The adoption of decentralized finance (DeFi) has rapidly increased in recent years, offering users the ability to access transparent financial services through autonomous, decentralized applications. However, with this increase in adoption comes the need for robust safety measures to protect users and prevent losses—with $3B+ in DeFi lost to hacks just in 2022, security should be a top priority for any DeFi protocol.

One important tool for promoting stability and mitigating systemic risk in the DeFi ecosystem is a circuit breaker. Circuit breakers can help mitigate the extent of common hacks and exploits, prevent protocol insolvencies, decrease systemic risks, and more.

In this article, we’ll explore the role of DeFi circuit breakers in helping ensure the safety and integrity of DeFi platforms and how they can be built using Chainlink Proof of Reserve and Chainlink Automation.

If you’d prefer to explore the topic in video format, watch this Smart Contract Automation Masterclass:

What Is a Circuit Breaker in DeFi?

DeFi circuit breakers are an important safety mechanism. They help to bring additional security and stability to the DeFi ecosystem. A circuit breaker is a mechanism designed to halt or pause certain activity in a protocol in the event of unforeseen or unusual circumstances, such as a sudden price drop or an undetected security vulnerability.

The Role of Circuit Breakers

Circuit breakers can help mitigate the extent of a number of potential security issues, such as:

• Sudden price drops—A large price crash can leave a protocol vulnerable to security attack vectors and manipulation.
• Significant liquidity removal—A sudden removal of a large amount of liquidity can lead to cascading failures in protocols that rely on optimal liquidity conditions for normal operation.
• Fractional reserve activity/undercollateralization—Reserves that aren’t sufficiently collateralized can lead to protocol failure and undercollateralized assets. 
• Price anomalies—Outlier price movements can disrupt the operation of a protocol and expose it to attacks, hacks, and exploits.
• Stable/pegged asset depeg—Stablecoins and pegged assets aim to maintain parity with a target price or index. If the peg is broken, it can lead to cascading failures in protocols utilizing the assets.

If a security issue is detected, the circuit breaker may be triggered to halt or pause activity until the issue can be assessed and resolved, helping to prevent protocol and user losses as a result of the incident. Circuit breakers can also help prevent cascading failures in DeFi, where one security vulnerability creates a harmful domino effect in an interconnected loop of decentralized applications.

How Chainlink Proof of Reserve and Automation Enable Secure and Decentralized Circuit Breakers

To help ensure end-to-end transparency for DeFi protocols, Chainlink Proof of Reserve (PoR) provides smart contracts with the data needed to verify the true collateralization of any asset backed by cross-chain and off-chain reserves. Chainlink Automation is a decentralized transaction execution service that empowers developers to enable conditional execution of their smart contract functions through a hyper-reliable and decentralized automation network.

Developers can combine Proof of Reserve and Automation to build circuit breakers that help prevent protocol insolvencies and systematic failures in DeFi. The unique combination of PoR’s decentralized verification and Automation’s transaction execution can help developers implement highly reliable, secure, and decentralized circuit breakers that protect against outlier security events.

Supported by Automation and PoR feeds, cross-chain token reserves can be monitored in real-time to help verify the collateralization of bridged assets and help prevent infinite mint attacks. By automatically detecting anomalies, Automation- and PoR-enabled smart contracts can programmatically apply protective measures, helping increase user confidence around bridged assets.

Chainlink PoR can also help mitigate risks associated with cross-chain bridges through trust-minimized verification, protecting against security risks posed by bridged assets, such as the extraction of tokens from the deposit contract on the source network and infinite mint attacks.

Use Case Spotlight: Circuit Breaker on Aave Using Chainlink PoR

BGD Labs is working on a solution to integrate Chainlink PoR into Aave on Avalanche to help ensure wrapped tokens in Aave markets on Avalanche are sufficiently collateralized.

The solution involves a smart contract that acts as a registry for pairs of asset addresses and Proof of Reserve feed addresses. For each asset in the Avalanche deployment of Aave, the contract checks whether the Proof of Reserve feed value is equal to or greater than the total supply of the asset. If any asset on the list does not meet this requirement, a list of assets is outputted, and emergency actions may be performed. Depending on which version of the Aave protocol is being utilized, these can be disabling the borrowing of all pool assets and freezing the assets in question or freezing the assets and setting their loan-to-value ratio to 0, removing the ability for these assets to be calculated as collateral on the platform.

Through trust-minimized mechanisms, the novel solution aims to validate that centralized wrapped assets or smart contracts such as cross-chain bridges can prove their reserves in real-time on-chain, enabling the protocol to react and apply protections if an anomaly is detected.

Summary

While DeFi is creating a more efficient and transparent financial ecosystem, the supporting security infrastructure must be held to the highest standards. Circuit breakers are a critical mechanism to help decrease systemic and protocol-level risks in DeFi, bringing about more peace of mind for users and builders alike.

If you are interested in exploring how Chainlink oracles can help bring increased transparency to your platform or application, reach out to an expert here.