Decentralized finance (Defi) has been a fast-developing sector of the crypto space that has surprised even those contributing to its growth.
Defi users are still trying to understand how Defi protocols have allowed traditional financial products and multiple yield-farming opportunities, but the change has also led to security concerns.
What are decentralized Exchanges?
Decentralized exchanges facilitate peer-to-peer cryptocurrency transactions. Since there is no intermediary involved, users can purchase crypto through direct P2P transactions and retain custody of their funds.
Decentralized exchanges have become increasingly popular because they differ drastically from centralized exchanges. Centralized exchanges require third-party custodians to handle users’ funds.
Centralized exchanges have a higher probability of data loss and theft. This is because they are operated by third-party entities that are responsible for monitoring security and asset transfer between parties.
Decentralized exchanges might seem like a promising alternative to their centralized counterparts, but they have setbacks that should be considered.
Are decentralized exchanges safe?
The emergence of decentralized exchanges has created new opportunities in the Defi sector. However, there are concerns about whether centralized and decentralized exchanges will entirely replace traditional exchanges. Some key areas of concern include market access and discrepancies in methods for individual and institutional investors to access decentralized exchanges.
At the same time, third-party centralized entities in the working of decentralized exchanges also present a risk for investors. The role of blockchain in decentralized exchanges is to facilitate the trading that has to come under scrutiny. Even if blockchain is supportive of the development of decentralized exchanges, it is important to look out for notable risks before participating in the market.
Can decentralized exchanges be hacked?
Questions are being asked to the extent that they overshadow more crucial concerns. One key drawback of centralized exchanges is that investors must pay for order flow. DEXs, on the other hand, do not force investors to pay for order flow. Miners or mining pools could obtain a preview of transactions while confirming and validating them on decentralized exchanges, allowing them to exploit market manipulation opportunities.
It should be noted that DEX trading bots scraped more than $100 million in just 30 days. So there’s no way you could undermine the threats posed by these decentralized exchanges risks to your assets. Payments for order flows have taken center stage, with more prominence recently.
DEX Risks that you cannot ignore
A look at the risks underlying decentralized exchanges could help understand their practical implications. Here are some of the top risks to consider when evaluating such exchanges.
Security Risks
Decentralized exchanges are not immune to all possible threats, and you must consider the threats carefully before deciding how to use them. While the creators of decentralized crypto exchanges have focused on private keys, those of decentralized exchanges point out that in the case of DEXs, private keys are a reason for safety concerns.
Decentralized exchanges can differ from fiat-based models in that they rely on peer-to-peer transactions and are therefore more transparent than centralized exchanges.
However, it is important to wonder whether decentralized exchanges can encourage the widespread adoption of DEXs. Centralized exchanges provide an important value improvement through their custodial services, which enhances trust among Defi participants.
Liquidity Risks
Decentralized exchanges are vulnerable to liquidity risks due to the infrequent volume of their trading. A lack of liquidity has been a major concern for crypto traders. However, liquidity is a formidable concern for different decentralized exchanges for different reasons. The important factor leading to liquidity risks on DEXs is the low trading volume on DEXs compared to centralized exchanges.
Limited Recovery Ability
For some, the perception that decentralized exchanges are unsafe leads them to believe that decentralized exchanges should not be used. However, decentralized exchanges cannot recover lost, misplaced, or stolen funds. This is because decentralized exchanges do not have the ability to recover stolen funds.
Without KYC processes and the ability to cancel transactions, you can’t recover lost data or assets. Refunds are incompatible with a network built on smart contracts, so you can’t rely on a support team for notifications about missing funds.
Scalability
The addition of risks in decentralized exchanges has focused attention on scalability issues. When used as a foundation for decentralized exchanges, the network congestion experienced by Ethereum-based blockchain networks translates to scalability issues for the decentralized exchanges.
They cannot prepare for mainstream adoption if the volume of first-layer transactions increases drastically. Decentralized exchanges are now limited to transaction capacities due to scalability issues and are unable to adopt the transformative network upgrades needed to resolve such issues.
How do we prevent the hacks?
- 100% Test coverage
Though 100% test coverage of the smart contracts and end-to-end code is not possible, developing a large enough test environment to validate the functionality in your project can help. - Secondary auditing
The thing to understand is that one audit of a smart contract before it is deployed is not enough. The ERC-777 token standard, which imBTC implements, may be considered less vulnerable than other standards, such as ERC-20, but a vulnerability in any of the functions used by Lendf. I could have been exploited in unexpected ways. - Use multi-sig
You should ensure that the Dapp project is secured by multiple signatures. This means that even if the hacker gains access to one private key, he will not be able to access the asset pool. There are two ways of achieving this. The first is to use a separate multi-sig contract, and the second is to develop a multisig logic within the Defi protocol. - Bug Bounty programs
Another way to identify vulnerabilities in code is to launch a bug bounty program and ask for help from the community. This builds credibility among the people using the Defi protocol or trading in the Exchange.
Conclusion
Decentralized exchanges are the most powerful tools in the crypto ecosystem, and make for a very attractive product for investment. However, one must not ignore the fact that just as you would with any other software, ensure that a decentralized exchange is secure before buying.
As the world gears up for decentralized exchanges, one of the biggest risks is dapp security. In addition to understanding how these markets work, you need to know how to avoid front-running and how liquidity works.
ImmuneBytes, the smart contract audit company, audit app platforms fortified with institutional-grade security. Defi auditors at our dApp audit company achieve market-leading security standards that are also highly functional.
