A Primer in the Risk Management of DeFi Credit Markets

How has DeFi achieved this stability? What is the system that has been forged in the fire of crypto market downturns, and how does it work?

To back up for a moment, most of the activity in DeFi credit markets involves depositing well-established crypto assets like ethereum into “lending pools” and using these assets as collateral to borrow stablecoins. Generally, the use cases include optimizing yields, trading on leverage, or taking advantage of arbitrage opportunities across the sector.

The table below shows the top five pools for Aave and Compound, their respective total supply, total outstanding loans, and annualized interest rates (or “APY”) to lend and borrow. The utilization rate indicates the percentage of deposits currently loaned to borrowers. The table shows that interest rates and utilization rates can vary significantly between stablecoins, which largely do not fluctuate in value, and well-established but still volatile crypto assets.

The Top Five Lending Markets in DeFi Consist of Stablecoins and the Most Established Crypto Assets

Aave and Compound’s top five lending markets as of May 4, 2022 (USD billion)

Source: Bitwise Asset Management with data from https://compound.finance/marketshttps://compound.finance/markets and https://app.aave.com/markets/https://app.aave.com/markets/. Data for Aave lending pools is specific to Aave v2 on Ethereum.

This table provides a view into how DeFi protocols have learned to balance incentives for lenders and borrowers to promote capital efficiency, while also maintaining the solvency of their lending pools—across very different types of assets. What we see, broadly, over the last two years is less the creation of new tools than the continuous refinement of existing tools, based on learnings from millions of transactions and tens of thousands of users.

In the present configuration that the leading DeFi protocols use, several asset-specific risk parameters control each lending pool, including most importantly: collateral factors, interest rate models, and reserve factors. DeFi lending protocols attempt to optimize those parameters to balance risk and reward through a dynamic risk management and governance process in which Aave and Compound token holders can participate.

Collateral factors limit the amount users can borrow against their deposited collateral. If the value of the collateral securing a loan falls below the required collateral factor, liquidators can purchase the collateral at a discount (like foreclosure sales in traditional markets).

Setting appropriate collateral requirements is a critical element of ensuring protocol solvency. Assets with deeper liquidity and less volatility tend to have higher collateral factors. Conversely, more volatile assets with less liquidity generally have lower collateral factors. However, too low collateral factors can inhibit existing borrowers and deter new ones, reducing borrowing power for users but helping ensure solvency in times of high volatility. At the same time, higher collateral factors can unlock borrowing power for existing and new users.

The chart below shows the collateral factors for each of the top five pools in Compound and Aave. Part of the ongoing risk management of the protocol requires assessing and adjusting the collateral factors for all assets.

Outstanding risks of DeFi 2.0 and how to prevent them: 

Although a step forward, DeFi 2.0 still shares many of the same risks as DeFi 1.0. Some of the more common risks are:

Compromised smart contracts: An audit never guarantees the security and safety of a smart contract. Therefore it’s important that users do as much layered due diligence and research of a protocol before investing in it.

Changing regulations: As governments and regulators have a growing interest in DeFi, projects and platforms may need to adjust rules and services to accommodate updated mandates and industry standards. While it can help offer greater stability and security, it also changes the level of support and compromises the amount of decentralisation involved.

Impermanent Loss: Even though DeFi 2.0 offers improved safety nets like the aforementioned insurance structures, there is still a significant risk for anyone who opts into liquidity mining due to market volatility.

Rigid user experience: If the website of a DeFi project goes down (for whatever reason), users will not be able to withdraw their staked assets unless they have the technical expertise to interact directly with the smart contract. To prevent this, it’s suggested that users also locate the smart contract on a blockchain explorer as well for their reference.

Conclusion

With the rapid advancement of DeFi 2.0, users don’t need to wait for access to these solutions or to find practical use-cases. Projects like Ethereum, Binance Smart Chain, Solana, and other competitive emerging blockchains are all starting to offer the services mentioned earlier across their networks. With that said, it’s recommended to do as much research as possible as investing in web3 always involves risk.

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