prominent example of this DeFi financial pyramid scheme is the Terra project, which utilized the LUNA and TerraUSD (UST) tokens. The project's founder, Do Kwon, enticed to transfer tokens to himself under the guise of a 20% annual loan agreement. Within just a few months, the project amassed $15 billion. However, when doubts arose about the project's reliability, the market panicked, and an outflow of investments occurred, resulting in significant losses for liquidity providers.

As the DeFi landscape continues to evolve, both investors and regulators must remain vigilant in identifying and combating these fraud schemes that prey on the decentralized interactions on which DeFi platforms rely.

Fake DeFi Investment Scam

Increasingly, we're seeing a rise in malicious individuals showcasing fabricated investment "success stories" on social media and other online platforms, using these false narratives to lure new users into their nefarious schemes.

The perpetrators of these scams typically entice their targets to deposit their hard-earned cryptocurrency assets into what appears to be a cutting-edge, high-yield DeFi project. However, the reality is that these are nothing more than elaborate traps, designed to funnel the pooled funds directly into the criminals' own wallets. Often, they'll leverage vulnerabilities in the associated virtual asset storage applications to gain unauthorized access to the pooled assets.

Money Laundering Through Cross-Chain Bridges

The pseudonymous, decentralized nature of DeFi has also made it a prime target for cybercriminals seeking to obscure the origins of their gains. Criminals are increasingly exploiting the features of this ecosystem to weave a complex web of obfuscation, transferring and transforming their proceeds in an effort to integrate them back into the legitimate financial system.

One common tactic is to leverage decentralized exchanges (DEXs), which operate outside the purview of regulatory oversight. Perpetrators will first store their tainted cryptocurrency in decentralized wallets, then exchange it on a decentralized exchange for alternative tokens. These are then deposited on centralized exchanges and converted into fiat currency, effectively erasing the digital trail.

One increasingly popular method to obscure the origins of illicit funds involves the use of interoperability bridges between blockchain networks. In this model, the perpetrator first transfers their tainted cryptocurrency tokens to a gateway bridge, which then provides them with a new set of digital coins. These newly acquired tokens are then exchanged for DeFi-based stablecoins, which can subsequently be converted into fiat currency on centralized exchanges.

Law enforcement agencies are sometimes on the lookout for individuals who frequently receive tokens from addresses associated with these cross-chain bridge services, as they may be unable to provide a legitimate explanation for such transactions. In one known case, a single gateway bridge was used to launder proceeds of $540 million from different criminal services, including ransomware attacks.

DeFi Mixer Scheme

One money laundering tactic that has gained traction among cybercriminals involves the use of DeFi mixer services. In this model, an individual who has amassed digital assets through illegal means will send them to a cryptocurrency mixing address, effectively "cleaning" the tokens. The perpetrator then transfers the "cleaned" funds to either a centralized or decentralized exchange, where they can be converted into fiat currency.

From a risk-based perspective, indicators of this type of money laundering scheme may include an exchange client frequently receiving incoming transfers from decentralized mixers, as well as making frequent transfers involving these mixing services. However, it is important to note that criminals are not limited to just mixers, but are also complementing their schemes with the use of decentralized exchange platforms, the purchase of non-fungible tokens (NFTs), and other crypto asset transactions.

Risks in DeFi Liquidity Provision

DeFi inherently carries the risk of impermanent loss, particularly for participants engaged in yield farming and liquidity provision activities.

The surge in decentralized exchanges has empowered users to contribute liquidity and assume the role of market makers. This mutually advantageous arrangement allows DEXs and traders to benefit from enhanced market liquidity, while users are rewarded with a portion of the trading commissions for providing liquidity.

However, the situation is not as straightforward as it may appear. Liquidity providers face a vulnerability to variable losses. When they provide liquidity, depositing their funds into a liquidity pool, the corresponding token prices and gas fees may experience fluctuations. Given the inherent volatility of cryptocurrency markets, this risk is quite substantial.

To mitigate the impact of impermanent losses, liquidity providers can opt for pools with lower price variations, such as those involving stablecoin pairings. Alternatively, they may consider high-fee and high-APY pools, though these tend to be subject to greater price swings. Ultimately, the prudent approach is to avoid excessive greed and proactively withdraw deposits before substantial price movements occur.

Miner Extractacle Value’s Risks

Miner extractacle value (MEV) is the profit that a miner receives for changing the order of transactions within the block he creates in the Ethereum network. This is possible thanks to the flexible system of smart contracts of this blockchain, that is, transactions in a block can be in different orders.

Therefore, miners can receive additional income. Before being included in a block, a transaction is sent to a publicly accessible mempool; this is a large set of transactions that await confirmation from the network. In this mempool there are MEV bots that are waiting for an opportunity to profit through arbitrage – a strategy designed to make money on the difference between buying and selling assets.

The main disadvantage of MEV is the increase in transaction costs for all players, which arises due to the “hijacking” of arbitrages. That is, as a result, transactions are not executed at the optimal rate, and that same “invisible tax” is imposed, which is beneficial to miners. This means that MEV will still exist in one form or another. Additionally, MEV threatens the stability of the Ethereum network consensus.

There are several projects that are trying to combat MEV (for example, Flashbots). However, in reality it is very difficult to somehow prevent miners from attributing an “invisible tax”. Additionally, the MEV issue has now moved beyond the Ether blockchain. Similar bots have appeared in Binance Smart Chain, where there are the same opportunities, but less competition. MEV is extremely rare on the Bitcoin network due to the design of its blockchain.

How to Reduce the Risk of Being Scammed

Navigating the DeFi landscape can feel like walking through a minefield — one wrong step, and you could lose everything. But by taking a few precautionary measures, you can significantly reduce your risk. Here are some key strategies to protect yourself from:

Ponzi Schemes

One of the most common scams in DeFi is the financial pyramid, often disguised as a cryptocurrency staking or farming opportunity. To avoid falling victim to such schemes, it is essential to approach any DeFi project with a critical and discerning eye. Carefully scrutinize the claimed profitability and thoroughly analyze the economic foundation of the project. Be wary of schemes that involve multi-level recruitment of participants and impose restrictions on the withdrawal of funds, as these are telltale signs of a Ponzi scheme.

Counterfeit DeFi Duplicates

Another prevalent form of fraud in the decentralized finance landscape involves the creation of fake copies of popular DeFi protocols and decentralized autonomous organization (DAO) communities. These counterfeit platforms are designed to take advantage of a user error: people believe they are interacting with legitimate projects, only to exploit them through malicious means.

Always verify the authenticity of the web domain and thoroughly research any platform before entrusting it with your assets or personal information. The best practice is to access DeFi project resources exclusively through verified links obtained directly from the official sources.

Social Engineering and Phishing

Cybercriminals have become increasingly adept at leveraging social engineering and phishing tactics to manipulate and exploit users. Fraudsters frequently send fake correspondence, ostensibly from the support services of well-known DeFi projects, requesting users to provide sensitive information for "account verification" or "unblocking" purposes. Additionally, they distribute links to counterfeit websites that mimic the login interfaces of popular cryptocurrency wallets and exchanges.

To safeguard against such attacks, it is crucial to maintain a healthy skepticism towards any unexpected messages or unsolicited requests, and to never enter your passwords or other sensitive information on unfamiliar or suspicious pages.

Malicious Crypto Applications

In the DeFi landscape, cybercriminals have resorted to a particularly insidious tactic — distributing malware disguised as useful crypto-related tools, such as wallets, trading bots, and analytical software.

The safest approach is to use only recommended software from reputable developers, readily available in official application stores and repositories. Avoid installing any crypto-related tools from untrusted or unfamiliar sources, as the risks of compromising your digital security and financial well-being far outweigh any perceived benefits.

Pump-and-Dump Crypto Scams

Scammers have also devised a tactic of creating wrong addresses with complete copies of popular digital assets, using their well-known names and logos. The goal of these fraudsters is to rapidly "pump up" the perceived value of these counterfeit tokens through hype and deception, and then quickly "dump" them, executing the classic pump-and-dump scheme.

To avoid falling victim to these traps, it is essential to perform one’s own research to verify the legitimacy of any cryptocurrency or token before making a purchase. This way you can significantly reduce the high risk of being caught up in these pump-and-dump schemes.

General Recommendations

To ensure you navigate this landscape with caution, consider the following basic guidelines:

1. Do Your Homework

Before investing in any DeFi project, thoroughly research its background. Check the development team's credentials, read through smart contract audits, and review community feedback.

2. Use Hardware Wallets

For maximum security, store your most valuable assets in hardware wallets. These devices keep your private keys offline, out of reach of hackers.

3. Diversify Your Investments

Don’t put all your eggs in one basket. Spread your investments across multiple platforms and assets to minimize your exposure to any single point of failure.

4. Stay Informed

The DeFi space is constantly evolving. Keep up with the latest news, updates, and security practices to stay one step ahead of potential threats.

All in all, DeFi offers incredible opportunities, but with those come significant risks. By taking proactive steps to protect yourself, you can enjoy the benefits of this financial system while minimizing the dangers. As the DeFi landscape continues to evolve, so too must your strategies for safeguarding your assets. Remember, in the world of DeFi, your security is in your hands — stay vigilant, stay informed, and stay protected.