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TLDR below. This is not financial advice.
Risk is one of the most prominent issues in traditional financial markets. In particular, risk helps investors to quantify a specific number representing an asset value, in order to assess whether that level of risk is acceptable.
In DeFi, however, risk is often undervalued as the majority of participants do not fully appreciate it. Several lending/borrowing protocols are at the forefront of this field when it comes to assessing the risk of an asset. In other protocols we rarely see full consideration of risk.
In this article, we will introduce the concept of systematic risk (generalised) from traditional markets to DeFi.
What Is Systematic Risk?
Assuming you invest in a single asset, what is the source of risk for this “portfolio”?
We can say that there are two common sources of uncertainty:
Risks arise from overall economic conditions, such as business cycles, inflation, interest rates and exchange rates. These economic factors are difficult to predict with certainty and all affect the return on assets.
Risk comes from the asset itself (specificity). For example, is the government controlling the asset or is their direct demand for it, etc. These factors affect one asset but do not affect other assets.
Now we look at the “portfolio” of even more assets (a diversification strategy), asking the same question, what about portfolio risk?
Diversifying multiple asset classes spreads the risk of the entire portfolio. The ability to decrease the value of one asset provides the ability to increase the value of another asset. These effects will offset and stabilise the return on the entire portfolio and portfolio volatility will continue to decrease.
However, even if we hold a certain amount of assets (e.g. >1000 assets), we still cannot avoid risk completely, because almost all assets are affected by factors such as general macro factors. For example, if all assets held are affected by the business cycle, then we cannot avoid business cycle risk no matter how many assets we hold.
This risk that persists even after diversification is called market risk, which is associated with sources of market-wide risk. Such risk is also known as systematic risk, or non-diversifiable risk.
Note: Risk that can be eliminated by diversification is called unique risk, nonsystematic risk, or diversifiable risk.
DeFi Systematic Risk
The definition of systematic and idiosyncratic risk for DeFi protocols is slightly different from their definitions in the traditional finance space.
Systematic risk is risk that is unpredictable and cannot be avoided by the protocol, this includes the market, user and tech risk.
Idiosyncratic risk refers to risk that can be mitigated under different specifications of protocol and depends on how well designed a protocol is to ensure its profitability and sustainability. This includes currency, economic parameters (operational), governance, financial and liquidation risks.
For each type of risk, we will explain in detail their definitions, potential methods for measurement, and their possible interactions with the other sources of risk exposure. Lastly, we will discuss the methods of overall risk assessment and compare the different protocols.
Here we define systematic risk as risk that cannot be predicted and avoided when analysing risk faced by DeFi protocols. Systematic risk represents a major group of risks consisting of market risk, user risk and tech risk.
Market risk is the risk of losses arising from market variables like price and volatility. Similar to traditional finance, market risk represents one of the largest group of risk exposures, because it consists of many areas and issues often occur on a large scale that cannot be mitigated from a single protocol’s perspective.
One of the most significant sources of market risk lies in regulation. In fact, this is faced by the DeFi sector in general. Being a newly developed and quickly growing industry, the whole DeFi sector is transitioning from a financial space with little regulation interference to one that is getting much more attention and stricter government supervision and regulation. DeFi service providers face the risk of regulation changes affecting their operations. In more severe cases, a particular DeFi service may be completely disallowed in certain geographical regions. These risks are not foreseeable by protocol owners.
Moreover, DeFi has only looked at the city in the last 2-3 years, we do not have enough data to make accurate policies. As a result, new policies can have an impact in different ways. We cannot measure such risks yet because government intervention can happen at any time and at any level.
Changes in price
For lending protocols, change in price is very important in mortgage lending. Any change in price affects the mortgage rate, utilisation rate and interest rate. In extreme cases, users are forced to exit their positions before being liquidated, or they have to add more assets to maintain their positions. These results will make the users’ change to rather inconsistent and harmful to the protocol.
The risk assessment of an asset from the price factor is to use the correlation matrix between it and major coins. If the correlation between them is large, it means that this token is prone to volatility and change.
Another way is to calculate beta, which is a concept in media finance. Beta represents the relative volatility of a token or portfolio relative to the market as a whole, by comparing changes in price.
Investors participating in the market will have a lot of investment opportunities from protocols with similar functions. They need to make investment decisions based on factors such as investment purpose, investment size and time period. They must consider the opportunity cost of their options and make the best decision given their conditions and constraints. Therefore, who the competitor is can directly influence the token investment decision making.
Black swan events
Black swan events are events that happen infrequently, are unpredictable, and have a high degree of occurrence, such as extreme price shocks.
In assessing them, we cannot factor such events into risk management, but it is important to recognise their importance in risk management.
Underlying blockchain layer
A project built on a layer 1 blockchain is generally at risk from any changes to the underlying blockchain layer. For example, anincrease in gas fees on Ethereum increases the transaction costs on protocols built on it.
User risk refers to the risk of losses for the protocol arising from user behaviour.
The key point is how token holders are incentivised by action. To do this, we need to figure out who is involved in the economy, and what their purpose is.
Even so, user behavior is difficult to predict even if we know what their intentions are for the protocol. Their behavior is collective rather than based on their own financial research. As a result, the market can experience major shocks and fluctuations in price.
Another way of analysing the user risk is through the concentration of tokens which can be measured by the amount of tokens held by the top addresses. In protocols with governance functions, a large amount of tokens held by a few wallets will lead to centralisation in voting, and the selection of proposals will benefit this small group.
Also, we need to acknowledge that user behavior is driven by the way the protocol is designed. Some specifications will direct users to act in certain ways using different incentives.
The third type of systematic risk faced by DeFi protocols is the tech risk, which refers to risk exposure coming from the tech infrastructure and smart contracts.
Malicious attacks on smart contract
For example, malicious nodes on the blockchain could make false validations to transfer tokens to their own addresses, resulting in direct financial loss to the protocol.
There is always a down surge in token prices and large liquidation losses from mass withdrawals after reports of security issues. Such risk assessment involves highly technical knowledge of blockchain and smart contracts. However, even if we have that ability, this does not mean that we can monitor such risks. Although they occur more rarely than market and user risk, they can bring large and long-term losses to the protocol.
Failure of tech infrastructure
As mentioned in the previous sections, many DeFi protocols today are residing on another protocol. Thus when technical failures occur in the underlying protocol, all activities have to halt.
Risks from the underlying protocol, although rare, cannot be controlled and are hard to predict from an individual protocol’s perspective. In extreme cases, when such events happen all the residential protocols will be affected, evening out the risk if we are comparing protocols against each other. But nevertheless, we should be aware that this is a source of risk exposure that cannot be controlled.
In conclusion, risk analysis of DeFi protocols is a very complex process as the areas of risk exposure are very different and often interfere with each other. For example, a protocol that allows more freedom in governance will attract investors who want to make the most out of being able to cast their votes on a wide variety of factors, but it will also be subject to more volatility in changes and be undesirable to another group of investors who want to hold the tokens for stability in asset value. Thus, we have to be clear of our purpose first, and then make the relevant analysis and comparison across protocols.