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A general overview of the risks lenders and borrowers face within DeFi’s lending protocols
Decentralized finance (DeFi) has introduced financial protocols that allow for direct lending and borrowing on their platforms, enabling users to lend and borrow assets without relying on traditional intermediaries.
These protocols mainly use smart contracts, which are self-executing agreements with the terms of the contract directly coded into them, offering improved transparency and security. Lenders provide their assets to a liquidity pool and receive interest as compensation, while borrowers can obtain loans by providing collateral. Interest rates are usually determined by algorithms, which showcase the supply and demand dynamics of the assets in the pool.
This article examines the economical risks associated with DeFi lending protocols, identifies their most vulnerable points, and discusses effective ways to monitor DeFi risks. In this article, we’ll examine indicators that highlight activity within the Aave protocol, the largest lending protocol in DeFi.
Lenders & Borrowers
The primary financial risk of depositing in a Lending Protocol is the possibility of not recovering your assets, typically occurring if a borrower fails to repay the loan.
Protocols in DeFi currently operate on an overcollateralized basis, meaning borrowers must provide a certain percentage of collateral upfront for the amount they are borrowing. If the value of the borrowed money falls below this threshold, mechanisms are activated to seize the collateral from the borrower, aiming to protect the lender’s assets.
Source: IntoTheBlock’s Risk Radar
These two indicators aim to monitor the group of loans that are at risk of liquidation. The indicator on the left, “The Health Factor Distribution,” displays the health factor of a lending position as a metric that reflects the safety level of a borrower’s position by calculating the ratio of held collateral to the borrowed amount. Users’ collateral is classified according to their respective health factors. Positions with a health factor above 1.50 indicate a lower risk level for the protocol. Monitoring the amount of collateral within each health factor category is useful for tracking purposes. If there’s a sudden drop in prices, understanding the protocol’s exposure level within each health factor range can aid in mitigating risk.
The indicator on the right displays the value of loans that are secured with volatile assets, which are within 5% of their liquidation threshold. This information helps users comprehend the protocol and specific pools’ exposure to high-risk loans, and it enables liquidators to anticipate future liquidations. A loan that is within just 5% of its liquidation threshold is deemed highly risky, given the increased chance of liquidation should the collateral’s value drop or the price of the loaned asset rise. By pinpointing loans that have a liquidation ratio below 5%, investors and users can gain a clearer understanding of the associated risk level, aiding them in making informed decisions about depositing into or using the protocol.
In the Aave protocol, as well as most lending protocols in DeFi, the individuals responsible for monitoring and ensuring that borrowers repay their loans are known as liquidators. Liquidators are responsible for liquidating the collateral that borrowers have put up for their loans if the value falls below the predetermined threshold. Maintaining a robust and active group of liquidators within the protocol is crucial for ensuring the protocol’s vitality.
Source: IntoTheBlock’s Risk Radar
The Liquidation Volume refers to the total value of funds that are confiscated and sold off when a borrower fails to repay their loan. This metric offers insight into the risk level within the system, with higher liquidation volumes suggesting that an increased number of borrowers are defaulting on their loans, thereby exposing the protocol to greater risk. Furthermore, it indicates the value captured by liquidators to shield the protocol from exposure to bad debt.
The actions and movements of large holders (Whales) are also vital for the economic security of the protocol. Their activities in the markets can swiftly influence various markets and significantly alter interest rates.
Large liquidations from whales could result in bad debt for the protocol if the incentives for liquidators are insufficient to motivate them to process the order. Therefore, it is recommended to continuously monitor their activities and the markets in which they are involved when participating in the protocols.
Source: IntoTheBlock’s Risk Radar
These two metrics provide a comprehensive overview of the current behavior of whales within the protocol. From the perspective of borrowers, analyzing the liquidation history allows you to evaluate the risks associated with lending to the protocol. Furthermore, by examining repays and total debt, users can assess the whales’ past interactions with the protocol and attempt to forecast their typical behavior. Additionally, the current borrow share enables liquidators and lenders to anticipate scenarios in which whales may be liquidated.
From the supply side, borrowers can monitor the supply share of lenders and estimate scenarios of liquidity withdrawals and their potential impact on the interest rates of their loans. Users can also observe the largest depositors to analyze their borrowing power relative to their deposits, which can provide useful information when investigating the leverage lenders have over the protocol’s deposits.
The Power of Insightful Monitoring
In conclusion, the DeFi ecosystem, particularly lending protocols like Aave, operates on complex mechanisms involving borrowers, lenders, and the critical role of liquidators to maintain the system’s health and security.
Monitoring indicators such as the Health Factor Distribution and Liquidation Volume offers valuable insights into the protocol’s risk level and the efficiency of its liquidation processes. The behavior of large depositors, or “whales,” significantly impacts market dynamics and the protocol economical well-being. Constant monitoring is required to mitigate risks associated with large-scale liquidations and interest rate fluctuations. Understanding the interactions between borrowers and lenders, and analyzing the largest depositors’ activities, helps users assess borrowing risks and the potential impact of liquidity movements on the ecosystem.
The views and opinions expressed in this article are solely those of the authors and do not reflect the views of Bitcoin Insider. Every investment and trading move involves risk - this is especially true for cryptocurrencies given their volatility. We strongly advise our readers to conduct their own research when making a decision.