What Is DeFi and How Does It Affect Cryptocurrency Security?

What if banks disappeared overnight, and you had full control over all your finances? There’d be no middlemen or hidden fees when you’re making transactions, too. 

This is what DeFi (decentralized finance) aims to achieve. It’s an emerging financial ecosystem, which is built on the extremely secure blockchain technology. 

So, you can lend, earn, trade, and borrow cryptocurrency om here without relying on traditional banks. And DeFi also operates through smart contracts (a type of codes that executes tasks automatically) – which makes the entire transaction process much more transparent. 

However, while DeFi is all about making you “financially independent” – it also comes with some security concerns. For example, as there’s no intermediary available to oversee the transactions, you’ll have to bear full responsibility for safeguarding your funds. 

Following proper DeFi security protocols may also include – protecting your privacy, using different security measures, and managing risks effectively.  

Let’s learn more about it. 

DeFi – What is It & How Does It Work? 

For centuries, most of our financial systems have been controlled by a central figure. For example, if you need a loan, you’d have to go to a bank. Or if you’re considering investing in a stock, you’ll have to put all your trust in a brokerage firm. It’s too much hassle. 

Decentralized finance (DeFi) disrupts this infrastructure by offering a more accessible and transparent alternative. These are deployed on a public blockchain, which allows everyone with an internal connection to participate in financial activities.  

How Does DeFi Work? 

Here’s a step-by-step guide on how a decentralized finance system works – 

A: Choose a DApp (DeFi Platform) 

Due to how accessible ETH is, there are way too many dApps available on the web. So, before you choose one of them, ensure that it follows all DeFi security protocols. Some popular examples of dApps can include – Aave, Compound, and Uniswap. 

B: Set Up Your Crypto Wallet 

You need a non-custodial cryptocurrency wallet, which supports the blockchain platform use by your DeFi app. MetaMask is the most popular ETH-based platform. So, firstly, you need to download and install the wallet app or extension. And then create a new wallet to store your seed phrase securely. 

Note: A seed phrase is a bunch of words that can be used to recover your wallet. 

C: Buy Cryptocurrency 

Now, you can start purchasing cryptocurrency on the DeFi platform. If you’re using an ETH-based option, you’ll need to pay transaction fees (also known as “gas”). In some cases, you’ll also need specialized tokens to lend, borrow, or trade cryptocurrency on it. 

Note: You can use a centralized exchange, such as Binance or Coinbase, to buy crypto. 

D: Transfer Crypto to Your Wallet 

You can transfer the bought crypto on your wallet and connect it to your dApp. After that, you can start using it for any kind of financial activity you want to perform with your cryptocurrency. 

Key Features of DeFi 

Some of the important features of DeFi are as follows – 

A: Automation 

Thanks to smart contracts, DeFi removes human intervention entirely from financial choices or operations. So, whether you’re making a trade or processing a loan, these codes can make your transactions happen exactly as you’d programmed them. 

B: Decentralization 

Traditional finance is usually controlled by centralized entities, such as banks. However, DeFi runs decentralized networks, which makes them accessible to everyone and censorship resistant. 

C: Accessibility 

As long as you have internet access, you can use your DeFi network to lend, borrow, and invest with your digital wallet. There’s no need to do paperwork or wait for approvals from another party. 

Blockchain: The Backbone of DeFi 

If DeFi is the future of finance, blockchain is what makes it work. Without it, DeFi wouldn’t exist – and, on top of it, it also ensures transparency, trust, and security in the system. 

Here’s how. 

1: Reducing Centralized Points of Failure 

Traditional financial institutions are vulnerable to cybercrimes because they rely on a centralized database. So, if its servers are hacked, all your sensitive financial data will be at risk. Apart from stealing, they can also change your personal information however they please. 

Blockchain, however, doesn’t have any centralized point of failure. So, even if a hacker compromises one node, the rest of the network will be unaffected. This makes the network far more secure. 

2: The Role of DLT (Distributed Ledger Technology) 

As a DLT technology, all records in blockchain are spread across more than one node (computers) instead of being stored in a single database. Every transaction goes through a thorough verification process by miners (or network participants) – which increases its security level even more. 

DeFi Security Challenges – Should You be Concerned? 

While DeFi is somewhat secure in its own accord, it can also be hacked easily. One mistake – and all your data can get exposed to someone who might misuse it gravely. 

So, let’s learn more about them. 

1: Risks of Smart Contracts 

DeFi operates on smart contracts, which get executed automatically when a predesigned task is completed. These codes are extremely secure, as they usually cannot be changed. However, this very same reason could be their downfall too. 

For example, if the data written on a smart contract is flawed, you won’t be able to change it quickly. This might affect the contract’s completion process. Furthermore, even a single bug available in the contract can be exploited by hackers to drain millions of dollars. 

2: Hacking and Digital Asset Custody Risks 

While you’re going to manage your digital asset custody by yourself – it can expose you to various cyber-risks, such as –  

• Malware attacks  
• Phishing scams  
• Wallet hacks  

As DeFi transactions are irreversible, if someone else gets access to your account, you won’t get access to it anymore. 

The Role of Smart Contracts in DeFi Security 

The best thing about smart contracts is that they remove the need for middlemen entirely. So, the transactions are faster, cheaper, and more transparent. Furthermore, they can also improve the security protocols of blockchain by preventing tampering. So, once deployed, no one can change it. 

However, as they are still quite new, smart contracts cannot be considered foolproof yet. For example, it can be hacked and exploited by hackers. And in some cases, if you have made a mistake while writing the code, you won’t be able to alter it anymore. 

1: Why Do Smart Contracts Matter? 

So, if you want to reduce the risks associated with smart contracts, proper regular audits are essential. Here is what you need to know about it –  

A: New Audit 

You can conduct a new audit after creating a smart contract for a project (which is about to launch). It’ll focus on identifying and fixing potential flaws before implementing the contract code. The aspects you need to check to ensure DeFi security are – 

• Security 
• Functionality 
• Code review  
• Compliance 

B: Repeat Audit 

If you’re trying to modify or making adjustments to an already-existing contract, it should be done through a repeat audit. It makes sure that new modifications aren’t creating any security flaws or influence the contract’s performance negatively. 

C: Fix and Limited Audit 

A fix audit is usually conducted when the development team finds out and corrects flaws. Through it, you can ensure that the new patches are resolving the mistakes and aren’t creating new issues. 

On the other hand, if your resources or time is short, you can perform a limited audit to focus on important aspects of the contract – 

• Functionality-related issues 
• Security features 

The Final Verdict 

Decentralized finance will certainly change how we borrow or trade our money. Thanks to blockchain technology, it’s already quite transparent and immutable as well. However, there are some security concerns that still plagues these platforms. So, if you want to have a seamless DeFi experience, protecting your data and making smart contract audits will be important. 

Good luck!