by Evgeny Gokhberg, Managing Partner at re7.capital
Risk management in finance is a well-studied and discussed subject. But how do you manage risk in new environments with many unknowns? This is the question that we tackle while deploying capital into the nascent crypto market.
DeFi represents a set of financial software applications that are built on top of blockchains like Ethereum. DeFi underpins the digital economy that is starting to grow worldwide using distributed blockchain applications. These applications enable exchanges, lending markets and asset management solutions.
For every traditional finance (TradFi) instrument, there is a DeFi equivalent. Because it is a niche and growing market, DeFi represents a source of uncorrelated returns and opportunity for funds willing to dive in.
Total assets in DeFi sits somewhere north of $60b, more than 100x growth from when the first DeFi applications were launched less than five years ago. The largest DeFi applications now hold billions of dollars.
DeFi is also a risky environment to deploy capital. As with any new software, there can be bugs, and these bugs can allow hackers to steal funds from DeFi protocols.
One of the main benefits of DeFi is that all of the financial data and actions of the market are transparent and visible on the blockchain. This offers great opportunities for those who are willing to dig through the data and “check the chain” to see what is actually happening in protocols.
Take for example a DeFi lending market like Aave – one of the largest DeFi protocols with total deposits of more than $5b. A user can deposit or borrow crypto assets like Ether or dollar pegged assets like USDC. They can then borrow against this collateral. Like an automated bank, the Aave protocol offers a deposit rate and collects a spread from lending out deposits from other users.
For a protocol like Aave, we can use on-chain data to see the health for every account, the total deposited and lent assets, and down to the minute changes in this data.
There have been cases with lending protocols where a mix of mispriced assets and low liquidity meant that large borrowers could walk away from their loans and leave the protocol with bad debt. This bad debt is ultimately borne by depositors, so it becomes extremely important to monitor these accounts to assess the health of the protocol and the risk to any deposits.
Part of managing risk in DeFi is being this technical. Looking at chain data lets us confirm parameters and settings for DeFi protocols. We also get real-time views into yields, capital flows, and other potential risks.
Protocols like Aave also manage the parameters for their lending market through a series of governance mechanisms that involve forum discussions and voting on the blockchain. This allows tracking upcoming changes to lending rates, incentive programs and other market news. We can then verify with on chain data the state of the market.
While DeFi is often seen as reinventing TradFi, there are many tools that are battle-tested in finance that are still applicable to the DeFi space. By combining well-used frameworks for risk management like counterparty analysis, and leveraging data from the blockchain, we are able to create even more comprehensive views into the possible risks that could manifest in our portfolio.
DeFi applications take advantage of this by publishing statistics and data on risk for their users. Simulating value-at-risk and other typical metrics from accounts gives a detailed view into a protocol’s risk profile. Third-party tools like the RiskDAO bad debt dashboard allow for tracking and review across the DeFi lending space. Transparent data that can work in risk modelling is a luxury in traditional finance. But it is standard in DeFi, made available because of the unique technology and open ledger of the blockchain.
While DeFi is still a nascent niche of the financial industry, it is growing quickly. With billions in assets already at work in various DeFi protocols, the utility of blockchain technology for financial applications is proving its worth.
However, anyone entering the space needs to have a deep understanding of the idiosyncratic risks that are also present in DeFi.
We expect more money to flow into space over time. But in order for this large capital to move in, risk management will need to be a major focus. By leveraging the unique features of blockchains we can get even more granular views into risk and manage this risk accordingly.