The ICON DeFi Guide: Part 7 — Where DeFi Has Gone Wrong
Now that you’re caught up to speed on the various DeFi products that ICON has to offer and how you can use them, I want to take a minute to dispel some misconceptions about DeFi while also being sure to emphasize the risks.
Since you know a bit more about these protocols, they’re probably already less scary in your mind than they used to be. But it’s possible you still have memories of headlines from the Summer/Fall of 2020 about hacks, rug pulls, and other issues that plagued the DeFi ecosystem.
However, in many cases, these issues were brought on by carelessness on the part of developers, traders, and speculators. DeFi is a tool after all, and any tool can be abused or misused (especially if operated improperly!).
So for this section, we are going to go through some of the most prominent issues that DeFi ran into, but do so in an educational context, so you can better understand them and learn how to avoid — or manage — them moving forward.
Food Tokens and Worthless Protocols
One of silliest things to emerge from the DeFi boom was the number of projects and protocols named after various foods. Sushiswap, YAM, Tendies, Pizza, etc. You probably saw your Twitter timeline obsess over a new one of these (either positively or negatively) for a couple days at a time before moving onto a new one to talk about.
It should be pointed out that just because a protocol is named after a food doesn’t automatically mean it’s a scam (SushiSwap, for instance, is still a healthy protocol). But a number of scams were certainly “food” DeFi products.
Part of the benefit of smart contracts is they are almost always open-source. This means those who want to improve upon existing projects have a foundation from which they can start, which is good. It also means people can easily rip-off what others have already built for nefarious reasons, which is bad.
The latter case was a common cause of scam protocols on DeFi. An anonymous team would essentially copy an AMM such as Uniswap and rebrand it as their own.
Then, perhaps they’d airdrop the native token on Telegram, creating a dedicated set of bagholders who were now cheerleaders for the project.
Then, they’d launch their protocol, promising a crazy yield such as 5,000% APY (annual yield) for those who became liquidity providers. With a team full of cheerleaders behind them who now had an interest in the token price going up, they’d hype up the project and advertise the crazy yield.
At this point, the team might list their token on Uniswap, and then conduct a rug pull (as described in the chapter on AMMs). Or, there might be a vulnerability in their smart contract that allows them to simply steal all the funds that liquidity providers deposited into the contract. Or, after the whales had pumped the price to unsustainable levels (drawing in FOMOing non-whales), they’d dump in a hurry, sending the price essentially to zero (this is essentially what happened with HOTDOG and Pizza.)
Either way, this entire scenario was full of red flags. The project wasn’t adding any new value. The founders were anonymous with no history of prior accomplishment. The promises of returns were likely too good to be true. The price was at a non-sensical height.
Of course, these were common red flags during the ICO boom as well, yet the idea of incredibly high returns is always enticing.
Fortunately, when it comes to DeFi on ICON, the projects currently available don’t have any of these red flags (at least from my perspective). But if you happen to see any new protocols pop up on ICON, it’s important to conduct your due diligence.
Excessive “Crop Rotation” or “Yield Hopping”
One of the most popular concepts in DeFi is “yield farming”. While the term does have some negative connotations, it’s generally a positive concept (as we go into in the next chapter).
Yield farming is essentially utilizing platforms in order to receive a return on your capital. During the DeFi boom, as protocols kept springing up, they have an incentive to offer ever-escalating competitive yields in order to lure in new users.
Accordingly, what many began to do was simply hop from one protocol to another, chasing whichever had the most lucrative yield at the moment. This activity became known as “crop rotation” (get it!).
Unfortunately, what happened is that larger holders would supply liquidity on one platform that was offering high yields (and could continue to offer high yields as long as liquidity providers were providing liquidity), capturing as much gain as they could. Then, as soon as a new platform popped up offering even greater yield, they’d simply move their funds from the old one into the new one.
This was good for the whales. It was not good for those left behind who were providing liquidity in a protocol that was effectively dead (because the whales had left), meaning the token value — and thus the yield — also dropped.
Those who were in the worse shape were those who had actually bought the token after watching it rise in price, as their investment usually cratered.
Of course, as long as you aren’t unsustainably chasing yields in this case — or buying useless tokens on the market — you shouldn’t have much to worry about.
Flash Loan Attacks
There have also been exploitations of vulnerable protocols that have led to a loss of funds from the protocol.
In these cases, the attacks are typically done using flash loans (another DeFi concept), and are usually very complex and difficult to execute. There’s a debate about whether or not these are “hacks” or not, as typically those exploiting the protocol are doing so within the design (aka the rules) of the protocol. That distinction doesn’t provide much comfort to those who have lost funds, however.
Rather than try to explain it all here, I’ll instead encourage you to watch this video on flash loan attacks from The Defiant, which a commentator correctly described as “One of those videos that is full of information, but still manages to captivate till the end”:
One of the main takeaways you likely got from this video is that even smart contracts that have been audited can remain vulnerable. That’s why it’s impossible to for anyone to say a certain DeFi protocol is 100% risk-free. (As I write this, I feel I should point out that there are currently no flash-loan providers on ICON, making this vector of attack currently non-existent.)
While DeFi isn’t entirely “safe”, neither is crypto as a whole. If you are careless about how you utilize your funds or the projects you participate in, your chances of losing your funds increases.
If you’re careful about how you utilize your funds and trust only trustworthy projects, you’re far more likely to walk away unscathed (and, hopefully, profitable!).
Now that we’ve seen what the downsides of DeFi can be, you’re probably ready to learn a bit more about how you can safely benefit from DeFi on ICON.
If you’d like to ask questions about DeFi, discuss strategies, or just have a general discussion, please join us in the ICON DeFi Discussion group I’ve created on Telegram to supplement this guide and build a vibrant DeFi community around ICON.