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Decentralized Finance (DeFi) - Understanding Risks in an Emerging Financial Paradigm

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Decentralized Finance (DeFi) - Understanding Risks in an Emerging Financial Paradigm

  1. 1. DECENTRALIZED FINANCE (DEFI) Understanding Risks in an Emerging Financial Paradigm Bernhard Haslhofer Annual Conference of the Austrian Blockchain Center (ABC) 2021-03-23
  2. 2. SOME CONTEXT
  3. 3. GOAL FOR TODAY 3 What is DeFi? What are the risks in DeFi? What can we do?
  4. 4. TRADITIONAL VS. DECENTRALIZED FINANCE [inspired by Zetzsche et al., 2020] Investment Banking Derivatives & Forex Private Banking Insurance Traditional Finance Decentralized Finance Loans Assets Derivatives Exchanges Distributed Ledger Smart Contracts
  5. 5. • Non-custodial: pseudo-anonymous actors have full control over their funds at any time • Permissionless: anyone can interact with DeFi services • Transparent: anyone can investigate and audit the state of protocols • Composable: financial services can be arbitrarily composed into new financial produces and services (“Financial Lego”) DEFI | PROPERTIES 5 [based on Werner et al., 2021] Loans Assets Derivatives Exchanges Distributed Ledger Smart Contracts
  6. 6. DEFI PROTOCOLS | SELECTION Source: https://defipulse.com/ Project Locked (USD) Blockchain Lending Maker Compound Aave 7.05 B 6.73 B 5.12 B Ethereum DEX SushiSwap Uniswap Curve Finance 4.60 B 4.26 B 4.21 B Ethereum Derivatives Synthetix Nexus Mutual HEGIC 2.19 B 292 M 75 M Ethereum Assets Badger DAO RenVM Vesper 1.39 B 774.7 M 739.1 M Ethereum (March 19th, 2021)
  7. 7. DEFI PROTOCOLS | EVOLUTION 7 Source: https://defipulse.com/
  8. 8. EXAMPLE | COMPOUND LENDING 8 Borrowing Agent Compound Comptroller Escrow collateral asset (ETH, ERC20) Borrow asset (CErc20, CEther) Redeem collateral asset (ETH, ERC20) Repay borrowed asset (CErc20, CEther)
  9. 9. GOAL FOR TODAY 9 What is DeFi? What are the risks in DeFi? What can we do?
  10. 10. TECHNICAL RISKS | OVERVIEW 10 [inspired by Werner et al., 2021] P2P Overlay Network Distributed Ledger (Consensus + State Replication) Applications (Smart Contracts) Nodes Smart Contract Vulnerabilities Transaction Ordering Attacks Network Congestion An adversarial agent can gain profits by exploiting the technical structure and design of a blockchain system
  11. 11. EXAMPLE | FRONT RUNNING 11 Everyone and everything has a partial view of the mempool (order book) …. also, non-mining nodes and bots. Inspired by Matteo Romiti, 2021
  12. 12. EXAMPLE | FRONT RUNNING 12 Traditional Finance Decentralized Finance Entering a trade or contract with advance knowledge of a transaction that will influence the price of the underlying security to capitalize on the trade. This practice is expressly forbidden by the SEC. Traders are not allowed to act on nonpublic information to trade ahead of customers lacking that knowledge. Submit a transaction which is intended to be executed before some other transaction. An agent may financially benefit from front-running one or more victim transactions. This common practice is not forbidden by anyone. Bots act on public information to trade ahead of other user lacking the technical skills and/or understanding.
  13. 13. Oracles SOCIO-ECONOMIC RISKS | OVERVIEW 13 P2P Overlay Network Distributed Ledger (Consensus + State Replication) Applications (Smart Contracts) Nodes Incentive Models Governance Models Miner Behavior Oracle Manipulation Miner Extracted Value Under- collateralization Governance Attacks
  14. 14. SYSTEMIC RISKS 14 DeFi protocols can be composed to construct complex, inter-connected financial systems and services (“Financial Lego”). P1 P3 P2 P4 P5 P6
  15. 15. SYSTEMIC RISKS 15 DeFi protocols can be composed to construct complex, inter-connected financial systems and services (“Financial Lego”). P1 P3 P4 P5 P6
  16. 16. GOAL FOR TODAY 16 What is DeFi? What are the risks in DeFi? What can we do?
  17. 17. UNDERSTANDING DEFI PROTOCOLS 17
  18. 18. UNDERSTANDING DEFI COMPOSITIONS 18 P1 P3 P2 P4 P5 P6
  19. 19. FURTHER INFORMATION 19 https://graphsense.info https://www.csh.ac.at/complexity-science/Cryptofinance/ bernhard.haslhofer@ait.ac.at contact@graphsense.info
  20. 20. • [Böhme., 2019]: A Primer on Economics for Cryptocurrencies (https://bdlt.school/files/slides/talk-rainer- b%C3%B6hme-a-primer-on-economics-for-cryptocurrencies.pdf) • [Zetzsche et al., 2020]: Decentralized Finance (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3539194) • [Gudgeon et al., 2020]: The Decentralized Financial Crisis: Attacking DeFi (https://arxiv.org/pdf/2002.08099.pdf) • [Werner et al., 2021]: SoK: Decentralized Finance (DeFi) (https://arxiv.org/abs/2101.08778) REFERENCES

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