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A framework for risk assessment that allows the timely measurement of a protocol's risk and compares it to other protocols will help investors make informed decisions.
This blog aims to increase understanding of this rapidly growing field of finance. It also begins to chart the path to a framework that will be used to assess risk within DeFi.
Cryptocurrency is a major force in the world of finance. Decentralized finance (DeFi) is a new, fast-growing component of the financial and crypto ecosystems.
Many investors are looking for yield in crypto as real fixed-income returns have been persistently low. Crypto offers greater opportunities for staking and participation than the traditional financial sector. How do we assess the risk of this rapidly evolving environment, despite the attractive returns?
In conventional finance, we evaluate an obligor's creditworthiness and risk using the well-established knowledge of micro and macroeconomic structures.
DeFi, however, is evolving rapidly with inadequate transparency, a lack of shared awareness of its risks, as well as methods to measure and reduce those risks.
What is DeFi?
Blockchains form the foundation of cryptocurrency. They act as an immutable digital ledger that is stored in a distributed network.
Each transaction is stored in a block, which, once validated and filled out, adds to the growing chain. Each block stores a hash one-way of the previous blocks. A network of validating servers adds new blocks to the chain by consensus.
This eliminates the need for middlemen and the associated requirements such as business hours and settlement.
Many blockchains and Blockchain Development Platforms support "smart contract" implementations to carry out the terms of an agreement.
Smart contracts do not refer to contracts in the traditional legal sense. They are actually computer programs that are stored and deployed on blockchains to execute themselves when certain conditions are met.
They are stored on the blockchain, not on a server.
This means that their code, logs of execution, and functions are distributed, transparent, and irreversible. Without centralized management or clearing systems, conditional transactions can be carried out via smart contracts, much like escrow and contract services in the real world.
This is a major step forward in the decentralization of financial transactions and paves the way for DeFi.
The term "DeFi" refers to the diverse variety of financial services offered on the open blockchain ecosystem. These services mirror those that are offered in the traditional system of finance: lending, borrowing, asset creation, and more.
Smart contracts are used to remove the need for an intermediary and facilitate transactions. Anyone can transact using these protocols. Some of the most prominent examples today include automated market-making, lending protocols, options exchanges, and other financial functions.
Why is this Important?
Many predict that the strong growth of the DeFi sector will continue. The regulatory uncertainty and the difficulty in modeling risks properly have kept many potential participants on the sidelines.
In many respects, this latter task remains paramount. How do we assess risk as the world's DeFi and traditional financial continue to merge? Quantifying risk helps to determine whether institutions follow risk best practices.
At a macroeconomic scale, we can't understand the risks the crypto ecosystem poses to larger financial markets unless we have a framework for risk assessment.
DeFi is gaining attention from traditional financial institutions around the world. It's likely that we'll see a convergence of the two due to their high complementarity.
Decentralized applications' low friction and transactional atomicity may be a boon to certain financial services segments and replace others. We are either witnessing a paradigm shift or a mere emergence of new technology. The first step must be to evaluate the risks and benefits of decentralized financial services.
What are DeFi Layers?
DeFi platforms are typically divided into layers that represent their core attributes:
- The settlement Layer is responsible for the settlement of all transactions between parties that interact through the DeFi Application.
The base blockchain is responsible for this.
DeFi's most popular blockchain is Ethereum.
However, other blockchain protocols like Avalanche or Solana are also gaining popularity.
- The protocol is composed of smart contracts and code.
- The Application Layer is a front-end interface that users can interact with via extensions or applications.
- The aggregate layer allows assets and products to be combined and used without explicit permission or agreement.
A yield aggregator protocol, for example, displays real-time yields from different assets and protocols.
DeFi's compositional capabilities are a unique and attractive feature. Smart contracts are open-source and public by nature, so developers can connect and access different applications, such as financial APIs.
Many of these combinations may be impossible in traditional finance.
Many innovative FinTech companies have developed impressive wrapper systems that support nonvolatile operations, such as read-only information.
Is the balance of an online user enough to complete a purchase? In some cases, the wrapper service may be at risk. However, in most cases, intermediaries and issuers are still responsible for the majority of the risk. While technology and artificial intelligence have made certain processes, such as business lending, easier, the final process is still far from being automated.
This automation is a key component of DeFi. Volatile operations such as trading, lending, and derivatives can be executed without any human oversight or involvement.
DeFi lending is currently a little different than its non-crypto counterpart, despite these technological advances. In traditional finance, we tend to see lending as a relationship between a lender (the lender) and a borrower (the borrower).
The lender provides capital for the loan, and the borrower can provide collateral or not. Business lending can be further divided into loans that have recourse (where the lender has the right to seek additional compensation beyond the value of collateral) and those without recourse.
The idea of a consistent identity or other representation of the borrower, which is simple to verify but challenging to manufacture, is crucial to recourse.
The blockchain is anonymous, open, and permission less. In crypto, recourse is not possible; it's easy and free to create a brand-new address in most cases.
The problem could be resolved by a loan-to-value ratio of one-to-1 or full collateralization. However, cryptocurrency exchange rates have historically been volatile due to leveraged speculations and other uncertainties.
This is true for both cryptocurrencies that are pegged to fiat currencies and stablecoins.
To hedge against fluctuation in collateral values, and because liquidation isn't an instantaneous process or foolproof, even with DeFi, most platforms require loan-to-value ratios that are much higher than 100%.
This may sound punitive, but the crypto market is a big fan of overcollateralized loans due to short-term liquidity needs, tax optimization, and leverage.
DeFi's current lending relationship can be viewed as a partnership between the platform and a borrower who has provided collateral.
Platforms typically offer two types of cryptocurrencies associated with them: a token that represents the value of the loan and another token called a governance token. The latter allows the token holder to have a say in platform decisions, as well as receive a portion of the platform fees.
Smart contracts on the platform retain custody of collateral during the entire loan period. The platform will provide a token that can be used to exchange the collateral and interest for a token.
These tokens are pegged to a fixed rate of a fiat currency or cryptocurrency and can be traded between parties. However, only the original party is able to redeem the collateral.
DeFi has many appealing characteristics, but the most important is its true transparency. It also allows you to validate ownership and settlement independently.
Due to this transparency, certain fraudulent acts, such as tricking multiple lenders by rehypothecation of leveraged assets, are virtually impossible. This does reduce some types of risk but not all. This leaves us with three fundamental questions: why is there a risk? What constitutes DeFi risk, and who bears the risk?
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What is the Risk?
In traditional lending relationships especially for business plans, we view the risk separately for both the lender and the borrower.
We can identify three types of risks for both parties: (1) valuation, which is the change in the value of the loaned amount and capital, including interest, (2) opportunity, which is the possibility of receiving a better deal in the future, and (3) counterparty.
In competitive and liquid markets, valuation and opportunity risks are both important. However, they tend to be equally known or unknown by both the lender and borrower.
Informational asymmetry is the main cause of counterparty risk. Both the lender and borrower have a better understanding of their side of the deal than the other. This gap manifests itself primarily in two ways: adverse selection and principal-agent issues.
Adverse Selection
A traditional transaction will usually have an adverse selection element. The company that is issuing the new bond has a better understanding of its financial and strategic position than those who are buying it.
Informational asymmetry creates a demand from lenders for a third party who has material insight about borrowers and can translate complex multidimensional risk into a metric that can be compared between borrowers.
Adverse selection is lessened thanks to this impartial third party, who has access to confidential information about the borrower (whether they are a consumer taking out a personal loan or a bond obligor).
experienced by lenders. Regulation and competition in the market help to reduce adverse selection on the lending side. Lenders must compete and comply with regulations.
The decentralized world of finance has a similar but not identical form of adverse selection. The borrower's interest rates are open, transparent, and verifiable.
Since lending code is immutable on the blockchain platform, there is no doubt that the methodology of the rates presented corresponds to the final outcome exactly. DeFi lending protocols current state means that only overcollateralized lending is possible.
Adverse selection becomes a matter of collateral valuation, which, with liquid collateral, is less of an issue.
As lending standards are transparent, the transparency of blockchain technologies virtually eliminates adverse selection.
Platforms themselves are at increased risk. The existence of public interest rate calculations, for example, significantly limits a protocol's defensive and rapid reaction to adverse market conditions.
The protocol may be unable to adjust rates dynamically enough in times of liquidity crunch or drawdowns, where collateral values may decrease rapidly, or many collateralized borrowers may withdraw at the same time. DeFi lending does not take into account historical borrower behavior patterns, despite the fact that crypto is non-discriminatory due to its trustless nature.
Principal-Agent Problems
Traditional financial intermediaries are prevalent because of the inherent conflicts that arise when agents get unequal compensation for a risk that is either assumed by an individual or entity that they represent.
Fund managers are often compensated based on performance - the reward increases for higher returns. On the other hand, due to limited liability, losses are also capped. This encourages riskier decisions, which can be to the detriment of fund investors.
Information asymmetry is often the cause of this moral hazard. A fund manager can take more risky bets because she has a better understanding of the real state and performance than the investors.
This reduces the gap in information by distilling complex and idiosyncratic data into comparable, rigorous assessments.
DeFi's principal-agent conflicts are caused by the mismatch between the incentives of those who own the platform (like liquidity providers and lenders) and those who run it.
Like the shareholders in a large corporation, most platforms are governed by a small group of active investors who have large stakes in governance tokens.
These investors usually have a long-term, aligned incentive to promote the best practices of the platform. Many platforms do this by, among other things, offering a platform for token swaps without serving as counterparties, thereby shifting all risk to the end user.
Others may assume some risk in order to promote platform health.
In a similar vein, inefficient governance incentive alignment might upset the delicate equilibrium between arbitrageurs, suppliers of liquidity, or those who lend in decentralized exchanges.
assets for exchange by automated market-makers. Contrary to traditional U.S. equity trading, which is regulated by the National Best Bid and Offer system and virtually eliminates price discrepancies between exchanges, many DeFi protocols rely on arbitrage activities in order to maintain spot-price synchronization.
It is not for free. Protocols often operate at a substantial loss to encourage liquidity. This can result in inefficient pricing.
Incentives that encourage arbitrageurs to a great extent can lead to a protocol's inability to function properly. It is important to optimize this balance regularly in order for a protocol to survive.
The governance issue is a classic conflict between principal and agent: although the platform's long-term value is provided by its liquidity providers and users, the platform is ultimately controlled (in reality) by a smaller governance body.
As governance tokens are freely traded on exchanges, this can exacerbate the problem as short-term traders or activist investors may disrupt platform governance. This will reduce stability and threaten long-term health. In practice, however, this is a relatively minor issue as the biggest holders tend to focus on long-term platform stability and growth to generate governance token value.
Read More: Best Defi Lending Platforms in 2023
Who is at Risk?
We can see that the counterparty risk is primarily on the lender throughout the life of the loan. The lender can suffer a loss if the borrower defaults at any time after receiving the loaned money.
The borrower may make a decision based on current lender conditions, but if the capital loaned is not a fiat currency and does not depend on the lender, then the lender will have to project the risk over the entire loan period.
In a competitive loan market where many borrowers and lenders exist, this is quantified in the spread of a debt obligation, which reflects the best pricing for an obligation's risk.
This is quantified by the spread of a debt obligation in a market with many borrowers and lending institutions. The spread reflects the best market pricing for the risk associated with an obligation. This risk is reflected at the obligor level and would be applicable to all debt issued by the same obligor.
It can also impact issuances in an asymmetrical manner. For example, solvency risks may be more prevalent for issuances that have long maturities.
Risk is typically measured in two dimensions: the probability of default and the loss if a default occurs. We can estimate default risks at the obligor level by comparing the yield to the risk-free interest rate.
Since most debt is traded infrequently, the price of the last trade may not be an accurate reflection of the current risk. We can derive implied riskiness for publicly traded companies by using equity value as a call option on the asset value of the firm.
This allows us to predict a firm's default probability in real-time.
We can understand the current DeFi lending paradigm as a lending relationship between a borrower who is overcollateralized and the platform.
Most platforms issue at least two instruments. A governance token that allows holders to vote for the platform's governance, and a promissory coin, which represents the loan value.
The platform's proper functioning is the primary factor that influences the counterparty risk for the borrower. The borrower, in the absence of an improper liquidation of collateral, such as platform errors or hacks, can return the tokens plus interest accrued to recover the collateral, regardless of the market value of the token.
Even in the event of an improper liquidation, the first to bear the risk is usually the protocol via its governance token holders.
Governance tokens are often used as a safety net for protocol shortfalls, such as those resulting from improper liquidation.
When the platform is profitable, many protocols will burn, destroy or otherwise invalidate governance tokens through open-market purchases, similar to equity purchase backs. Most platforms reward governance holders in exchange for taking on risk, with regular dividends derived from the platform's fees.
The platform can create governance tokens when it experiences major losses or has solvency problems. This will dilute the value but provide emergency capital to the platform.
It ensures that the governance token holders are aligned with the platform. Good governance should make holders money and bad governance should penalize holders. This also implies a way to measure risk.
As we see the equity price as a good predictor of future credit risk (as in the Merton model), we could also view the performance and value of governance tokens to be a quantitative measure of the market's view of a protocol's risks.
This risk also has to be reflected in the promissory assets. Many protocols use promissory assets that are indexed to a benchmark.
However, the real value of these tokens tends to be based on the risk implicit in the collateral.
How can we Model the Risk?
DeFi is a technology that promises to transform the financial services industry. Despite its risks, DeFi's interest has increased significantly.
As more institutional investors consider allocating, it is necessary to have a method that is consistent in evaluating and quantifying the risk dimensions. It has been challenging to quantify risk due to the rapid growth and evolution of DeFi. How should we approach risk scoring and modeling in this new paradigm?
The analysis of risk in the DeFi protocol can be very different from traditional finance. DeFi protocols are transparent and comprehensible, allowing for a technical evaluation of risks.
Instead of using VaR models to estimate the risk of an unknown counterparty, fine-grained models can be trained directly from historical data. All of the previous trades, transfers, and borrowings made by a user can be seen publicly and give a direct insight into that person's behavior.
The technical complexity of these models is higher. One must ensure that the model's mechanics, predictions, and execution match exactly the smart contract.
DeFi tends to have more agents/principals since we are replacing a trusted entity with a group of untrusted parties that come to an agreement. Models must account for much greater variability of counterparty behavior compared to traditional finance.
Although it is a topic that is constantly evolving, the risks are still similar to those found in traditional financial products.
Systemic risks, or those that have an influence on a significant section of the entire DeFi ecosystem, can be separated from idiosyncratic risks, or those that only have an effect on one of these dimensions. protocol or a group of protocols. Although the idiosyncratic risk is unique to each platform, the exposure to systemic risks may differ significantly.
DeFi is Associated with a Number of Systemic Risk Factors, Including:
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Currency Risk: Crypto assets are volatile and expose investors to significant risks, including currency risk, derivative assets, and protocols built on blockchain solutions.
The interconnectedness of DeFi services makes it difficult to measure the idiosyncratic risks of a single platform.
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Regulatory Risk: Regulators' views and reactions towards DeFi are changing, but there is little guidance in the area so far.
There is still a lot of uncertainty in the long term about the impact that regulation will have on DeFi, as governments try to strike the right balance between opportunities and risks posed by this technology.
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The Risk Associated with Blockchain: Although certain platforms operate across multiple blockchain projects, the majority of platform designs use a single blockchain as its protocol layer.
Blockchain Development Solutions are therefore exposed to implicit risks.
If the blockchain underlying the platform were compromised or abandoned in any way, it would also suffer.
Risk Factors that are Idiosyncratic Include
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Security Contract Risk: In DeFi, code is the final word.
The value and security of a platform are only as good as the smart contract code it uses and how well its team is trained.
Hacks have caused billions of dollars in estimated losses.
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Governance Risk: The governance of DeFi platforms is what makes them live or die.
Governance is a risk factor that can impact not only a protocol but also other protocols dependent on it.
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Oracle Risk: Oracles, or trusted entities, are responsible for providing timely and secure data to transactions and contracts that depend on events off-blockchain, such as price changes.
Oracles are smart contracts, blockchains, or external data sources.
Oracles, due to their privileged status, are targeted by malicious actors, resulting in potentially catastrophic consequences.
Oracle issues caused over $120 million of losses to lenders.
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Cooperative Risk: The primary embedded risk of the lender-borrower relation is due to improper collateral valuation and liquidity.
Liquidation has become largely decentralized.
Platforms rely on outside parties, who, in exchange for fees, liquidate collateral as needed.
When the valuation-liquidation mechanism fails, this causes both significant risk and opportunity in business processes.
The most important aspect of understanding platform exposure is mitigation techniques. All DeFi platforms rely on the same primitives, namely a blockchain expert that supports smart contracts and crypto-accessible collateral.
However, the economics built into the design of the protocol, the quality and maintenance of smart contracts by developers, as well as the dynamic tweaking by governance holders of key parameters have a dramatic impact on risk quantification. We can provide a list of the best and worst scenarios for risk factors identified for arbitrary platforms, as well as sample factors that may reduce risk exposure.
Future of Crypto Risk Assessment
Consistent risk modeling is necessary due to the multidimensionality and complexity of risk. This includes contract, market/currency instability, oracle/external dependency, governance, regulation, and cooperation.
A coherent risk assessment framework, which allows the measurement of risk in real time for a protocol and allows comparisons of risks between protocols, would be helpful to mitigate the many obstacles that hinder further growth.
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Conclusion
DeFi and traditional systems are continuing to merge, and the solution will require the expertise and knowledge of both established and new risk assessment providers.
DeFi is a new financial ecosystem that presents new opportunities as well as new risks. It aims to meet the same needs of the market for capital and services, largely benefiting the same participants. A Blockchain Development Company can help you achieve your goals for DeFi.
