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15 Feb 2022

Identifying and Managing DeFi Risks: A Quick Guide

Deepan Datta

DeFi has shown how radically it can improve and bring efficiency in financial transaction processes, becoming a buzzword of sorts right now. People find it easy to conduct transactions on decentralized financial systems. As a result, the ecosystem has grown several times in recent months.

According to the analytics platform that tracks the growth of the DeFi ecosystem Defillama.com, the total value locked on various DeFi platforms has crossed $250 billion, a growth of over ten times in the last 12 months.

Another indicator of this growth is the success of Uniswap, a leading global decentralized exchange platform. Uniswap gets an average daily trading volume of over $2 billion (₹15,000 cr), which is greater than most other centralized exchange platforms.

Although the concept of DeFi is revolutionary, as it gives users more control over money, there are certain risks associated with transacting on its platforms. This article offers you an overview of these potential risks and some tips to help you manage them.

Key Takeaways

  • DeFi platforms are subjected to greater technological risk and protocol risk
  • Traditional risk management models don’t apply to DeFi
  • Monitoring the trends and developments in the DeFi platforms is key to identifying risks at an early phase
  • As the DeFi ecosystem grows, native risk management models are expected to come up, making it a much more secure and stable financial ecosystem

Risks Vectors in the DeFi Ecosystem

In the traditional financial space, counterparty risk is considered the major risk in any transactional process. So all risk management models in traditional finance focus on managing this kind of risk.

But, in DeFi, the risk metrics are entirely different, because of the technological and fundamental differences. There are five fundamental types of risk in the DeFi protocol.

Intrinsic DeFi protocol risks

DeFi eliminates counterparty risks with its programmable smart contract protocols. However, risks can arise from the default behavior of the smart contract protocol under certain market conditions. These are referred to as intrinsic DeFi protocol risks. The risk types within this vary for each DeFi platform.

In peer-to-peer (P2P) lending protocols, for example, the liquidation feature allows protocols to maintain the lending to market collateralization ratio at appropriate levels. For example, when the value of a crypto asset drops, borrowers need to provide additional assets as collateral to secure the loan, else the position will be liquidated to cover the risks of the lender. 

The same feature also allows participants to take back a part of the principal in an uncollateralized position. A rise in the value of pledged assets enables participants to withdraw from the collateralized portion in the DeFi protocol without disturbing the market collateralization ratio.

In cases of failure by borrowers to match the market collateralization ratio when the value of pledged assets drops or large liquidity outflows creates an imbalance, the protocol forces liquidity providers to pay more fees to withdraw from the liquidity pool.

Exogenous protocol risks

Exogenous protocol risks refer to those that arise as a result of the exploitation of the vulnerabilities in the DeFi protocol. Among other things, bugs in smart contracts, the exploitation of flash loans, or oracle manipulation can lead to the DeFi protocol being exploited.

Flash loans are uncollateralized loans issued and settled within a single block time. On the other hand, oracle helps blockchain networks to import off-chain data and convert it into an on-chain format compatible with smart contracts.

Governance risks

One of the unique characteristics of the DeFi ecosystem is that it is algorithmically decentralized. But governance votes and proposals can alter the characteristics of DeFi platforms.

For instance, the person holding the maximum number of coins in the DeFi protocol can influence the outcome of any governance proposal. 

Therefore, any DeFi protocol with high token centralization or a higher whale share should be avoided, as such protocols have the highest risk of governance attacks.

Blockchain risks

At present, most DeFi platforms are built on the Ethereum blockchain, which faces issues like scalability and high transaction costs.

We have seen in the past, how miners on the Ethereum blockchain started prioritizing transactions with a higher gas fee, creating bottlenecks and higher than usual transaction processing costs and times.

Also, dependencies on both Layer 1 and Layer 2 blockchains can affect the functionality of DeFi protocols. There exists the risk of validators conspiring to form a cartel to influence rewards distribution in the network.

Layer 1 is a primary blockchain, whereas, Layer 2 is a side chain that processes transactions at a faster rate, reducing the load on primary blockchain and transaction cost. 

Market risks

High volatility in crypto assets creates a lot of risks for investors in DeFi. For example, a deep correction in the price of crypto assets can lead to massive outflow from the DeFi liquidity pool, creating imbalance and slippages.

Furthermore, the lock-in period for investments in the liquidity pool means investors need to hold their position for a fixed minimum number of days, despite the market situation. This is because any massive outflow in liquidity due to volatility can have a cascading effect on the entire DeFi ecosystem.

DeFi risk management

How to Manage Risks in DeFi?

DeFi is an emerging marketplace, and there are no established risk management practices at present that you can refer to. However, monitoring DeFi market trends and risks can help you reduce the impact on your DeFi investment portfolio.

For example, monitoring the whale share and composition, liquidity flows, slippages, the effect of volatility, and governance proposals gives you a lot of information about the direction of the growth of the DeFi ecosystem.

You can easily access different metrics of the DeFi protocol on the coin page of coinmarketcap.com. For example, you can look up the audit report to check the transparency report and governance proposals.

Adjusting your DeFi positions based on risk factors will help you reduce the impact of risk.

Alternatively, you should also consider having a diversified portfolio of DeFi projects. Instead of chasing the yields in the short term, investing in promising, undervalued, and non-overlapping DeFi projects will help you generate a higher return over the long term. You can identify promising projects by checking the market cap to Total Value Locked (TVL) ratio. Tokens with the lowest correlation are considered undervalued, and their chances of growth in valuations are higher.

Read here: The Ultimate DeFi Handbook for Investors

Wrap-Up

Compared to the traditional financial system, DeFi introduces a new set of risks and challenges, which a non-specialist may find hard to identify because of the complexities involved and their technical nature. This may pose a challenge to the attempt to streamline institutional adoption of the DeFi ecosystem.

Therefore, to safeguard the interest of investors and promote greater adoption, the industry needs to develop native risk mitigation strategies and models that will help in the balanced growth of the DeFi ecosystem. 

Download the CoinSwitch app and start exploring the projects involved in the development of the DeFi ecosystem

Disclaimer : Crypto products and NFTs are unregulated and can be highly risky. There may be no regulatory recourse for any loss from such transactions. The information provided in this post is not to be considered as investment/financial advice from CoinSwitch. Any action taken upon the information shall be at user's own risk.

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Deepan Datta

Content Writer

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