The higher the risk, the higher the reward. This is the working philosophy of all DeFi systems. While DeFi systems offer complete autonomy regarding your financial decisions and allow you to make a fortune with automated systems, they also present a unique set of challenges in the form of risks involved.
Unlike traditional banking, DeFi systems work 24/7, making it impossible to track everything. With humongous financial investments and non-stop operations, these systems attract numerous malicious factors that can risk your investments and result in you losing all your assets.
Learning about the risks involved with DeFi systems and how to avoid them is no longer a luxury for crypto investors due to some major setbacks in recent years. It has become a part of their lifestyle and how they operate. Let us help you understand all the risks associated with any DeFi system and what steps you can take to minimize them.
Why is Decentralized Finance (DeFi) Risky?
While DeFi is revolutionizing how you do transactions and control your assets, it is not without its risks.
- Lack of Central Oversight: DeFi systems without the oversight of any central systems, like the SEC in CeFi. If you lose your funds due to a hack or a scam, you will be on your own with no help from external governing bodies. Due to no central oversight, DeFi has remained a favourite place for hackers to invade throughout the years.
- Smart Contract Vulnerabilities: Smart contracts are code that executes automatically once deployed. If a smart contract is deployed with a bug or a vulnerability, it can be exploited, leading to catastrophic damage, including loss of all funds from a DeFi system.
- Market Volatility: Assets used in the DeFi system, like ETH, are extremely volatile. Any swing in the market can destroy their value, leading to draining liquidity pools in a matter of minutes.
- Evolving Regulatory Landscape: As many countries don’t recognize DeFi systems, they still operate in legal gray zones. Any change in government policies can wipe out the funds for a DeFi system or seize them indefinitely.
- Oracle Risk: Many DeFi systems rely on the oracle for external data. If Oracle is compromised, it can lead to a potential disaster.
- Custodial Risk: Some DeFi systems still require members to deposit funds. Any mismanagement or fraud can lead to the collapse of the DeFi system.
Top Risks Associated With DeFi Every Investor Should Be Aware Of
DeFi systems are powerhouses of the digital economy. While they offer a decentralized space for investors, this charm also attracts numerous malicious factors. Below is a list of risks associated with DeFi networks you should be aware of before taking the plunge.
Smart Contract Vulnerabilities
Smart contracts are the backbone of a DeFi system, and their function is to automate everything, from treasury management to update protocols. A single vulnerability in their code or execution can lead to a major hack of the whole DeFi system.
As smart contracts are immutable, this means they can’t be changed once deployed. In case of a vulnerability, it becomes difficult to remove an already deployed contract or fix it. In 2024, the Bybit hack resulted in a loss of over $1.5 billion in a few seconds due to a vulnerability in the smart contract.
Hackers can link together smart contract vulnerabilities to perform an “Exploit Chain”. This can be even more catastrophic as it can result in loss of treasury, governance, and sometimes the whole system.
Impermanent Loss
While not as visible and catastrophic as a smart contract hack, impermanent loss can occur when the price of tokens in liquidity pools (LP) diverges from their original position due to arbitrage brokers.
Even if the position of the token returns to its original position, it can skew the ratio between your paired tokens. Impermanent loss only affects liquidity providers in a DeFi system.
Protocol Governance Risks
In DeFi systems, governance is often used to refer to transparency and user control, as it is maintained with specific protocols on the smart contract. However, DAOs created with malicious intent or DeFi systems overrun with bad people with governance tokens can result in catastrophic results for their community.
With whale domination, few people can overtake a DeFi system with full control over governance tokens. They can pass protocols that can drain your funds in an instant. Admins can use multisig to override the smart contract, which enables them to move funds without your consent.
Oracle Manipulation
Oracles work as a bridge between a DeFi system and the real-world data. They provide price feeds and determine collateral value. They also set interest rates and borrowing limits.
Hackers can manipulate oracles to control feeds, interest rates, or even flash loan exploits to drain funds from a DeFi system immediately. The bZx oracle exploit via flash loans in 2020 resulted in a loss of over $350,000 in less than a few minutes.
Liquidity Risks
Liquidity allows a user to trade, borrow, and withdraw assets from a DeFi system conveniently. However, loss of liquidity pools during a market crash can lead to disaster for the users.
With the liquidity risk of a DeFi system, it loses its buyers and sellers. This results in assets falling in price rapidly, allowing malicious people to exploit the system.
This gives rise to a vicious circle. Price drops, users panic, liquidity dries, price falls further, panic amplifies. All the assets are converted into liquidity, and the users lose their assets as collateral.
Regulatory & Compliance Risks
As DeFi systems work across borders without legal governance, they always land in a gray area where government and authorities can attack them relentlessly. Legal uncertainty is the biggest challenge faced by DeFi systems in 2025.
Governments can stop users from accessing a DeFi system and freeze their assets by delisting them from exchanges. This is rare in advanced countries; however, countries in Asia still face this problem, with users losing their assets in an instant.
Stablecoin De-peg Risk
Stablecoins are designed to maintain a fix price of $1 for trading, saving, and lending in DeFi systems. They can be either collateral-backed or algorithmic.
However, if a stablecoin loses its peg, the results can be catastrophic. Upon losing the peg, users rush to sell stablecoins, resulting in a further price drop. Lending platforms, DEXs, and DAOs, depending on stablecoins, suffer insolvency.
TerraUSD loses its peg in 2023, leading to a loss of over $40 billion and the shutdown of major exchanges.
Rug Pulls
Rug pull refers to a scam by the developers of a DeFi system. It happens when the developer of a cryptocurrency sells their tokens, takes all funds, and abandons the project. This leaves the users with worthless tokens.
To protect yourself from rug pulls, always invest in a token with credible developers. Shady DeFi systems lack credible and transparent audits. They usually have unlocked liquidity and random token distribution to the community. Thorough research before investing in a DeFi can save you from an irrecoverable disaster.
Phishing & Social Engineering
Phishing and social engineering target humans and try to exploit their weaknesses, unlike attacks on the smart contract. These methods involve manipulating users into giving away their private information, including private keys of their wallets, or tempting them to interact with malicious apps.
With social engineering, hackers can manipulate you into giving them your seed phrases, private keys, login credentials, or token approvals. With this information, they can drain your account in a second. You can protect yourself by never sharing your personal details or wallet information with anyone.
For phishing attacks, hackers use fake software that resembles trading apps or digital wallets. They ask users to reset information for security purposes. Once you add your credentials, they gain access to your wallets and assets. Hackers can also use phishing by impersonating support agents from your DEX or other exchanges to extract sensitive information.
Private Key Mismanagement
Private key manages all your assets, wallet, and identity on a blockchain. It is your ultimate access pass to everything in DeFi. However, the onus of responsibility to protect the private key lies upon the user.
Unlike traditional banking, where you can recover your passwords with technical help or by using the “forgot password” button, there is no help or method available to recover your lost private key. Once it is gone, it is gone forever, potentially locking all your assets in a blockchain. Ronin Network lost $624 million once hackers managed to get their private keys.
Interconnectedness
DeFi works by connecting its various protocols. While this increases the efficiency of a decentralized network, it also allows hackers to launch a coordinated attack on a system. This can bring down the whole system even when one protocol is compromised.
Major DeFi systems share assets across platforms, making it easier for users on-chain to participate. Some systems even use bridge or cross-platform protocols to function properly. This allows hackers to target one module and use it to exploit the main treasury reserves of a blockchain. The consequences are often severe, leading to the complete collapse of a DeFi system.
Some Major DeFi Failures in the Past
While DeFi systems have seen major success and boom since their inception, there have been some major failures in the past few years that highlight how risky this venture can be. From smart contract hacks to private key mismanagement, DeFi systems have lost billions of dollars to malicious factors.
The DAO Hack (2016)
In 2016, DAO was targeted due to its reentrancy flaw. The hacker used a malicious smart contract to recursively call the withdrawal action without updating the balance. This resulted in DAo losing $60 million, which the hacker transferred to a child DAO controlled by him.
The DAO hack had major consequences and led to the first hard fork for Ethereum. It split into ETH, ETC (Ethereum Classic) as a result of the hack.
Terra-UST Collapse (2022)
UST was a stablecoin created to maintain a 1:1 peg with the US dollar. In early May 2022, Anchor Protocol offered up to 20% APY on UST deposits, which is unsustainable. This attracted billions from investors in capital.
Major investors soon started pulling capital, leading to a fall in UST value against the dollar. This made users panic, and they started burning UST for LUNA to reduce supply. This resulted in LUNA’s supply increase from 350 million to 6.5 trillion. UST fell to $0.10, losing all its peg. This resulted in a loss of over $40 billion, the highest recorded in the history of crypto.
Curve Finance/Vyper Exploit (2023)
In 2023, Curve Finance was hit by a series of exploits in Vyper, a Pythonic language used to create Ethereum-based smart contracts. A flaw in the reentrancy locks led to multiple attacks on the withdraw functions and the release of more funds than usual.
With the Vyper exploit, liquidity pools lost over $47 million in an instant. This resulted in mass user panic, leading to the emergency transactions. Due to this exploit, the CRV token lost its value.
Key Considerations for Managing DeFi Risks
To save yourself from DeFi risks, you need a proactive, informed, and diverse approach. Whether you are a newcomer to DeFi or a seasoned investor, you should understand the key pillars of DeFi risk management to avoid or minimize your losses in case of a malicious attack or a security lapse.
Educate Yourself About the DeFi Ecosystem
Before you start investing in a DeFi system, educate yourself about its functioning and protocols. You can always take online DeFi courses to gain an in-depth understanding of decentralized systems.
DeFi systems are complex with their digital tokens and protocols. As these systems have expanded exponentially in the past few years, the risk of attacks has increased too. All DeFi systems have permissionless access and work without government interference.
These are core concepts that you should learn before diving into the world of DeFi. The more educated you are about a DeFi system, the higher your chances will be of avoiding any risk.
Always Do Your Own Research (DYOR)
The responsibility in a DeFi system lies with the user and is non-negotiable. With great financial freedom comes greater financial responsibility. Always do your research before investing in a DeFi system.
Read about the developers’ history and see if they have been previously involved with any scams or rug pulls. Don’t join systems that are overhyped on social media by bot-run accounts. Make sure that you completely understand the fundamentals of the DeFi system you are interested in. This involves researching protocols, learning about tokens, and active engagement with the community.
A good DeFi system allows neutral and transparent audits of its smart contract by third parties. This is a great indicator to judge whether scammers or legitimate individuals run a DeFi system. Do your diligence, as there will be nobody to help you in case of a scam.
Use Reputable Protocols and Audited Contracts
DeFi systems are run by code, which is executed through smart contracts. Systems with proven security and neutral audits should be your first choice. As smart contracts are immutable, they can’t be changed once deployed. It means a vulnerable or poorly audited contract can result in the loss of treasury funds quickly.
Aave and Compound run on protocols that have undergone rigorous testing and improvements over the year. They also allow transparent audits, making them the most trusted DEFi systems in the world.
Start Small and Diversify
Like every smart person, never put all of your eggs in one basket. Start investing small amounts in DeFi systems after thorough research. Diversify your portfolio by investing in well-established and new ventures.
If you want to take a risk, go with 1-2% of your total investment to minimize your loses. Not only will this help you secure your finances in the DeFi world, it will also help you learn a lot about different protocols and communities.
Keep Your Funds in Secure Wallets
In DeFi systems, you must manage and secure your assets. There is no central management to help you with it. The best way to secure your crypto assets is by storing them in hardware (cold) wallets.
These wallets keep your private keys offline forever, thus stopping hackers from ever accessing them. These wallets are best for long-term storage and slow transactions, and provide complete protection against theft of your digital assets.
Keep a Close Eye on the Market and Regulatory Developments
Keeping yourself up to date with regulatory developments and market trends is crucial to your survival in the DeFi world. As DeFi systems work in a legal gray area, it gives governments leverage against them. They can impose certain regulations on a DeFi system, resulting in the inability of its users to access it or freezing their assets completely.
To be successful, you must keep track of government movements and read about their past policies in your region regarding DeFi systems. Betting against a ruling government is never a safe option.
Market trends also influence the value of assets and impact crypto trading. Be involved with the community and watch the news to learn how the market is shifting. Only make your next move when you are confident in your market knowledge.
How Institutions Are Approaching DeFi Risk Management
DeFi systems in 2025 are too big and lucrative to be ignored by financial institutions. Banks, hedge funds, and financial managers are finally entering the DeFi world. However, they are overly cautious and use various risk management measures to avoid uncertain loses.
These institutes evaluate a DeFi protocol with smart contract audits, risk scoring models, and scenario analysis.
Smart Contract Audits: Institutions often hire third parties to audit a smart contract of a DeFi protocol of interest to them.
Risk Scoring Models: Institutes use risk scoring models that evaluate the health, liquidity, governance, and exploit history of a protocol.
Scenario Analysis: Institutes use stress tests to simulate market crashes, liquidity, or governance failure of various DeFi protocols.
However, this doesn’t end here. Once an institution becomes satisfied and invested in a DeFi protocol, it uses various monitoring and compliance tools to check the health of the system. They use RegTech to ensure the DeFi system is complying with evolving laws and implement KYC/AML.
They prepare incident report plans to prepare for any unforeseen failures. Institutes always use insurance to cover their loses before making a large investment in any DeFi system.
The best method employed by institutions is diversification. It serves as their safety net in case one or more DeFi systems fail, even with full preparation. All institutes invest in various protocols and have large crypto teams that help them with their investment decisions.
By adopting these methods, institutes have become more bold and are becoming a major player in the DeFi world with massive capital investment.
Learn to Analyze and Manage DeFi Risks With Dypto Crypto
While the risks associated with DeFi protocols seem scary and can deter potential newcomers, you can mitigate them with a good understanding and careful planning. We at Dypto-Crypto offer free guides, tutorials, and resources that can help you understand DeFi risks and courses that will teach you how to avoid and manage DeFi risks successfully.
Our weekly newsletter is also available for free with a free sign-up to cover all your latest crypto needs. With so much to offer for free, all you have to do is sign up for free and become a master of the DeFi world.
Frequently Asked Questions (FAQs)
Q: What are the biggest risks in DeFi right now?
A: Smart contract vulnerabilities, hackers, exploits, market volatility, liquidity problems, regulatory uncertainty, and interconnectedness.
Q: How can I protect my funds when using DeFi platforms?
A: By understanding the risks associated with DeFi platforms and using cold wallets to keep your private keys offline forever.
Q: Can DeFi protocols be insured?
A: Yes. You can use various insurance models that provide you protection against smart contract vulnerabilities, hacks, stablecoin de-pegging, and custodial risks. Some major names include Nexus Mutual and InsurAce.
Q: Why are institutions interested in DeFi despite the risks?
A: Institutions have a lot of fail-safe measures in place before investing in a DeFi system. However, the risks still outweigh the safety measures. Due to efficiency, innovation, and access to USD liquidity, institutions can no longer ignore DeFi systems.
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