Understanding and managing economic risks in DeFi

The next is a visitor article by Vincent Maliepaard, Advertising Director at IntoTheBlock.

Financial dangers have led to nearly $60 billion in losses by way of DeFi protocols. Whereas this quantity appears excessive, it solely displays losses on the protocol degree. The precise complete is probably going a lot greater when particular person consumer losses on account of varied financial danger components are taken under consideration. These private losses usually come up from risky market circumstances, complicated dependencies between protocols, and sudden liquidations.

Understanding financial dangers in DeFi

Financial danger in DeFi refers back to the potential monetary loss on account of hostile actions in market circumstances, liquidity crises, flawed protocol design, or exterior financial occasions. These dangers are multi-faceted and might come up from completely different sources:

1. Market danger: Volatility in asset values ​​can result in important losses. For instance, sudden drops within the value of collateralized belongings can set off liquidation occasions, which might result in a cascade of compelled gross sales and additional value drops.
2. Liquidity danger: The shortcoming to shortly purchase or promote an asset with out inflicting a big affect on the value. In DeFi, this could manifest throughout a market sell-off, when liquidity sources dry up, exacerbating losses.
3. Protocol danger: This danger arises from errors or inefficiencies within the design of DeFi protocols. Transient loss, oracle manipulation, and governance assaults are examples of how protocol-specific dangers can materialize.
4. Exterior danger: Elements exterior the protocol, comparable to actions by main market gamers or adjustments in macro charges and circumstances, can introduce important dangers which are usually past the management of customers or a protocol.

The layers had been throughout the financial danger

In DeFi, financial dangers are ubiquitous, however they are often understood at two completely different ranges: protocol-level dangers and user-level dangers. By distinguishing between the 2, customers can higher outline the dangers that affect their methods and monitor key indicators to take preventive motion.

Dangers on the protocol degree

Protocols implement safeguards by means of variable parameters designed to restrict publicity to financial losses. A typical instance is the lending and borrowing parameters set in lending protocols, that are examined and calibrated to stop dangerous money owed from accumulating. These measures are usually utilitarian in nature and goal to broadly shield the protocol from financial dangers, thereby benefiting the best variety of customers.

Whereas managing financial dangers have gotten more and more vital to stop large-scale losses on the protocol degree, the main focus is restricted: on the protocol itself. They don’t tackle the dangers that particular person customers can introduce by making economically dangerous selections inside their very own methods.

Consumer-level dangers

Consumer-level danger is commonly restricted to the quantity of leverage a person takes in lengthy or brief positions, however that is simply scratching the floor. Customers face a variety of further dangers comparable to liquidations, non permanent losses, slippages and the potential of blocked credit score liquidity. These particular person dangers are usually not throughout the scope of protocol danger administration, however can have important monetary penalties for particular person customers.

The excellent news is that these user-level financial dangers are very actionable. By understanding their very own danger profile, customers can actively handle and mitigate dangers particular to their technique. This personalised strategy to danger administration stays probably the most underutilized instruments at the moment obtainable to DeFi contributors.

The interconnected nature of danger inside DeFi protocols

Financial danger administration is crucial when addressing dangers spanning a number of DeFi protocols. Whereas protocol audits and danger parameters strengthen particular person protocols, DeFi customers usually use a number of protocols of their methods. This makes danger administration at consumer degree essential.

Every further protocol or merchandise introduces new danger components, not solely due to that new protocol, but additionally due to the interplay between these protocols. Even when every protocol is safe by itself, dangers can come up from how your technique combines these completely different protocols.

For instance, think about a situation the place a consumer makes use of a Liquid Restaking Token (LRT) as collateral to borrow an asset, which is then staked right into a liquidity pool (LP) on a third-party automated market maker (AMM). The principle concern may very well be the leveraged credit score place, however there are further dangers. The steadiness of the LRT’s hyperlink may affect the liquidation within the mortgage protocol, whereas the composition of the LP may affect the exit and exit charges, probably resulting in capital loss in repaying the mortgage. These interconnected dangers aren’t beneath the management of any single protocol and are subsequently greatest managed by the consumer.

Steps to grasp and handle financial dangers

Managing financial danger in DeFi requires a well-thought-out strategy, because the complexity of multi-protocol methods can introduce unexpected vulnerabilities.

1. Dive deep into the protocol mechanisms: Understanding the underlying mechanics of a protocol is step one in figuring out potential financial dangers. Traders and builders ought to fastidiously study the financial fashions, assumptions and dependencies throughout the protocol.
2. Monitor market indicators: Maintaining a tally of market indicators comparable to asset volatility, liquidity and total sentiment is crucial. Analyzing on-chain information particular to the protocols you utilize is a sensible technique to keep knowledgeable. For instance, in case you are engaged on a lending technique on Benqi, monitoring the well being issue of loans on the platform is essential. This supplies perception into how secure your credit score place is and helps you anticipate potential issues earlier than they escalate.

   

3. Create a holistic danger profile: Understanding how interconnected dangers can affect your total technique is essential to efficient danger administration. Though particular person methods fluctuate, danger evaluation might help establish downside areas. For instance, if you happen to use a Liquid Restaking Token (LRT) as collateral to borrow belongings, monitoring the soundness of the LRT’s peg is crucial to keep away from sudden liquidations. Sudden spikes or volatility within the peg could point out the necessity to take precautions, comparable to lowering publicity or rising collateral.

   

In abstract, managing financial danger in DeFi is about being proactive. By understanding protocol mechanisms, intently monitoring market indicators, and constructing a holistic view of potential dangers, customers can higher navigate the challenges of multi-protocol methods and shield their positions.