DeFi Risks - How to Reduce The Risk of Being Scammed

Everyone in DeFI is always excited about the possibilities it brings - autonomy, transparency, and the chance for high returns. But as with most things, you soon realize that with great opportunities come great risks. While DeFi is indeed revolutionary for financial markets, it's also attracting a whole new breed of complex scams that could catch even the most experienced investors off-guard.

In this article, we will go over the most common types of scams in decentralized finance, how to reduce risk of being scammed, and some general recommendations.

New Forms of Cybercrime in DeFi

Because of DeFi's swift expansion, traditional finance has been upended, which has given thieves greater opportunity to wreak damage. Consumers should be extremely cautious because bad actors are constantly changing their tactics. Because DeFi is decentralized, users have more control, but scammers may operate more readily, making it difficult for authorities to keep up. You must therefore typically consider your personal safety.

The first step to securing your financial security is being aware of these threats.

Even technical understanding by itself is insufficient to completely comprehend the unlawful conduct occurring in DeFi. Moreover, there are no clear guidelines or established processes for carrying out an exhaustive investigation into these kinds of offences.

The DeFi market had an amazing value of $69.76 billion by August 2024. Its use of blockchain, which has several benefits over traditional banking, is the reason for its quick growth. In the context of cryptocurrencies, it encourages a range of digital initiatives, provides fresh concepts swiftly, and creates special interpersonal interactions that are not present in traditional finance.

DeFi stands for an entirely fresh perspective on money. In conventional finance, it restricts the authority that banks and other financial intermediaries hold. Users now have greater financial control and can select the most efficient techniques with the aid of these new DeFi apps. Because DeFi protocols offer low rates, no territorial limits, anonymous transactions, a sense of freedom, steady value, and the opportunity to enhance one's income, they are immensely popular.

Here are some of the main risks that have been found in DeFi:

• Weaknesses in DeFi protocols
• Unpredictable prices of cryptocurrencies
• Complicated connections between different DeFi platforms
• The unique way users interact directly with each other
• An unclear link between traditional finance and DeFi.

Other important risks are things like losing private keys, difficulties in updating and managing the systems, and problems when different DeFi apps work together. There are also technical risks, such as bugs in smart contract issues, miner-related risks, transaction risks, and oracle-related risks, which also pose significant threats. Issues such as not having enough money available, market ups and downs, and credit problems add to those challenges. You could say that these legal and regulatory risks come from either not having clear rules or having rules that are too strict, which creates confusion and makes it harder to prevent bad behavior.

DeFi apps have technical weaknesses that make it easy for hackers to get around security and launch big cyberattacks. On top of that, there aren’t strong laws in place, so there’s little to stop criminals from taking advantage of DeFi.

A Case Study: The Euler Finance Hack

DeFi crimes have come a long way since the earliest days of simple phishing attacks. These days, hackers are creating and using ever-more-advanced methods that exploit the very technology designed to protect us. Take the infamous 2023 Euler Finance hack as an example, where a vulnerability in the DeFi lending protocol led to the theft of $196 million in crypto assets. The most concerning aspect is that despite thorough testing and several security audits, the attackers managed to gain access.

The DonateToReserve functionality was found to have a vulnerability, which led to the breach. As a result, there was an imbalance between the two tokens, one of which stood for collateral and the other for debt. A "white hat" hacker found the problem in July 2022 and notified the DeFi platform's developers of a "first deposit error" that allowed for the elimination of all assets and the implementation of false pricing. Despite fixing the problem, the team unintentionally created a new weakness that the fraudster took advantage of.

Using funds from the BNB Blockchain, the thief first converted BEP-20 tokens to ERC-20 tokens via a cross-chain bridge. They then attacked the Euler Finance Protocol with six prearranged attacks.

After the hacker reached out to the team and offered to return most of the stolen digital assets, the CEO of Euler Finance offered a reward for information on the hacker. Furthermore, the hacker gave back most of the items they had stolen on March 25 and April 4.

This shows that no system is 100% secure and that hackers can exploit even well-vetted DeFi platforms. The difficulty of preserving anonymity on the blockchain is illustrated by the Euler Finance team's ability to track down and get in touch with the attacker.

Common Risks in DeFi

DeFi is highly innovative, and there is a lot of good genuinely impressive tech that comes with it, but the risks are just as important to watch out for. There are real dangers, like hackers stealing cryptocurrency or flaws in the code that can be exploited.

To stay safe, it is essential to really understand these risks and how they work.

Cryptocurrency Asset Theft

Recent studies show that cryptocurrency theft is actually a really big problem in decentralized finance. Hackers are targeting it more and more, making it one of the main ways digital assets are stolen, both in how often it happens and how much money is lost.

There are a few reasons for this. First, as more people get interested in and invest in DeFi, there are more opportunities for criminals to attack. Also, because such platforms are "open" and connected to each other, there are weak spots in how they communicate, which hackers can take advantage of.

One common trick used by DeFi thieves is called a flash loan. This is a type of loan where you can borrow a large amount of cryptocurrency without any collateral, as long as you pay it back in the same transaction. If you don’t pay it back, the system cancels the whole deal automatically. This makes it easy for hackers to quickly borrow huge sums, use them to mess with prices, and then return the money-all in one go.

Here’s how a flash loan attack usually works: The hacker borrows a lot of crypto, uses it to interact with other DeFi programs, and if they return the money, everything goes through. If not, the transaction is cancelled. Criminals use this method to manipulate the prices of different cryptocurrencies, hoping to take control of a DeFi system, change its code, and steal whatever money is inside.

Some hackers go even further by messing with the code itself, making it look like they paid back the loan in full when they actually didn’t, allowing them to walk away with stolen funds.

The "Exploit Code" Model

One of the sneakiest and most dangerous tricks cybercriminals use to attack DeFi platforms is exploit code. This is special software made to find and take advantage of weak spots in smart contracts and other DeFi services. These exploits allow bad actors to bypass security measures withdrawing funds from user wallets and platform reserves.

There are also cases of perpetrators even teaming up these exploit codes with automated trading bots to make their attacks even worse. This powerful combo lets them quickly take control and steal millions before anyone can stop them.

Hacking model

Since there are no middlemen in DeFi, hacking usually means illegally changing smart contracts or the systems they run on. The longer a service has been around, the safer it usually gets, because developers fix bugs and security issues over time.

But the biggest risk in DeFi comes from something called cross-chain bridges. These bridges hold a lot of tokens and their code is often open for everyone to see. While this makes the system more transparent and trustworthy, it also makes it easier for hackers to find private keys and transaction info compared to the stronger protections used by centralized exchanges.

Investment Model

Unfortunately, Defi's evolution has attracted a lot of scams. Because these platforms handle more money and seem like good places to invest, criminals have come up with many ways to trick people in the space.

One common scam is called the "investment model." Scammers put money into a liquidity pool to attract new investors, then they fake the price of a token to make it look higher than it really is. They use this inflated price to pay back the first investors, but then they use sneaky smart contract tricks to steal the money, leaving later investors with big losses.

A well-known example of this scam is the Terra project with its LUNA and TerraUSD (UST) tokens. The founder, Do Kwon, convinced people to send him tokens by promising a 20% yearly loan. In just a few months, the project raised $15 billion. But when people started doubting it, investors rushed to pull out their money, causing huge losses for many.

As DeFi keeps changing and growing, both investors and regulators need to stay alert and work hard to spot and stop these scams that take advantage of how DeFi platforms operate without middlemen.

Fake DeFi Investment Scam

Increasingly, malicious individuals tend to showcase fabricated investment "success stories" on social media and other online platforms - which use false narratives to lure new users into their schemes.

These scammers usually convince people to put their hard-earned cryptocurrency into what looks like a promising, high-return DeFi project. But in reality, it’s just a clever trap to steal all the money and send it straight to the criminals’ wallets. Sometimes, they also exploit weaknesses in the apps that store these digital assets to sneak in and take the funds without permission.

Money Laundering Through Cross-Chain Bridges

Because DeFi is decentralized and lets users stay anonymous, it has become a favorite spot for criminals trying to hide where their money comes from. They use the system’s features to create complicated ways to move and change their stolen funds, making it hard to trace and turning the money back into normal cash.

One common trick is using decentralized exchanges (DEXs), which aren’t closely watched by regulators. Criminals put their dirty cryptocurrency into decentralized wallets, swap it for other tokens on a DEX, then send those tokens to regular centralized exchanges where they convert them into regular money, wiping out the digital trail.

Another popular method involves using bridges that connect different blockchain networks. The criminal sends their stolen tokens through a bridge, which gives them new tokens on another network. They then swap those for stablecoins in DeFi, and finally turn those stablecoins into regular money on centralized exchanges.

Law enforcement keeps an eye on people who often get tokens from these cross-chain bridges, especially if they can’t explain why. 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 way cybercriminals launder money is by using DeFi mixer services. In this model, someone who got digital assets illegally sends them to a mixing service, 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.

Risk-based signs that this kind of money laundering might be happening include a user on an exchange often getting transfers from these mixers or frequently sending money through them. But criminals don’t just use mixers-they also use decentralized exchanges, buy NFTs, and do other crypto transactions to hide their tracks.

Risks in DeFi Liquidity Provision

DeFi has a built-in risk called impermanent loss, especially if you're trying to earn rewards by yield farming or providing liquidity.

The rise of decentralized exchanges means people can now add their funds to these platforms and act like market makers. This is good for everyone: the exchanges and traders get more liquidity, and the users who provide the funds get a cut of the trading fees.

But there's a catch! If you provide liquidity, you could face what is known as impermanent loss. When you put your money into a liquidity pool, the prices of the tokens and the gas fees can change. Since the crypto market is so unpredictable, this can be a pretty big risk.

To reduce this risk, you can choose pools that have less price fluctuation, like those with stablecoins. Or, you can go for high-fee and high-APY pools, but those tend to have bigger price swings. The best way to handle it is not to be too greedy and pull your money out before big price changes happen.

Miner Extractable Value’s Risks

Miner Extractable Value (MEV) is extra profit that miners can make by changing the order of transactions inside the blocks they create on the Ethereum network. Because Ethereum’s smart contracts let transactions be arranged in different orders, miners can take advantage of this to earn more money.

Before transactions get added to a block, they sit in a public waiting area called the mempool. In this mempool, special bots called MEV bots look for chances to make money by doing arbitrage-buying and selling assets quickly to profit from price differences.

The downside of MEV is that it makes transaction costs higher for everyone. This happens because miners “hijack” these arbitrage opportunities, meaning transactions don’t happen at the best prices, and users end up paying an extra hidden fee that benefits the miners. This “invisible tax” means MEV will probably always be around. It can also make the Ethereum network less stable.

Some projects, like Flashbots, are trying to fight MEV, but it’s very hard to stop miners from taking this extra fee. MEV isn’t just a problem on Ethereum anymore-it’s also showing up on other blockchains like Binance Smart Chain, where there’s less competition. MEV is very rare on Bitcoin because its blockchain works differently.

How to Reduce the Risk of Being Scammed

Getting into DeFi can be risky - one wrong step, and you might lose it all. But if you take a few simple steps, you can protect yourself quite a bit. Here are some tips to keep you safe::

Ponzi Schemes

Ponzi pyramid schemes, which sometimes pose themselves as cryptocurrency farming or staking opportunities, are among the most prevalent scams in DeFi. Any DeFi effort should be approached critically and perceptively to prevent becoming a victim of this. Examine the project's economic basis in detail and closely examine the stated profitability.

Systems that restrict the withdrawal of cash and recruit participants at several levels should be avoided as these are classic indicators of a Ponzi scheme.

Counterfeit DeFi Duplicates

Another common scam in the DeFi arena is the use of fake versions of well-known DeFi projects and online groups. These phony platforms are designed to steal your money and personal information by tricking you into thinking you are using the real thing.

Before giving a platform your money or personal information, do your research and make sure you are on the right website. Only links from reputable, authoritative sites should be used.

Social Engineering and Phishing

Cybercriminals are getting better at tricking people using social engineering and phishing. They often send fake messages that appear to be from the support teams of popular DeFi projects, asking you to share sensitive info for “account verification” or “unblocking” it. They also send links to fake websites that copy the login pages of well-known crypto wallets and exchanges.

To stay safe, always be cautious of unexpected messages or requests, and never enter your passwords or personal info on websites you don’t trust or recognize.

Malicious Crypto Applications

In DeFi, some cybercriminals trick people by spreading malware that looks like helpful crypto tools - such as wallets, trading bots, or analysis apps.

The safest way is to only use software recommended by trusted developers and download it from official app stores or trusted sites. Avoid installing any crypto tools from unknown or suspicious sources because the risk to your security and money isn’t worth it.

Pump-and-Dump Crypto Scams

Scammers sometimes create fake versions of popular digital coins, copying their names and logos. They try to make these fake tokens look valuable by creating hype, then quickly sell off their own shares for a profit - this is called a pump-and-dump scam.

To avoid getting tricked, always do your own research to make sure a cryptocurrency or token is real before you buy it. This will help you stay safe from these kinds of scams.

On top of that, always remember that celebrities and even politicians are capable of pulling such scams as well, so do your own research before supporting any tokens.

General Recommendations

To make sure that you handle decentralized finance with caution, examine the following basic guidelines:

1. Do Your Homework

Before jumping right into any DeFi project, take the time to research it well. Look into who’s behind it, check if their smart contracts have been audited, and gather community feedback.

2. Use Hardware Wallets

For maximum security, store your most valuable crypto in hardware wallets. These devices keep your private keys offline, making it much harder for hackers to steal them.

3. Diversify Your Investments

Don’t put all your eggs in one basket. Spread your investments across different platforms and assets to lower your risk.

4. Stay Informed

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

DeFi has both opportunities and risks involved. However, you can take the appropriate steps to protect yourself, your identity, and your funds. Your strategy for protecting your assets should change along with DeFi itself. Remember: in DeFi, your security is in your hands - stay vigilant, stay informed, and stay protected.