5 Risk Factors that a DeFi Investor Should Know About

The issue of risk is becoming more and more important as the decentralized finance (DeFi) market develops. DeFi offers the promise of automated, transparent, and decentralized financial services that are currently under analysis, but many of the different risk aspects in DeFi products have yet to be studied.

The fact that risk management in DeFi doesn’t follow the same logic as traditional financial instruments is part of what makes it so difficult. For decades, capital markets have advanced around risk management models focused on market variables like volatility. That is because other variables may be reduced by intermediaries’ risk and reputation. DeFi eliminates intermediaries and replaces them with automated financial technology, smart contracts, which allows for unprecedented levels of financial automation while also introducing new risk vectors we haven’t seen before.

Traditional risk management theory may not apply to the world of DeFi, so other techniques must be used. The first step toward efficient risk management in DeFi is to categorize the numerous risk dimensions of its investments and trading.

The so-called smart contract risk is something that many investors are aware of, but there is no such a generic concept. There are several types of smart contract risk, as well as other peripheral risks, which must be considered when assessing DeFi protocols.

There are many forms of risk in DeFi, but the majority of them can be categorized into one of the following five categories:

1. Intrinsic Protocol Risk

DeFi platforms automate financial primitives in the form of smart contracts. One of the most significant elements of risks in DeFi apps is the dynamics of those protocols. Intrinsic protocol risk refers to inherent protocol hazard that exists by default within a design. Even if the protocols are functioning as intended, they still pose significant risks to investment strategies.

Intrinsic risk in DeFi exists in a variety of forms. In DeFi lending methods such as Compound or Aave, liquidations are a method for keeping lending market collateralization sustained. Liquidations allow participants to invest in uncollateralized positions and take part of the principal. Slippage is another issue found in automated market making (AMM) protocols like Curve. High slippage levels in Curve pools may result in investors being forced to pay high fees to get rid of the liquidity provided by the protocol.

Intrinsic risk in DeFi protocols is one of the most common instances of risk migration from human counterparties to protocol mechanics.

2. Exogenous Protocol Risk

DeFi trades are frequently exposed to exogenous factors that change the protocol’s anticipated performance. Oracle manipulation, flash loan exploits, and attacks that take advantage of coding flaws in smart contract logic are examples of this risk kind.

Exogenous protocol risk, as highlighted by several protocols, will be an ever-present aspect in the development of DeFi.

3. Governance Risks

DeFi’s decentralized governance proposals regulate the actions of a protocol and, frequently, are the reason for changing liquidity compositions in affecting investors. For example, governance proposals that change balances in AMM pools or collateralization ratios in lending protocols assist liquidity flow into or out of the protocol. Another concerning aspect of DeFi governance from the risk perspective is the growing centralization of many DeFi protocols’ governance structures.

Although decentralized governance mechanisms are architecturally decentralized, many of them are controlled by a relatively small number of people who can have an impact on any proposal. This aspect isn’t nearly as worrisome as it appears since many of the major players able to influence the outcome of DeFi governance votes are there only because they actively contribute and align with the DeFi ecosystem.

DeFi protocols, on the other hand, are vulnerable to governance attacks from a risk management viewpoint. In general, DeFi might benefit from stronger governance structures.

4. Underlying Blockchain Risk

DeFi protocols have a level of infrastructure dependency on their underlying blockchain. A vulnerability in the consensus mechanisms of a certain blockchains can become exposed on DeFi protocols that run on that platform. A common example of this is a validator cartel in a proof-of-stake (PoS) network, in which several validators collaborate to bias the network’s reward distribution and may effectively halt DeFi protocols from operating.

5. Market Risk

We tend to focus too much on the technical and infrastructure elements, while neglecting the native market risk exposure of crypto investments. For example, if the price of an asset differs widely from when liquidity was first supplied to a pool, investments in non-stablecoin AMM pools are at risk of loss. Another example is a rapid drop in the value of an asset that could trigger the massive removal of liquidity from a pool, causing major levels of slippage.

DeFi protocols’ programmable nature allows them to react to traditional market risk elements such as volatility and price in ways that might have cascading effects, potentially impacting investors’ positions.

DeFi-First Risk Management

Trusted intermediaries and infrastructure are typical in conventional risk portfolio theory. DeFi introduces new kinds of risks to capital markets that have not previously existed. It’s probable that DeFi will require a native risk management model that includes the sector’s native protocol, infrastructural, and market risks in order to facilitate institutional adoption.

We might see native DeFi risk management models at the protocol level as well as incorporated into tier 2 financial services dapps (dApps). For example, we may think about future-generation DeFi protocols that establish incentive mechanisms when liquidity pools become unbalance, or native DeFi insurance models that protect against slippage or impermanent loss.

Risk management methods developed the groundwork for contemporary financial markets, and they are likely to play an important role in the next generation of DeFi protocols. However, like with a lot of other things, risk management theory must be reinvented for a new era of decentralization and automation.

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Sani Abdul-Jabbar

Sani Abdul-Jabbar

Sani is the Board chair at VezTek, a Los Angeles based provider of software development and on-demand tech. talent for Blockchain and Web3.0 initiatives.