Decentralized finance (DeFi) has grown significantly and has become an integral part of the global crypto markets. However, its continued growth heavily depends on how secure the technology is against attacks. According to data from DefiLlama, over $5 billion in the total value of assets has been lost in DeFi protocols to date. To remedy this situation, the Ethereum community has come up with a new token standard called ERC-7265.

This is partner content sourced from Laura Shin’s Unchained and published by CoinDesk.

In this guide, we will explain the ERC-7265 token standard and the role it plays in DeFi risk mitigation.

Understanding the ERC-7265 Token Standard

The ERC-7265 proposes adding a “circuit breaker” mechanism to DeFi protocols to stop the transfer of tokens in the event of a hack.

Re-entrancy attacks, logic errors, and manipulation of oracles can cause these hacks. The circuit breaker would operate on a smart contract interface and be independent of the underlying protocol structure. The circuit breaker primarily acts as a conduit for token transfers and will simply pause token transfers on a protocol when a predetermined threshold for a specific metric is surpassed.

The transfer of tokens will halt until the protocol issue is solved. The circuit ERC-7265 standard will work to prevent losses from malicious protocol attacks. For developers working on ERC-compliant protocols, the ERC-7265 offers the flexibility to customize the circuit-breaking mechanism to a protocol’s specific needs.

The circuit breaker is customizable in one of two ways. It can delay settlements and temporarily hold custody of assets during the post-protocol breach phase. Additionally, it could reverse any attempted outflows. The two approaches give developers full autonomy while boosting protocol stability.

DeFi protocols can incorporate ERC-7265 to improve security and reduce potential losses.

The Role of the ERC-7265 in DeFi Risk Mitigation

The ERC-7265 standard, if widely adopted, can help to prevent DeFi risks in the following ways:

Increases security

Adding a circuit breaker mechanism can prevent significant losses when unusual market situations occur or when specific metrics are surpassed which may indicate malicious activity. The circuit breaker pauses token outflows, and this serves to protect customer assets.

Improves protocol stability

During unpredictable market conditions, the circuit breaker can halt token transfer to reduce the possibility of catastrophic losses. Protocol users can be more proactive in resolving any issues while token outflows remain halted. Including the ERC-7265 standard can help boost people’s confidence and trust in a DeFi protocol.

Reduces Risk

The ERC-7265 standard adds an extra layer of security to Ethereum protocols, as developers can choose to either delay a settlement or revert any token transfers. With such a safeguard in place, a DeFi protocol can reduce its risk profile and boost investor confidence.

Protect Users

In the case of extreme market volatility or smart contract vulnerabilities, the circuit breaker can help to prevent serious losses and protect users’ assets.

Developer customization

Developers can adopt any of the two ERC-7265 implementations depending on a protocol’s unique requirements, like the tokenomics and use cases. The two approaches include postponing settlement and holding custody of assets or reverting attempted token transfers.

Benefits and Drawbacks of ERC-7265

The ERC-7265 standard offers several benefits and concerns. They include:

Benefits

Easily customizable – Developers who adopt the ERC-7265 standard can customize the thresholds depending on the requirements of each protocol. Flexibility is crucial for protocols with collective user governance that need community buy-in to implement the safety feature.
Reduced losses – DeFi protocols will experience fewer economic losses caused by market upheavals or code vulnerabilities.
Drive adoption – The incorporation of ERC-7265 can help rebuild user trust in DeFi protocols and ultimately drive the adoption of DeFi technology.
Prevents attacks – The ERC-7265 standard prevents future attacks by removing the financial incentive for attacks to occur in the first place.
Interoperability – Adding a circuit breaker mechanism to various DeFi protocols can increase interoperability and allow users to transfer assets across different ecosystems.

Drawbacks

Protocol integrity – Developers must apply the ERC-7265 standard correctly to DeFi protocols to avoid any negative impact on network integrity.
Network shutdown – If events are mistaken and the threshold is triggered, the circuit breaker will engage, causing the entire network to halt. This scenario can be destabilizing to an entire community.

The Bottom Line

The ERC-7265 standard can potentially be an effective tool in lowering risks and securing the DeFi ecosystem. However, its adoption heavily relies on its acceptance by the Ethereum community and the commitment of its developers to incorporate the standard into the network infrastructure. That said, should it meet the approval of stakeholders, it will open doors for DeFi protocols to become more secure and resilient.

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