DeFi lending protocols are platforms that allow users to borrow and lend cryptocurrencies without going through intermediaries such as banks. In these protocols, borrowers can use their cryptocurrencies as collateral to obtain loans. Collateral is held according to the agreement and is returned to the borrower upon repayment of the loan. Lenders, on the other hand, can earn interest on their cryptocurrency holdings by lending them to borrowers on the platform.
The remarkable growth of the cryptocurrency industry has attracted hundreds of billions of dollars in funding. However, as the industry expanded, so did the number of scams and vulnerabilities. These risks have not been fully adopted at the individual and protocol levels. This article aims to clarify the most important economic risks of DeFi lending protocols. Let’s examine the key components of a loan agreement and understand the essentials of risk management.
Why is risk management important in DeFi?
Effective risk monitoring and control is critical to any financial service. The recent crash in the DeFi market proves that risk management is critical to spur growth in the industry. Both users and protocols must prioritize risk management as a fundamental factor for the success of the DeFi ecosystem.
While technical issues lead to most attacks in DeFi, economic risks lead to higher monetary losses. In general, economic risks can be very complex. However, such risks can be managed by observing metrics. These include liquidity changes in the protocol, active participation of liquidators, whale activity, and user leverage. Additionally, users have the ability to take steps to protect themselves from financial risk.
This section uses metrics from IntoTheBlock’s Risk Radar platform to demonstrate an example of proactive risk monitoring. The data shown in the indicator comes from the Benqi protocol.
Liquidations are important in DeFi protocols because they help maintain the stability of lending platforms. In DeFi lending, borrowers typically use cryptocurrencies as collateral for the loans they receive. If the value of the collateral falls below a certain threshold, the borrower is assessed as “subprime.”
To prevent defaults and bad debts, DeFi lending protocols actively liquidate debt by selling collateral on the open market to pay off debt. This process is usually carried out by independent liquidators operating within the ecosystem to help ensure that lenders’ deposits are safe and well-maintained by the solvency of the platform.
DeFi Risk Radar | Source: IntoTheBlock
Liquidator leaderboard metrics can help DeFi lending protocols mitigate risk by providing information on liquidator efficiency and performance. By examining the data displayed in the graph, the protocol is able to assess the performance of liquidators and identify trends. These can include which liquidators are most successful and what types of collateral are most often involved in the liquidation process. This data can be used to customize the protocol’s liquidation process, incentivize liquidators to be as efficient as possible, or adjust collateral requirements for certain assets.
Lending activity is important to gauge the health and development of DeFi lending protocols. High levels of lending activity usually indicate high credit demand. This could be a positive sign for the development of the protocol. Additionally, monitoring lending activity can help protocols manage risk, allowing protocols to identify potential problems, such as over-reliance on assets or borrowers. By monitoring borrowing activity, the protocol can adjust lending policies and collateral requirements to manage risk. In order to maintain the solvency of the platform.
Health Factor Distribution Index
The Health Factor Allocation Index tracks when positions should be liquidated. If the health factor is below 1, it can be liquidated, resulting in a loss for the borrower. This indicator can be used to analyze the range of different borrowers of the agreement. If the health factor for the majority of the supply is low, then the solvency of the pool/protocol is at risk due to mass liquidations.
DeFi Risk Radar | Source: IntoTheBlock
This indicator provides valuable insights for depositors and liquidators. As the number of loans at risk of liquidation increases, depositors face more risk when investing in the protocol. Liquidators, on the other hand, can use this information to their own advantage. This is especially true during periods of market volatility, when the indicator can predict where major liquidations are likely to occur.
Furthermore, a balanced distribution of health factors suggests that loans in the protocol are more evenly distributed among borrowers, reducing the likelihood that all loans will be liquidated at the same time. This creates a decentralized and diverse lending portfolio, which is often seen as a positive attribute of DeFi lending protocols.
A DeFi lending protocol with a high health factor allocation is considered safer for depositors as it reduces the likelihood of mass liquidations. Liquidations of this magnitude are generally unprofitable for liquidators due to slippage on decentralized exchanges (DEXs). Therefore, a high distribution of health factors will give depositors more confidence in their position in the protocol.
The Net Liquidity Flow indicator tracks net liquidity in, out, and into the protocol. This indicator helps identify potential liquidity risk vectors that may drive issuer action. For example, a large outflow of funds may mean that users withdraw funds due to concerns about the security of the protocol, which may lead to a liquidity crisis. Conversely, a large inflow can indicate user confidence in the stability and security of the protocol.
DeFi Risk Radar | Source: IntoTheBlock
This metric provides valuable information that enables protocols to identify potential liquidity risks that could trigger their user activity. In response to any issues, protocols can make necessary adjustments to their risk management strategies and take steps to protect themselves from bad debts. For example, lenders may consider raising collateral requirements. Or lower the loan-to-value ratio of the loan to reduce risk.
Tracking the activity of whales in lending protocols is important because these major players have the potential to have a significant impact on the market. Their actions can affect the supply and demand of assets in the protocol, causing volatility and potential risks for other users. By monitoring whale activity, lending protocols can better understand potential market movements and adjust their risk management strategies accordingly.
This indicator monitors the lending, repayment, and liquidation activities of large depositors in DeFi lending protocols. It can be helpful to analyze a large number of trading strategies and the intentions behind them.
Whale Credit History | Source: DeFi Risk Radar IntoTheBlock
The above indicators provide detailed information on the lending patterns of most users of the Benqi protocol and can be used to hedge against bad debts. By examining the data, the protocol and its users can spot any possible risks or weaknesses in their lending portfolio, such as overreliance on a small group of people, overutilization, or overborrowing.
A recursive lending strategy is one in which an asset is borrowed, then given to a lender and possibly re-borrowed. This strategic model has gained traction in the DeFi space, allowing for larger token rewards on a given asset. However, it also carries some risk as it requires constant monitoring of market conditions and interest rate fluctuations to prevent liquidations.
Recursive Lending Supply Share | Source: Into The Block Risk Radar
Understanding recursive lending rates in DeFi protocols helps assess the stability of the protocol and its potential for profitability. Liquidity ratios obtained from recursive lending strategies can indicate how dependent a protocol is on incentives to attract depositors. v High recursive lending rates may mean less stable liquidity and a preference for short-term profits rather than long-term committed agreements.
Additionally, the liquidity ratio provided by recursive lending strategies can serve as an indicator of how much profit a DeFi protocol is generating. This is valuable for evaluating potential investment opportunities.
Understand the loan agreement and be aware of the risks
DeFi is constantly evolving, and niche indicators like the ones discussed in this article can help steer the ecosystem in the right direction. While DeFi offers attractive profit opportunities, there are also significant risks. Keeping track of all these risks is crucial, especially when depositing large amounts of money.
On the other hand, the industry is establishing best practices for mitigating technical and economic risks, such as audit options, deposit management using multi-signatures, and improved price predictions. Industry players can consolidate and mitigate economic risk by gaining insight into transparency tools/indicators powered by open-source encryption. While the risks will continue to exist, developers and users can better understand and take steps to reduce them.
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According to BeInCrypto