Sound the alarm for DeFi: DeFi is facing economic security threats, and a sound economic model is necessary
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Chain News ChainNews (ID: chainnewscom)
Chain News ChainNews (ID: chainnewscom)
, Author: Johnny Antos, partner of the consulting firm Prysm Group, compiled by: Zhan Juan, published with authorization.
Decentralized Finance (DeFi) is being hailed as the next revolution in the crypto world. But the recent surge in hacking attacks targeting DeFi projects suggests that DeFi projects may still not be mature enough to fully replace standard financial services.
Our analysis shows that 5% of DeFi value ($50 million worth of crypto assets) was compromised in hacks and other platform attacks over the past year, in part due to economic vulnerabilities in the design of DeFi platforms.
This is just the beginning.
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What is DeFi and why is it a target?
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Data source: Prysm Group analysis, as of September 2019
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Data source: DeFi Pulse, as of May 2020
As the value of DeFi increases, so does the potential gain from attacks on it. Unsurprisingly, hacking has increased significantly in 2020, just when the value of DeFi storage is at its peak.
Data source: Prysm Group analysis, as of May 2020
When millions of dollars are potentially at risk, the tech mantra of "move fast and break things" carries a heavy responsibility. Also, when user trust is breached, compromised protocols are difficult to recover from; after $25 million was siphoned off dForce’s Lendf.Me smart contract, the platform remains shut down and users may never come back (chain Note: With the dForce team successfully recovering the stolen funds, the team is planning to gradually open the Lend.Me platform and strive for users to return).
At Prysm Group, we specialize in identifying, analyzing and addressing the economic vulnerabilities faced by blockchain platforms as they launch and grow. In these DeFi incidents, four economic security threats emerged. DeFi projects must invest in understanding how these vulnerabilities occur, and how to fix them (if mass adoption is to be achieved). There are four main types of threats to the economic security of DeFi projects that we have seen so far:
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Relevant determinants of crypto-token value
The value drivers of DeFi tokens and financial instruments are often complex combinations of other fiat currencies (such as a basket of currencies) and/or other tokens (such as stablecoins).
In this way, there is a higher risk that accidental events or actions by malicious actors will cause the price of the token to change, and this change may be undesired.
The value of DAI depends not only on the price of its collateral, but also implicitly on the smooth functioning of its collateral source market. When the price of ETH dropped significantly on Black Thursday, the ETH trading market became congested. On MakerDAO, this resulted in Vault owners being unable to deposit additional collateral, Keepers unable to access DAI liquidity, and ultimately causing DAI to fall off its peg.
Due to the impact of the Black Thursday incident, MakerDAO has expanded the source set of collateral to include ETH, BAT, USDC and wBTC, trying to solve the problem of collateral and risk concentration. However, about 90% of DAI collateral is still ETH. In addition, MakerDAO also needs to carefully consider how future events on the underlying platform of any of these collateral sources will affect DAI.
For any stablecoin that is not fully collateralized (1-1 token-to-collateral ratio), platforms must understand the various interdependencies that drive the value of their tokens and develop a remediation plan for any weaknesses. Conducting agent-based simulations during the design process can help identify elements of a token design that are most vulnerable to adverse events.
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Incentive Compatibility of Oracles in DeFi
DeFi typically relies on some form of oracle, where many individuals report information, with a composite function determining the "truth" that the protocol subsequently uses.
Platforms are compromised when individuals have a profit motive and can sway the direction of oracles at low cost. This is also a security threat in many of the incidents mentioned above. Pegnet is a decentralized stablecoin platform that has moved more than $500 million across its network since it went live in August 2019.
Yet in April 2020, four mining entities managed to submit 35 of the top 50 offers for the pJPY oracle on the Pegnet platform, artificially inflating the starting balance of their pJPY tokens from a measly $11 to Approximately $6.7 million. Although these mining entities did not honor their pJPY, they clearly demonstrate that significant price manipulation via oracles is entirely possible.
Like many components of blockchain-based systems, the design of oracles can be analyzed through game-theoretic models. A rigorous analysis of oracle design can reveal the precise strategies and steps that each stakeholder might employ in engaging in dishonest (but perhaps economically rational) behavior, and devise levers to mitigate those behaviours.
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DeFi Pricing and Auction Mechanism
Many DeFi systems typically require pricing and auction mechanisms for various financial instruments.
In the MakerDAO system, when the collateral value of a small vault drops below a certain threshold, the vault is liquidated and auctioned off to a group of liquidators who inject DAI into the system in exchange for ETH (or other token-denominated ) collateral. If multiple liquidators (or multiple liquidation bots) participate in these auctions, bidding competition results in the auction's collateral being purchased at a fair price.
However, as we mentioned in a previous Coindesk article, the failure of the auction mechanism played a key role in the previously discussed MakerDAO incident. Ethereum’s network congestion created a scenario where two liquidators each bid separately in liquidation auctions, winning multiple auctions with zero DAI bids. Since MakerDAO's auction mechanism does not specify a reserve price or minimum bid, there is no way to prevent ETH assets from being sold for free after liquidation. This created a $5.7 million gap in the MakerDAO system and created a host of other problems for MakerDAO.
There is a rich economics research literature on auction design. Two factors that have been shown to have a significant impact on auction results are whether a reserve price is set and how the auction closes are determined. If the insights from these studies were applied to the design of MakerDAO, it would greatly improve the operation of these auctions and prevent the MakerDAO system from running into a multi-million dollar deficit again.
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Governance gaps in DeFi
There is such a risk in the DeFi system that a small economic loophole may destroy the integrity of the entire system.
This risk can be mitigated by establishing dedicated risk management mechanisms, such as backup plans, fail-safes, and crisis governance mechanisms. However, building emergency support components is often complex.
In the case of Lendf.Me, dForce could have prevented losses through some kind of crisis governance mechanism. However, to the best of our knowledge, there are no emergency shutdown procedures or plans to stop platform operations in a timely manner in the event of a system breach. It took about 4 hours between the dForce team getting news of the attack and the Lendf.Me deposits being frozen. It is surprising that dForce is still unable to act in a timely manner in a situation where dForce does not employ decentralized governance and therefore does not take the time to coordinate stakeholders to implement emergency procedures.
Slow action, limited response, these are not urgent actions to promote user trust.
As we discussed in a previous CoinDesk article, well-defined crisis governance is an essential part of any blockchain platform. From the moment a platform goes live, it is critical to have a clear set of rules that dictate what events trigger a crisis governance process, who is allowed to make decisions on behalf of the platform, and what options they have for action.
Without this infrastructure, the disruption caused by inaction during a crisis could do significant damage and hinder user adoption.
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DeFi needs economic security
