Thread by @0x_emperor

1/ Recently read @nic__carter and @Linda_Jeng's paper, "DeFi Protocol Risks: the Paradox of DeFi", a relatively thorough & broad list of defi risks, a great paper and soon to appear as a chapter in a book. It's particularly interesting because of the several risk vectors it lists

2/ "Defi can be defined as the movement that leverages decentralized networks to transform old financial products into trustless & transparent protocols that run without intermediaries.” Although the paper mentions major categories, a more thorough list is

https://twitter.com/Fiskantes/status/1400553722644733954?s=20

3/ Defi offers the promise of:
i) automated delivery of finance by smart contracts
ii) transparency enables efficient auditing
iii) Unbundling finance removes traditional intermediaries & makes it more equitable
iv) Reduces execution risk

4/ But defi has risks across 5 categories
(i) interconnections with the traditional financial system,
(ii) operational risks stemming from underlying blockchains
(iii) smart contract-based vulnerabilities
(iv) other governance and regulatory risks
(v) scalability challenges.

5/Reliance of stablecoins and market liquidity on third parties
(i) 16% of Maker's 6.5 billion dollar collateral is a liability of a third party
(ii) USDC & USDT represent critical sources of liquidity for various DeFi protocols
Any regulatory pressure can result in interference

6/A handful of banks provide critical services to cryptocurrency firms, a disruption/insolvency among any one of these banks would adversely affect the cryptocurrency industry

In 2019, India's central bank ordered banks to cease relations with crypto firms & it created turmoil.

7/ "Consumer fintech apps now make crypto highly accessible to retail investors who may not fully understand what they are trading."

"Several cryptocurrency brokers, custodians, and lenders have begun to see themselves as interfaces to DeFi protocols."

8/ "Corporations are obtaining direct exposures to native cryptocurrencies either as an alternative treasury asset or in preparation to actually use the tokens to transact on the protocol directly. "

9/ "Consensus on blockchains is not a given."

Bitcoin had two major "rollbacks" in 2010 and 2013.

Ethereum seems more fallible and fragile as the service provider, Infura's ("The AWS of the ethereum ecosystem") downtime in 2020 intermediated transactions ground to a halt.

10/ "Blockchains are not immune to politics, as they are, after all, governed by the humans that establish their rules."
The 2016 "DAO hack" intervention caused a hardfork, Ethereum’s future switch to Proof of Stake was cited as justification for rolling back the exploit.

"Although the hard fork was thought of as a prudent move and such interventions help obtain recourse when big issues occur, they also introduce subjectivity and arbitrariness into the settlement process."
But the possible argument to this is, haseebq.com/ethereum-is-no…

11/ Proof of Work Consensus Failure
" Coordinated consensus attacks, These attacks consist of exploits in which validators employ their privileged access to transaction order to extract some value from the blockchain. "

Verge rolled back 200 days of data in early 2021.

12/ Another type of exploitation, Miner Extractable Value, MEV refers to the value that validators (the entities assembling transactions into blocks) or third parties can extract from transacting users by frontrunning them and selectively reordering transactions.

13/ Even Proof of stake could be susceptible to some issues, like, "In certain network arrangements, the number of validator slots is fixed, creating strong incentives to consolidate power and cartelize."
A recent example of Validator collusion on steem network against Justin sun

14/ Inflation bugs, which inflate the supply of coins ahead of a pre-agreed or expected schedule pose a significant threat as well.

Bitcoin, Bitcoin Private and Stellar were subject to such exploitations.

Particularly insidious to defi and can destabilize the ecosystem.

15/ Smart contract introduce several attack vectors to the ecosystem due to the underlying technical nature, owing to the complexity of interactive blockchain-based smart contracts and the difficulty of anticipating complete edge cases before deploying code

16/ Oracle attacks’ are among the most popular means of attack.
"Market dislocations at spot exchanges feed into oracles & affect DeFi systems built atop these price feeds"
"Flash loans also provide additional attack vectors and are sometimes used to make oracle attacks happen."

17/ Additionally:
Some of these, smart contract attacks, have also been game-theoretic in nature and were hard to guess or think of, only clear or evident in retrospection. They exploit the underlying economic model of these systems.

18/ Other governance and regulatory risks:
Many DeFi protocols retain the discretionary option for administrative teams or other entities to shut them down, upgrade them, pause the contract, and in some cases, drain user funds.

19/ Most Defi tokens can be thought of pseudo-equities because tokens endow token holders with some rudimentary governance rights as well as either implicit or direct claims on cash flows generated through DeFi protocols.

If securities regulators deemed such pseudo-equity tokens to be unregistered securities and pursued not only their issuers and promoters but also the venues upon which they trade, the financing and governance model of these DeFi projects would be significantly impaired.

20/ Scalability issues are a fundamental constraint to blockchains, solving them come at a variety of tradeoffs.

But not scaling them is not an option, because the cost of using the networks prices out swathes of investors and would be counterintuitive to the ethos of Defi.

21/ "Here is where all the chaos in DeFi is really from - systems that are built to be scalable and automated but that are underspecified or not understood by their creators. "

22/ "In sum, blockchain technologies bring many benefits. But the tools or processes used to disintermediate or gain efficiency also have costs in recourse, reversibility, risk management, etc. – the ‘paradox’ of DeFi."

n/ DeFi is achieving something truly novel: facilitating business model experimentation & evolution in a very short time. We've seen the evolution of defi systems from nascency to rediscovery of current financial systems & are moving towards discovering new financial primitives