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Risk management in DeFi seldomly involves a single protocol.
Created Using DALL-E
Risk management is one of the most complex aspects of deploying capital in DeFi. The lack of intermediaries is one of the hallmarks of DeFi, but it also means that financial risk needs to be managed at the infrastructure level, which creates a different dimension of nightmare scenarios.
When thinking about risk in DeFi positions, investors typically need to wrestle with different questions:
Can the protocol manage the risk of my position?
Are there other protocols, assets, or bridges that can impact my position?
How about the underlying blockchain?
Creating a comprehensive picture of risk for any DeFi position is not an easy feat. However, there are some first principles that definitely help. One that I find particularly useful is to analyze the different levels at which risk can accumulate in DeFi protocols. Using an oversimplified taxonomy, there are four fundamental levels that can represent risk vectors in DeFi positions:
· Baseline: Risk associated with vulnerabilities in the underlying blockchain runtime.
· In-Protocol: Risk related to the specific protocol risk parameters.
· On-Protocols: Risk conditions associated with the financial composition and mechanics of the different markets/pools in protocols.
· Across-Protocol: Risk conditions based on cascading conditions across different DeFi protocols.
Baseline Risk
These are risk conditions triggered by activity in the underlying blockchain of a DeFi protocol. Patterns such as malicious contracts being deployed or potential attack vectors to the baseline blockchain are examples. The canonical example of these risk vectors is positions in lending protocols in Solana being liquidated following an outage of the blockchain.
Managing this type of risk often entails integrating smart contract monitoring and security platforms. This type of risk management assumes no knowledge of the specific DeFi protocols.
In-Protocol
Each DeFi protocol has a series of parameters that govern different risk profiles. For instance, lending protocols such as Aave and Compound use different parameters to model liquidations. In-protocol risk management relies on modeling risk conditions based on the combinations of those parameters.
In-protocol risk management mostly focuses on conditions at the protocol level and not related to individual financial positions. There is an interesting trend in which this type of risk management is moving to the protocol itself.
On-Protocol
Acknowledging that this is not the greatest term, these types of risk conditions are implemented outside a DeFi protocol and combine both the behavior of the protocol as well as individual financial conditions. Examples of these risk conditions include liquidations in lending protocols or slippage in AMMs.
On-protocol risk management typically involves external code that is monitoring specific conditions and triggering actions in a given DeFi protocol.
Cross-Protocol
Risk conditions in DeFi often involve multiple protocols. A classical example of this are exploits in bridges that ripple into losses on DeFi protocols in specific protocols. Another canonical example is depegging scenarios in derivatives on specific crypto-assets.
Cross-protocol risk conditions capture scenarios that involve multiple DeFi protocols. This type of risk management is particularly complex and involves pretty sophisticated simulations.
The aforementioned levels capture most of the risk vectors in DeFi positions. Developing a comprehensive risk management strategy involves monitoring and reacting to conditions across those levels, which is far from an easy endeavor. As DeFi evolves, some of these levels will become more robust while others are likely to become more vulnerable. More about that in a future post.
Four Levels of Risk Management in DeFi was originally published in IntoTheBlock on Medium, where people are continuing the conversation by highlighting and responding to this story.
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