Risks and Challenges in DeFi

Decentralized Finance (DeFi) introduces a new open and borderless financial ecosystem, built entirely on blockchain networks. But along with its innovation comes a growing list of vulnerabilities.

Unlike traditional finance, DeFi systems rely on smart contracts, governance protocols, and external data feeds to function. Each of these components carries its own set of risks, many of which can be exploited if not properly addressed.

In this lesson, we’ll explore the most pressing risks facing DeFi today, including technical flaws, manipulation strategies, and governance vulnerabilities. We’ll also look at how technologies like AI are beginning to play a role in risk mitigation.

Smart Contracts: The Double-Edged Sword

On many chains like Ethereum, smart contracts are the foundational building blocks of DeFi protocols. Smart contracts simply refer to code published atop blockchain networks that can have complex logic built in, which in turn may automate financial functions ranging from trades to interest payouts. However, they’re only as secure as their code.

If a smart contract has a bug or isn’t designed with proper safeguards, it can be exploited. The consequences can be devastating: funds locked, stolen, or permanently lost. For instance, as of 2024, over $10B had been lost to DeFi exploits.

These issues are often made worse by the composability of DeFi, where one protocol depends on others. This means that a failure in one contract can cascade through the ecosystem.

Even high-profile protocols have faced significant losses due to smart contract exploits. These incidents underscore the importance of code reviews, formal verification, and continuous monitoring.

Tools like bug bounties and third-party audits help, but they can’t eliminate all risk. As protocols grow more complex, so do the potential attack surfaces.

In contrast, the XRP Ledger (XRPL) addresses many of these vulnerabilities head-on by embedding essential DeFi primitives directly into its protocol, eliminating the need for external smart contracts in core operations. 

For instance, the XRPL’s  decentralized exchange (DEX), automated market makers (AMMs), payment channels for streaming micropayments, and special-purpose tokens known as “Multi-Purpose Tokens” (MPTs) all run on the ledger’s battle-tested consensus engine. This protocol-level design shrinks the exploit surface, enhances composability through inherent interoperability, and paves the way for safer, more scalable DeFi without the cascading failures that plague contract-dependent ecosystems.

Regardless of any DeFi protocol’s home chain, what’s emerging now in a big way is the use of AI-based tools to scan for anomalies and predict vulnerabilities. These tools can detect unusual activity and flag risky contract behaviors before they escalate, which is a critical step in catching threats early.

Still, AI is no silver bullet. It adds a layer of defense, but must be paired with human oversight and strong governance structures.

Oracle and Governance Risks

DeFi protocols often rely on external data feeds known as oracles for price data. But when oracles are manipulated, attackers can trick smart contracts into executing faulty transactions.

One notable method is oracle manipulation, where attackers move prices on low-liquidity exchanges to influence the oracle feed. This remains one of the most persistent and difficult challenges in DeFi security.

Governance risks are also on the rise. Many DeFi systems are governed by decentralized autonomous organizations (DAOs). In theory, this distributes control. In practice, it can invite manipulation.

For example, a well-funded attacker could accumulate enough governance tokens to control votes and redirect funds or change protocol rules.

A Quick Primer on DAOs and Voting Mechanics

DAOs operate via smart contracts that enable community-driven decisions: users propose changes (e.g., protocol upgrades or fund allocations), and token holders vote to approve or reject them. 

Voting is typically token-weighted, meaning influence scales with holdings, so those with many tokens (“whales”) carry disproportionate sway. This design incentivizes skin-in-the-game but amplifies security risks, as concentrated ownership can enable capture by outsiders or insiders. (If that sounds a bit confusing, it is! But an outsider (e.g., a shady investor) could buy up tokens quietly and swing votes to siphon funds or weaken rules. Or an insider (e.g., the founding team) might hoard tokens to rubber-stamp their agenda, undermining the “decentralized” ideal.)

To counter this, DAO members’ active role matters: engage by holding and voting on tokens, joining discussions, or contributing proposals. Strong community involvement fosters checks and balances, turning governance from a vulnerability into a collective strength.

Flash Loans

Flash loans are uncollateralized, instant loans unique to DeFi, but they must be borrowed and repaid within a single blockchain transaction. They were originally used for arbitrage, leveraging the network’s atomicity (the entire transaction either succeeds or reverts). They became a game-changer for legitimate uses like cross-exchange arbitrage and liquidations, letting anyone operate like a high-frequency trader without upfront capital.

Yet this speed and scale amplify risks: attackers can borrow massive sums that, within the same transaction, are able to manipulate prices (e.g., dumping on low-liquidity pools to skew oracle feeds), trigger faulty liquidations, or exploit contract flaws before repaying.

High-profile cases, like the 2022 Mango Markets exploit that drained $100M+, highlight how flash loans turn minor vulnerabilities into multimillion-dollar heists. Vigilance in protocol design and oracle redundancy is key to harnessing their power safely.

Staying Ahead of DeFi Threats

Security in DeFi is a moving target. As developers build new tools, attackers find new strategies. This cat-and-mouse game makes risk management a full-time concern for any serious protocol.

Incident reports like the Vow hack of August 2024 and the $1.5B Bybit breach in early 2025 highlight DeFi’s maturation challenges, with over $3B in losses in 2025 alone signaling persistent risks amid rapid innovation.

The good news is that the ecosystem is evolving. Solutions like decentralized oracles (e.g., Chainlink) are helping make price feeds more secure. Governance frameworks are getting more sophisticated, and AI-driven anomaly detection is gaining traction.

Ultimately, navigating DeFi requires balancing innovation with caution. Builders and users alike must stay informed, and protocols must constantly adapt.

Knowledge is power. 

This chapter’s cautionary tales help explain the careful design choices made on the XRPL blockchain.

With the XRPL, various features like the built-in DEX, AMMs, and compliance tools (e.g., Clawback and Multi-Purpose Tokens) are built at the protocol level, not the smart-contract level, which sidesteps many smart contract vulnerabilities and flash loan exploits that plague EVM chains. This foundational security, alongside sub-second finality and low fees, empowers builders and users to innovate boldly, turning potential threats into opportunities for resilient, enterprise-grade DeFi.