DeFi Risk Management: Building a Safe and Reliable Decentralized Finance Ecosystem

Decentralized Finance ( DeFi ) has realized a decentralized version of traditional financial services through smart contracts, including asset trading, lending, insurance, and various derivatives. Besides credit services, most financial services in the real world can find corresponding solutions in the DeFi ecosystem. These protocols are characterized by complete decentralization and automated operation, without centralized institutions for management and maintenance. For this reason, risk management of contracts has become a major challenge faced by the industry.

Decentralized Finance integrates the dual characteristics of finance and technology, mainly facing the following types of risks:

1. Code Risk: This includes potential vulnerabilities in the underlying Ethereum code, smart contract code, and wallet code. Historical DAO incidents, recent vulnerabilities in certain DEX attacks, and various wallet theft incidents fall under this type of risk.

2. Business Risks: Mainly refers to vulnerabilities in the business design process that may be reasonably exploited or manipulated by attackers. For example, the congestion attacks encountered by an early game project, and a lending platform suffering asset losses due to the use of an insecure price oracle. Actors who profit from exploiting these vulnerabilities are usually referred to as "arbitrageurs," and their impact on DeFi projects can be twofold.

3. Market Volatility Risk: Due to the fact that DeFi projects may not fully consider extreme market conditions during their design, issues such as liquidation can occur during significant fluctuations. The crisis encountered by a certain stablecoin project on March 12, 2020, is a typical example.

4. Oracle Risk: Oracles, as the infrastructure that provides critical external data, are essential for most DeFi projects. If an oracle is attacked or fails, the DeFi applications that rely on it may collapse. In the future, decentralized oracles will become one of the most important infrastructures in the DeFi ecosystem.

5. "Technical Agency" Risk: Refers to the potential risks that non-professional users may face when interacting with convenient tools and smart contracts developed by centralized teams.

In order to effectively manage these risks, DeFi projects need to comprehensively consider the above factors during the design phase. A complete risk management process not only includes providing risk warnings in documentation but also requires the implementation of a series of risk management measures. Most of these measures are adopted in a decentralized manner, with some being realized through community governance (primarily on-chain governance).

The following is a DeFi Risk Management Framework, mainly divided into three stages: before the event, during the event, and after the event:

Preliminary: The focus is on the formal verification of contract code. This includes a deep understanding of the methods, resources, and boundaries of the instructions used in the contract, as well as the interactions between these elements during the combination process. Methods that are not sufficiently justified or combinations with unclear boundaries should be treated with caution. This approach is closer to mathematical proof rather than traditional software testing methods.

In-process: mainly involves shutdown design and anomaly triggering mechanisms. The contract should be able to identify and intervene in potential attacks, including automatic shutdowns and governance shutdown designs. Anomaly triggering is a control management method for unexpected situations that occur during the contract's operation, usually executed automatically, to adjust risk management parameters.

After the fact: This includes several key steps. First, the discovered code vulnerabilities are repaired through on-chain governance (DAO). Secondly, if the governance assets themselves are attacked, a contract fork may be necessary, which is an important aspect often overlooked in the industry. Additionally, insurance mechanisms can be utilized to disperse potential risks and reduce possible losses. Finally, the community can leverage on-chain data tracking to collaborate with relevant institutions to recover lost assets.

Currently, the industry's understanding of DeFi security is still in its early stages and the thinking patterns are relatively traditional. To adapt to future developments, it is necessary to introduce new concepts and methods such as boundaries, completeness, consistency, formal verification, shutdown mechanisms, anomaly triggers, governance, and forking. Only in this way can a safer and more reliable DeFi ecosystem be built.