How Crypto Cross-chain Investigation Shapes the Future of DeFi
Merkle Science
Decentralized finance (DeFi) has grown in popularity as an alternative to traditional finance. It is a decentralized, transparent, and secure financial system based on blockchain technology. However, as with any technology, DeFi faces security challenges that must be addressed in order to maintain user trust and confidence.
- One of the emerging risks of DeFi is cross-chain crime, which refers to the use of cross-chain bridges to launder money and engage in other illicit activities.
- Cross-chain bridges enable users of DeFi services to move funds seamlessly across different blockchains and using a wide range of crypto assets.
- The downside is that criminals and high-risk entities have used DEXs, cross-chain bridges, and coin swap services to transfer and launder their illicit proceeds.
The US Department of the Treasury has warned about the emerging risks of cross-chain crime in a new assessment of DeFi. The Treasury's DeFi risk assessment marks an important development in anti-financial crime efforts in the crypto space. The assessment considers risks associated with DeFi services, including decentralized exchanges, lending protocols, mixers, and cross-chain bridges.
In this article, we will delve into the complexities of cross-chain crime in the DeFi space and explore the potential future of this revolutionary financial landscape.
Understanding DeFi
Decentralized finance (DeFi) is an emerging financial technology that offers financial instruments without relying on intermediaries such as brokerages, exchanges, or banks by using smart contracts on a blockchain. DeFi platforms allow people to lend or borrow funds from others, speculate on price movements on assets using derivatives, trade cryptocurrencies, insure against risks, and earn interest in savings-like accounts.
DeFi uses a layered architecture and highly composable building blocks. The DeFi ecosystem is built on top of public distributed networks and uses self-executing agreements written into lines of code called smart contracts, ensuring that access to financial services is democratized. The DeFi stack consists of several layers, including the settlement layer, asset layer, protocol layer, and application layer. Ethereum as a Layer1 chain settles every transaction on its network, while Layer2 is the framework that gets built on top of the blockchain. DeFi is built on Layer1 and Layer2 solutions, which offer a way of improving scaling and reducing transaction fees
The Rise of Cross-chain Interoperability
Cross-chain interoperability is a critical feature of DeFi that enables different blockchains to communicate and exchange data seamlessly. It allows users to access assets and services across multiple blockchain networks, thereby expanding the possibilities of DeFi applications. Through cross-chain bridges and protocols, users can trade and transfer assets between different blockchains with relative ease. Some examples of cross-chain interoperability projects include Cosmos, Chainlink, Polkadot, Hybrix etc.
But as the adoption of DeFi grows, cross-chain interoperability faces several challenges that need to be addressed to ensure its successful implementation. Here are some of the challenges:
Scalability issues:
Cross-chain interoperability requires a high level of scalability to handle the increased traffic and data exchange between different blockchains. The current blockchain infrastructure is not designed to handle the high volume of transactions that cross-chain interoperability requires, which can lead to network congestion and slow transaction times.
Security and privacy concerns:
Cross-chain interoperability introduces new security and privacy risks, such as the possibility of double-spending, data breaches, and loss of funds. The security risks associated with holding assets across multiple blockchains can also be significant, opening the door for hacks and potential loss of funds.
Lack of standardization:
Different blockchain systems and languages make it challenging to establish a common standard for cross-chain communication. This lack of standardization can lead to interoperability issues and make it difficult for different blockchains to communicate with each other.
Complexity of cross-chain solutions:
Cross-chain interoperability solutions are complex and require a high level of technical expertise to implement. This complexity can make it difficult for developers to create interoperable solutions that work seamlessly across different blockchains.
By addressing these challenges, the blockchain industry can unlock the full potential of cross-chain interoperability and enable users to access a wider range of assets and services.
The Dark Side of DeFI: Cross-chain Crime
It is worth noting that DeFi protocols accounted for 82.1% of all attacks in 2022, up from 73.3% in 2021. Additionally, cross-chain bridge protocols specifically were responsible for 64% of the losses suffered by DeFi actors. These figures highlight the significant impact of cross-chain crime in the DeFi space. As the DeFi ecosystem continues to flourish, it has also caught the attention of malicious actors seeking to exploit vulnerabilities within the system. Cross-chain crime refers to illegal activities that occur across multiple blockchain networks, taking advantage of the decentralized nature of DeFi platforms. These crimes may include:
Rug Pulls and Exit Scams
Rug pull scams in blockchain refer to fraudulent schemes in which developers promote a new crypto project or token to investors, only to disappear with the invested funds, leaving investors with valueless assets. These scams are a type of exit scam and are prevalent in the decentralized finance (DeFi) space. Rug pulls are executed through various tactics and techniques, taking advantage of the decentralized and relatively unregulated nature of the crypto world. Here is a technical breakdown of how rug pull scams are typically carried out:
Creation of a New Token:
Fraudulent developers create a new cryptocurrency token, often on a blockchain like Ethereum or another compatible platform. They have the ability to generate tokens easily without undergoing a code audit or proper due diligence.
Listing on Decentralized Exchanges (DEXes):
The scam project's token is listed on decentralized exchanges or peer-to-peer marketplaces for crypto traders, such as DEXes. These platforms allow the token to be traded and provide liquidity.
Marketing and Hype:
Fraudsters utilize social media and other channels to create buzz and hype around the project. They make enticing promises of high returns and use various marketing tactics to attract a community of investors.
Price Pump and Dump:
The scammers artificially inflate the price of the token by buying a significant amount themselves or using other manipulative techniques. This creates a false sense of demand and attracts more investors.
Exit and Abandonment:
Once the price reaches a peak or when enough funds have been accumulated, the developers suddenly exit the project, leaving investors with worthless tokens. They disappear with the funds, making it difficult for investors to trace or recover their investments.
Rug pull scams exploit the lack of regulatory oversight, loose fundraising regulations, and the relative anonymity of the crypto world. The use of smart contracts, which are agreements governed by computer software, adds complexity to tracing or recovering funds in case of fraudulent activities. These scams highlight the importance of conducting thorough research, due diligence, and skepticism when investing in new crypto projects.
Flash Loan Attacks
Flash loans are a type of uncollateralized lending that allows users to borrow assets with no upfront collateral and return them within the same blockchain transaction. While flash loans have legitimate use cases, such as arbitrage and high-speed trading, they can also be used maliciously to exploit vulnerabilities in smart contracts and manipulate prices.
Flash loan attacks are a type of exploit where malicious actors take advantage of the temporary liquidity provided by flash loans to manipulate prices or steal funds. The key to the success of a flash loan attack is the ability to repay the loan within the same transaction block, which allows the attacker to take advantage of temporary liquidity without providing any collateral. Some notable examples of flash loan attacks include the bZx hacks, Uranium Finance, and Meerkat Finance. To prevent flash loan attacks, DeFi platforms can implement best practices such as reentrancy guards, access control mechanisms, and third-party auditing.
Arbitrage Exploitation
Arbitrage is the exploitation of price differences between different markets or platforms to generate profits. In DeFi, arbitrage opportunities arise due to the fragmentation and inefficiency of the market. There are two categories of arbitrage strategies in DeFi: yield arbitrage and cross-DEX arbitrage.
Yield arbitrage involves exploiting differences in interest rates across different DeFi protocols, while cross-DEX arbitrage involves exploiting price differences between different decentralized exchanges (DEXs). While arbitrage is a legitimate trading strategy, it can also be used maliciously to manipulate prices and exploit vulnerabilities in smart contracts. To prevent arbitrage exploitation, DeFi platforms can implement access control mechanisms, circuit breakers, and third-party auditing.
Smart Contract Vulnerabilities
Smart contract vulnerabilities refer to weaknesses or flaws in the code of a smart contract that can be exploited by malicious actors to steal funds, disrupt the regular functioning of the contract, or cause other types of damage. Smart contracts are self-executing programs stored on a blockchain that automate the execution of an agreement between different parties. They are used to manage financial assets and other types of transactions in a decentralized and trustless manner. However, despite their potential, smart contracts are not immune to vulnerabilities and attacks.
Here are some of the most common smart contract vulnerabilities and how they are exploited by hackers:
Reentrancy:
This vulnerability allows an attacker to repeatedly call a function within a smart contract before the previous call has completed, leading to the theft of funds.
External Calls:
This vulnerability allows an attacker to execute malicious code on a smart contract by calling an external contract.
Missing or Inadequate Validation:
This vulnerability allows an attacker to bypass validation checks and execute malicious code on a smart contract.
Integer Overflow and Underflow:
This vulnerability allows an attacker to manipulate the value of a variable in a smart contract, leading to the theft of funds.
Time Manipulation:
This vulnerability allows an attacker to manipulate the timestamp of a smart contract, leading to the theft of funds or other types of damage.
Denial of Service:
This vulnerability allows an attacker to disrupt the regular functioning of a smart contract by consuming all available resources.
Hackers exploit these vulnerabilities by analyzing the code of a smart contract and identifying weaknesses that can be exploited. They then use various techniques, such as reentrancy attacks, to steal funds or disrupt the regular functioning of the contract. To prevent smart contract vulnerabilities, developers can conduct thorough code audits, implement best practices for security, and follow industry standards for smart contract development.
The Future of DeFi: Mitigating Cross-chain Crime
Decentralized finance (DeFi) has the potential to revolutionize traditional financial systems by providing open, permissionless, and trustless alternatives. However, the DeFi ecosystem is not immune to financial crimes, and cross-chain crime is a significant issue that needs to be addressed. Here are some ways to mitigate cross-chain crime in DeFi:
Auditing and Security Measures
Developers can conduct thorough code audits and implement best practices for security to prevent smart contract vulnerabilities. They can also follow industry standards for smart contract development and implement access control mechanisms, circuit breakers, and third-party auditing. Additionally, blockchain analytics solutions can play an important role in the detection and mitigation of risks from DeFi. Techniques that can be leveraged by developers to make their contracts more secure are:
Infrastructure Audits
This helps in evaluating DeFi security beyond merely assessing the internal contracts. Auditing the underlying infrastructure and inherited components is essential to ensure a comprehensive analysis. Infrastructure audits help to identify vulnerabilities in the underlying infrastructure and inherited components.
Gas Optimization
This audit is essential to assess and optimize gas usage. Gas optimization helps to reduce the cost of executing smart contracts and improve the efficiency of the DeFi protocol.
Regulation and Compliance
The US Department of the Treasury has warned about the emerging risks of cross-chain crime in multiple assessments of DeFi. In 2023 alone Multiple crypto businesses such as Coinbase, binance and Ripple have directly faced the brunt of the SEC for non-compliance, licensing, and insider trading issues.
Rather than trying to fit existing regulations tailored for traditional finance markets, regulators should focus on the types of financial crimes that are unique to the DeFi ecosystem and that truly hurt the end user. The SEC, NYDFS, FinCEN, and MAS have taken a strong approach post the fallout of FTX which caused the crypto ecosystem a loss of $150 billion. In the wake of this, regulators should align methods of detection and prevention with crypto’s core values of decentralization and trustlessness intact.
Decentralized Insurance
Decentralized insurance can provide protection against financial losses resulting from cross-chain crime in DeFi. Decentralized insurance platforms use smart contracts to automate the claims process and ensure transparency and fairness in the payout process. Decentralized insurance can also provide coverage for smart contract vulnerabilities and other types of risks associated with DeFi.
Mitigating cross-chain crime in DeFi requires a multi-faceted approach that includes auditing and security measures, regulation and compliance, and decentralized insurance. By implementing these measures, the DeFi ecosystem can become more secure and resilient, enabling it to reach its full potential as a driving force in redefining the future of finance.
Here are some relevant examples of decentralized insurance:
- Nexus Mutual: Nexus Mutual is a decentralized insurance platform that provides coverage for smart contract vulnerabilities and other types of risks associated with DeFi. The platform uses a risk-sharing model, where members pool their funds to cover potential losses.
- Opyn: Opyn is a decentralized insurance platform that provides coverage for options trading on Ethereum. The platform uses smart contracts to automate the claims process and ensure transparency and fairness in the payout process.
The Challenge of Regulatory Compliance
Although blockchain technology promises transparency, the lack of standardized global regulations poses a significant challenge in combating crypto criminals. Varying regulations across different jurisdictions create loopholes that criminals can exploit, hinder cooperation between authorities, and delay the process of tracing and recovering stolen funds.
Improving Anti-Money Laundering (AML) Measures in Blockchain
To effectively combat crypto criminals, we propose a multi-faceted approach to bolster AML measures in blockchain technology.
Enhanced Identity Verification
Blockchain platforms and cryptocurrency exchanges must implement robust identity verification procedures for users. This can include Know Your Customer (KYC) protocols to ensure all participants are properly identified and linked to legitimate financial accounts. Furthermore, entities need to implement robust policies and protocols to counter anti money laundering and counter financing of terrorism.
Compliance with AML/CFT regulations:
DeFi platforms must comply with anti-money laundering/combating the financing of terrorism (AML/CFT) regulatory obligations and report more information about their activities, including transaction monitoring and sanctions screening. This can be done without compromising user privacy by using non-correlatable peer Decentralized Identifiers (DIDs) and zero-knowledge (zk) proofs.
Real-Time Transaction Monitoring
Incorporating advanced real-time transaction monitoring tools enables immediate detection of suspicious activities. Machine learning algorithms can be employed to identify patterns indicative of money laundering and promptly flag such transactions for further investigation.
Due diligence on DeFi liquidity pools:
DeFi service providers can conduct due diligence on DeFi liquidity pools to stay clear of exposure to criminal and fraudulent activity in the world of DeFi. Merkle Sciences’ risk management platform helps crypto funds, exchanges, and custody providers identify and monitor risk in DeFi liquidity pools.
Conclusion
Decentralized Finance has undoubtedly disrupted the traditional financial landscape, offering a plethora of opportunities for financial inclusion and innovation. However, the rise of cross-chain crime highlights the need for continuous vigilance and proactive measures to safeguard the integrity of the DeFi ecosystem. By fostering a secure and trustworthy environment, the future of DeFi holds immense promise, empowering users worldwide with financial freedom like never before.
While blockchain technology has tremendous potential to transform various industries, it must also confront its weaknesses head-on. Addressing the inefficiencies that enable crypto criminals to launder billions of dollars is imperative to safeguard the reputation and integrity of blockchain. By implementing stringent AML measures, enhancing smart contract security, and fostering collaboration among regulators, we can create a more robust and secure blockchain ecosystem that protects users and thwarts the illicit activities of crypto criminals.
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