November
8, 2020
5 min read
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The cryptocurrency world is prone to hype, whether on the grand scale of the ICO boom and Bitcoin price pump of 2017 or the lesser scale of a new project or platform launching. This year has been all about DeFi and its revolutionary potential to reshape finance. In February, total value locked in decentralized finance applications exceeded $1 billion for the first time. By late October, it had hit $12 billion. The growth reflects the increasing willingness of traders to speculate on this nascent and largely experimental sector. With the potential for returns bordering on the ridiculous — 52,000 percent in one estimate — it’s hardly surprising.
But activity in DeFi is now showing signs of slowing down, with the volume on decentralized exchanges starting to drop off. Perhaps this was inevitable, but it represents a timely moment to reflect on some of the lessons learned from riding the DeFi rollercoaster.
1. DeFi can be dangerously exposed to price manipulation
Price manipulation became a problem early in 2020, as users sought to exploit the relatively new availability of flash loans. A flash loan involves taking out an uncollateralized loan using a protocol like Aave or dYdX, and using it in one or more related trades, then repaying the initial loan and pocketing any profits. The catch is that the entire series of events has to be performed within a single Ethereum transaction.
One challenge of decentralized finance is that the Ethereum blockchain doesn’t know the market value of the tokens based on its platform. Therefore, DeFi protocols use price oracles to settle trades. In February, a trader took advantage of the fact that bZx, a lending protocol, used the prices on decentralized exchange Uniswap as its price oracle. With low liquidity in a particular Uniswap pool, it was easy to borrow enough in a flash loan to dump tokens on Uniswap, forcing the price down while a parallel trade took out a long position. The trader came out of this chain of events with $330,000 in profit.
So, what can we learn from this? DeFi needs better price oracles. Relying on a single data point with fluctuating liquidity represents a vulnerability. Decentralized oracle services such as Kylin Network aim to overcome this challenge. A decentralized oracle doesn’t use a single price feed. Instead, it takes data from many different sources. Kylin Network is developed on the new interoperability platform, Polkadot. Therefore, it is a cross-chain protocol that can both take data from multiple blockchains and be deployed on applications running on any platform.
By using price oracles that take data from multiple feeds, then engineering an arbitration mechanism that allows for real-time validation, DeFi applications can reduce or even negate the risk…
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