This article aims to provide an overview of decentralized finance (DeFi) risks and the steps needed to manage them. If you are unfamiliar with DeFi, do read our introductory article on DeFi before reading this article. You may also consider reading our article on how to do your own research (DYOR), DeFi risks, and impermanent loss before reading this article.
DeFi: A Nascent Space
In 2021, the total value locked (TVL) in DeFi protocols grew by an estimated US$100.2B in a mere five months. The average trading volume on decentralized exchanges (DEXs) rose by 100% in the same time frame. With the continued disruption of traditional financial (TradFi) markets, it is imperative for investors to manage the risks they face in DeFi.
Risk management in DeFi is challenging as it is incompatible with traditional risk management theories. In order to address market factors like volatility, capital markets focus on establishing reputable intermediaries to facilitate transactions for investors. However, DeFi’s blockchain technology excludes third parties from its financial exchanges, making it essential for conservative investors and cryptocurrency beginners to create new risk management skills to navigate this nascent space safely.
While there are various approaches to mitigate risks, this is the most commonly used version of risk management:
1. Identifying Different DeFi Risks
Investors should identify risks and sources by collecting sufficient and accurate information about their investments for proper risk management. Check out this non-exhaustive list of risks unique to the DeFi space!
Price risk is the most common risk that DeFi investors are exposed to, where there is a chance that the value of a crypto coin or token declines. Crypto assets are subjected to market volatility, and this results in price fluctuations. Find out more about price risk here!
Security risk involves the threat of malicious attacks exploiting smart contract vulnerabilities. In the event of an exploit, developers are unable to fix the coding bugs or loopholes due to the immutable nature of the blockchain.
Token risk comprises the legitimacy and safety of a token and its developers. Investors should research projects they are interested in and the reputation of their creators. Each token has its unique tokenomics and set of risks that every investor should know.
Protocol risk includes certain mechanics embedded into the code of a protocol. For example, some tokens are inflationary in nature, meaning that the number of tokens in circulation increases over time, and this could cause the price of the token to decrease. As these tokens are distributed to protocol users, there tends to be downward pressure on the price due to increased selling.
2. Measuring Risk
Beyond identifying DeFi risks, investors must measure the extent to which it can affect their portfolios through quantitative data. Risk metrics, such as price (or delta) risk, allow us to examine the sensitivity of token price to changes in the underlying security. For example, a delta of 0.10 means the token price will move by $0.10 for every $1 move in the price of the underlying asset. Deltas determine directional risk, where positive and negative deltas signal investors to buy and sell, respectively. To complement this metric, investors can also research volatility risks of tokens or assets, which reveals how much the underlying asset price has fluctuated over time. Investors should also gather qualitative information, such as the overall economic health from a macroeconomic (macro) overview and industry-specific risks such as regulation. Subsequent articles will deep dive into these metrics and how to calculate them using simple mathematics and tools.
3. Managing Risk
The most important step in the framework is to find ways to reduce DeFi risk. While there are many ways to manage risk, the most popular approach is diversifying assets and hedge positions.
The old adage of not putting all your eggs in one basket is an academically proven strategy to reduce overall portfolio risk. By spreading your investments across different protocols or assets, you can reduce the idiosyncratic risk of a specific asset, which refers to the inherent risks of an individual asset, such as a specific token. A diversified portfolio can thus avoid the full brunt of a single asset’s collapse. Yet, investors should keep in mind that diversification cannot reduce total risk due to the overall volatility of the crypto market. Market climate heavily influences the prices of crypto assets, and if a single token’s price collapses, its neighboring coins may also take a dip.
Investors should thus consider hedging their positions alongside diversification. Hedging refers to holding two or more positions simultaneously to offset any losses from the initial positions with gains from the other. For example, crypto hedging strategies involve short selling and derivative trading of perpetual swaps, options, and futures.
4. Monitoring Risk
However, risk management does not stop at preventive measures, as investors should continue to monitor their positions and associated risks regularly.
Checking the News
Investors should stay up to date with news surrounding assets and their associated assets as part of their daily routine. If a crypto project has critical issues in its audit report, investors should revisit their investments and consider withdrawing funds. Monitoring the macro environment is also essential as changes to interest rates and monetary policies may impact the crypto market. This includes the regulatory status of cryptocurrencies and centralized exchanges (CEXs) within an investor’s native region or country.
DeFi Analytics Platforms
The process of monitoring risk can be made simpler with portfolio trackers that provide investors risk metrics to chart and track. Harvest by Treehouse is a useful analytics platform that provides historical data that is used to estimate the delta of a crypto asset. Harvest also accounts for potential risks, including impermanent loss, thus providing a comprehensive portfolio view for investors. Try it out here!
A Continuous Process
Risk management is ultimately an unceasing process that every investor must undertake to protect their assets. Building the habit of managing risks early can benefit your investment journey tremendously. Managing your risk appetite and investing in safer DeFi investments before gradually advancing is a recommended good practice.
At Treehouse, we want to empower people to confidently navigate DeFi, and this includes helping users with understanding and assessing risk properly. In case you missed it, check out our recommended list of risk-related pieces!
New to DeFi? If you found this useful, check out our other Learn DeFi articles to dive deeper into the wonderful world of DeFi! Alternatively, browse our Insights section to read more in-depth analyses on the DeFi space. You can also try out our flagship product, Harvest, to get a comprehensive analysis of your DeFi assets. Lastly, subscribe to newsletter updates in the box below!