Hello, everyone! We’re thrilled to have you back at Lobster Academy!
Investing in DeFi can be as exciting as it is risky. To become confirmed investors, understanding the inherent risks of DeFi and learning how to mitigate them is essential. Today, we’ll explore these risks and offer strategies to manage them effectively. Let’s take a look!
In this article we will unfold risks that you may don’t know such as :
∘ Smart Contract Risks
∘ Liquidation Risk
∘ Oracles Manipulation
∘ MEV (Maximum Extractable Value)
∘ Impermanent Loss
Let’s dive deeper into each of these areas.
Smart contracts, the autonomous backbone of DeFi, facilitate transactions without intermediaries. Despite their benefits, they’re not immune to vulnerabilities.
A case to point out is the 2016 “The DAO” hack, where hackers stole 3.6 million ETH, valued at $50 million at the time. Mitigating these risks begins with due diligence. Opt for DeFi projects that have passed thorough audits by reputable firms like Certik, TrailOfBits or OpenZeppelin.
Protocols can mitigate the risk associated with smart contracts by implementing bug bounty programs. These programs leverage the expertise of the community, encouraging individuals to identify and report vulnerabilities in the code. In return for discovering a bug, the contributor receives a reward from the company.
For instance, our partner dHEDGE, has undergone several Certik audits and initiated a bug bounty program to uphold the highest security standards.
Engaging with lending protocols introduces the risk of liquidation if the collateral’s value falls.
This dynamic involves two parties: the lender, who deposits assets to earn interest, and the borrower, who provides crypto as collateral to secure a loan. Liquidation happens when the collateral’s value declines, posing a solvency issue, prompting the protocol to liquidate the position automatically.
To mitigate this, closely monitor your collateral’s value and maintain a strong loan-to-value ratio. Though stablecoins are generally safer, they’re not completely risk-free, as depegging events can still lead to liquidation.
At Lobster, when our algorithm takes a loan, it ensures that your liquidation is as far as possible. Every hour, our algorithm will calculate your liquidation risk and rebalance your position.
Oracles play a critical role in DeFi by providing off-chain data to smart contracts, such as asset prices for lending protocols. However, their manipulation can lead to major financial issues.
A hacker could manipulate the oracle and trick the lending protocol into believing that the price of ETH is $1, then borrow a huge amount of money at a fraction of the cost.
Mitigating this risk is quite difficult as you don’t have any power on those oracles. To shield yourself from oracle risks, investigate the protocols’ chosen oracle services for their reliability and security.
MEVs stands for Maximum Extractable Value, it is a method used to exploit your transactions at your expense.
MEV attacks are bots used to front run your transaction when trading on a DEX. When you buy a token on a DEX, your transaction is placed in the mempool (the blockchain queue of transactions), a bot can find it and submit its transaction just before yours. The bot’s transaction will profit from the slippage caused by your trade and will sell right after. You’ll pay more than you agreed to pay in the first place. MEVs bots can make you lose hundreds and even thousands of dollars.
To reduce this risk, you can use an RPC endpoint (Remote Procedure Call) that will hide your transaction so bots cannot find it before it has been validated by the blockchain.
One famous RPC Endpoint for the Ethereum blockchain is MEV Blocker that you can find here : https://mevblocker.io/#rpc
Note that when using a private RPC your transaction might be slower than usual but that’s the price to pay to not get exploited by MEV bots.
Impermanent loss occurs when the value of the assets deposited in a liquidity pool changes compared if they were held outside the pool.
We have written an in-depth article explaining what impermanent loss is and how to reduce it.
In a nutshell, to minimize impermanent loss, choose a pool with correlated assets such as stable/stable pool or volatile/volatile pool such as ETH/stETH.
Another solution is simply to use Lobster. Our algorithm manages to minimize the impermanent loss even on decorrelated asset pairs such as WBTC/ETH.
Empowering your DeFi journey with Lobster 🦞
Understanding the inherent risks of DeFi is the first step towards making informed investment decisions. At Lobster, we’ve engineered our algorithms with these risks in mind, developing robust solutions to mitigate them. We encourage you to explore our documentation for a deeper dive.
Remember, investing in DeFi is not a game. It requires knowledge, vigilance, and strategic action. With Lobster by your side, you’re well equipped to navigate the complexities of DeFi investing.
Stay informed, stay safe, and happy investing!
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