Within the dynamic panorama of decentralized finance (DeFi), danger administration is the bedrock upon which sustainable lending protocols are constructed.
The problem lies to find the fragile steadiness between paternalistic administration of danger (i.e. thresholds for borrowing are decided by DAO governors and danger managers) and permitting the invisible hand of the free market to find out danger tolerance.
Michael Bentley is CEO of Euler Labs.
Because the house grows, it is essential that we correctly perceive the trade-offs inherent in several danger administration fashions.
Euler v1 serves as a thought-provoking illustration of the perpetual debate between immutable code and ruled code. Whereas Euler v1 adopted a paternalistic protocol design, with code ruled by a decentralized autonomous group (DAOs) that would adapt to financial shifts or bug discoveries, it confronted a crucial turning level in early 2023: a $200 million exploit.
See additionally: Hacker Behind $200M Euler Assault Apologizes, Returns Funds
Regardless of rigorous auditing, insurance coverage and a considerable bug bounty instituted at launch, a seemingly minor bug emerged, resulting in a code repair adopted by an extra audit and DAO vote within the months resulting in the assault. Nevertheless, this repair inadvertently uncovered a bigger assault vector, culminating within the exploit final yr.
Though we finally took actions that might result in one of many largest recoveries the crypto house has ever seen, the query nonetheless arises: is paternalism in DeFi inherently dangerous?
I nonetheless assume, as I at all times have, that paternalism is all about trade-offs and private danger tolerances. In the end, customers should weigh the perceived dangers themselves and determine what is correct for them.
The complexity of danger in lending protocols
Think about a lending protocol the place debtors use USDC as collateral to safe loans in ETH. Figuring out the optimum loan-to-value (LTV) ratio for this transaction turns into a formidable job. The perfect LTV continually shifts, influenced by elements like asset volatility, liquidity, market arbitrage and extra. Within the fast-paced world of DeFi, calculating the proper LTV at any given second is impractical.
Lending protocol design due to this fact necessitates heuristics and pragmatic decisions. This results in three broad classifications of danger administration fashions.
International paternalism by way of DAO governance
Immediately, the most well-liked type of danger administration for DeFi lending protocols is the “paternalistic” mannequin, ruled by DAOs and danger administration organizations like Gauntlet, Chaos and Warden. I name this the “paternalistic” mannequin because it tends to imagine {that a} governing physique — be it a DAO or different type of group — understands the danger tolerance its customers ought to assume higher than the customers themselves.
This “world” strategy, adopted by protocols like Euler v1, Compound v2, Aave v2/v3 and Spark, includes setting LTV ratios comparatively conservatively. If the danger surroundings deteriorates, governance can modify the protocol-wide LTV ratios for all customers.
See additionally: Aave Neighborhood Voting to Deploy Model 3 on Ethereum
Whereas this mannequin ensures capital effectivity for debtors and prevents liquidity fragmentation, it’s not with out drawbacks. DAOs are made of individuals with diverse ability units, lots of whom might not be certified to vote immediately on danger parameters themselves.
Delegation of voting energy will help put management in additional certified DAO member palms, however this solely helps to centralize determination making within the palms of some people, who usually find yourself wielding appreciable energy. Even when these specialists make “good” choices, DAO governance takes time and choices won’t be applied sufficiently shortly if the surroundings modifications quickly.
Governance additionally forces protocol customers to simply accept or reject a single danger/reward end result, when in actuality customers have very completely different tolerances. It additionally arguably trains customers to anticipate that danger might be managed for them, due to this fact conditioning customers to depend on paternalistic danger administration, doubtlessly hindering their capability to make knowledgeable danger/reward choices for themselves sooner or later.
The invisible hand by way of remoted swimming pools
The free market ideas underpinning the “invisible hand” mannequin empower lenders to decide on their danger/reward preferences actively. First coined by economist Adam Smith, the “Invisible Hand” is a metaphor for the unseen forces that drive a free-market economic system towards optimum options. Though definitely not infallible, it’s the foundation of most all free-market capitalism right now.
Protocols like Kashi, Silo, Compound v3, Morpho Blue, Ajna and FraxLend permit lenders to deposit into numerous (for essentially the most half) ungoverned, remoted swimming pools, providing flexibility in LTV ratios, based mostly on free-market ideas. With many swimming pools to select from, customers are free to lend throughout a variety of doable LTV ratios (and different danger parameters). Some would possibly take a cautious strategy, lending at low LTV ratios and attracting fewer debtors, whereas others could be extra open to danger and leverage.
See additionally: The Subsequent Era of Automated Settlement
This, in flip, permits completely different use instances for lending and borrowing to emerge. On the protocol layer issues are sometimes considerably less complicated with free market fashions too. The absence of governance permits immutable primitives to be constructed that can be utilized by anybody. Complexity and product-specifics will be pushed to an aggregation-layer or user-interface layer (see beneath). While this doesn’t essentially scale back the complexity of the system general, it does simplify the complexity of the trusted codebase for the subset of customers who’re comfortable to handle their very own dangers.
Nevertheless, this strategy isn’t with out its personal challenges, corresponding to liquidity fragmentation, which makes it more durable for lenders and debtors to attach. Remoted swimming pools not solely make it more durable for lenders and debtors to search out each other, however they usually additionally make borrowing costlier (even when customers are capable of finding a match). That’s as a result of in most remoted lending market protocols debtors use collateral which earns them no yield (i.e. Morpho Blue, Compound v3, FraxLend).
In distinction, in monolithic lending protocols debtors can concurrently use an asset as collateral and lend it out on the similar time. This could considerably scale back the prices of borrowing, and even make borrowing worthwhile, enabling interest-rate arbitrage (by way of “carry trades”). And with extra borrowing, comes extra yield for lenders. However there is no such thing as a free lunch right here. Lenders are uncovered to rehypothecation dangers on monolithic lending protocols in a method that they don’t seem to be on remoted lending protocols.
See additionally: Rehypothecation Could Be Frequent in Conventional Finance however Can By no means Work With Bitcoin
Native paternalism by way of aggregators
Aggregators are an answer to the drawbacks of remoted swimming pools. It’s typically claimed that aggregators assist to unravel the liquidity fragmentation drawback related to remoted swimming pools, for the reason that isolation is essentially abstracted away for lenders. Nevertheless, lenders are solely half the equation right here. Even when lenders use aggregators, the image for debtors continues to be fragmented. Aggregators allow customers to deposit property right into a managed pool, the place danger administration is delegated to an area danger supervisor. They summary away the complexities of remoted swimming pools, providing passive entry to numerous danger/reward alternatives.
Aggregators right now are available in a number of flavors. There are impartial aggregators, like Yearn and Idle, that are usually agnostic concerning the downstream lending markets they deposit into. They merely attempt to maximize the danger/reward for his or her customers, no matter how rewards are achieved. And there are extra protectionist aggregators, like MetaMorpho, which can be extra opinionated about the place the yield comes from, usually attempting to handle danger by preserving capital inside their very own ecosystem or merchandise.
Whereas aggregators improve flexibility for lenders, they arrive with extra charges and inherent paternalistic drawbacks. And so they do nothing to deal with the challenges dealing with debtors, who nonetheless should work with fragmented experiences and will require their extra methods or fashions for efficient danger administration.
The necessity for modularity and adaptability
To actually scale decentralized lending and compete with conventional finance, DeFi wants a lending ecosystem with modularity at its core, wherein completely different protocol designs serve completely different consumer wants. There is no such thing as a one-size-fits-all resolution to constructing a lending protocol.
Ruled monolithic lending protocols present capital effectivity however lack numerous danger/reward alternatives. Remoted lending markets, pushed by the invisible hand, provide flexibility however endure from liquidity fragmentation and excessive borrowing prices. Aggregators, whereas addressing some points, introduce their very own set of challenges.
That is the place protocols that leverage modularity will actually shine — by their very design, they may facilitate the creation and use of extremely customizable experiences — bridging the hole between monolithic lending protocols and remoted swimming pools. Recognizing numerous consumer preferences, they may allow the deployment and interlinking of custom-made lending vaults in permissionless environments.
See additionally: The 5 ‘Unsolved Issues’ of Crypto In line with Haseeb Qureshi
Modularity marks a paradigm shift in DeFi composability and connectedness. Protocols like Euler v2 will empower customers to seamlessly change between completely different danger administration fashions based mostly on their preferences. True freedom isn’t about selecting between paternalism vs. the invisible hand; it’s about having the ability to change seamlessly between whichever type of mannequin you like at any time you need.
It’s this flexibility that may foster innovation and development via community results as an increasing number of numerous vault sorts are deployed.
On the core of Euler v2’s design philosophy is the Ethereum Vault Connector (EVC) being constructed in-house. Though not but deployed, the EVC is at the moment present process rigorous critiques, audits and is supported by a considerable bug bounty. As soon as reside, it is going to be the bedrock on which customers can construct vaults on high vaults. This agnostic strategy accommodates each immutable and ruled preferences. Customers looking for the simplicity of immutable, governance-free vaults can create and make the most of them in a permissionless method.
On the flip aspect, these wanting a paternalistic expertise led by a DAO, danger administration organizations, or a specialised aggregator layer can go for that different. Crucially, the underlying code maintains neutrality, offering customers the liberty to specific their private preferences.
