Decentralized finance (DeFi) is experiencing renewed momentum. The exercise in new ecosystems, and the excessive yields, resemble the well-known 2021 DeFi Summer season. The number of modern protocols makes it extremely onerous for buyers to maintain up, whereas on the similar time, the spectacular progress raises issues about dangers accumulating within the DeFi ecosystem.
You may need heard the doomsday analyses evaluating probably the most profitable protocols of this wave, like Ethena or Eigen Layer LRTs, with danger administration disasters like Terra, with out actually offering any credible proof of the parallels. Reality is, this new technology of fast-growing DeFi protocols is rather more mature and a whole lot of thought has gone into danger administration. Nonetheless, there may be nonetheless loads of danger.
Jesus Rodriguez, the CEO of IntoTheBlock, is a speaker on the AI Stage at Consensus 2024, Might 29-31.
The most important danger within the present DeFi market just isn’t primarily based on mechanistic failures corresponding to people who prompted the collapse of Terra, however quite on three key components: scale, complexity, and interconnectivity.
Protocols on this DeFi wave have grown fairly massive in a matter of months, they allow extra complicated monetary primitives, and they’re extremely interconnected. That mixture of complexity, measurement and interconnectivity has drastically outpaced the capabilities of the danger fashions within the present DeFi market. In easy phrases, there are many danger circumstances within the present DeFi markets for which we don’t have credible danger fashions. And that hole appears to be rising, not shrinking.
The 4 Largest Dangers in Fashionable DeFi
Danger has been a part of the DeFi narrative because the starting, and it’s totally straightforward to debate it in broad, generic phrases. This new period of DeFi brings novel improvements and has grown considerably quick. Because of this, danger is taking over a distinct connotation than earlier than. Taking a first-principles strategy to research danger on this period of DeFi highlights 4 elementary components: scale, velocity, complexity and interconnectivity.
As an example these components, take into account the variations in quantifying danger for a primary AMM with a couple of hundred million in TVL versus an AMM that makes use of restaked belongings with their corresponding level techniques and introduces its personal tokens and factors. The previous danger mannequin might be solved with primary statistical or machine studying strategies. The latter enters the area of rather more superior branches of arithmetic and economics corresponding to complexity or chaos principle, that are nowhere close to being utilized in DeFi.
Let’s have a look at the various factors in additional element.
1) Scale
The precept of the connection between danger and scale in DeFi is extremely easy. In monetary markets, modeling danger at a smaller scale, say a couple of hundred million, could be very completely different than at a couple of hundred billion. At a bigger scale, there are all the time danger circumstances that floor that weren’t current at smaller scales. This precept definitely applies to DeFi as a parallel monetary system with many interconnected primitives.
Ethena is among the most modern tasks of the present wave of DeFi and has attracted billions in TVL in only a few months. The most important problem for Ethena within the present market is to adapt its danger and insurance coverage fashions to that scale within the occasion of funding charges going detrimental for a very long time.
2) Pace
The connection between danger and velocity is the normal friction between rising too large too quick. As a danger situation, velocity acts as an accelerator to scale. A protocol that goes from a couple of million to some billion in TVL in only a few months may not have the time to regulate its danger fashions to the brand new scale earlier than unexpected danger circumstances seem.
The fast rise of EigenLayer triggered a complete motion of LRTs, a number of of which grew to a number of billions in TVL in only a few months whereas nonetheless missing primary functionalities corresponding to withdrawals. The mixture of velocity and scale can exacerbate easy depegging circumstances into actually impactful danger components in a few of these protocols.
3) Complexity
All the discipline of complexity principle was born to review techniques that escape the legal guidelines of predictive fashions. Financial danger has been on the middle of complexity principle virtually since its early days as world economies quickly outgrew danger fashions post-World Conflict II. Modeling danger in a easy financial system is, effectively, simply easy.
Within the new wave of DeFi, we now have protocols corresponding to Pendle or Gearbox, which summary fairly subtle primitives corresponding to yield derivatives and leverage. The danger fashions for these protocols are basically harder than these from the earlier technology of DeFi protocols.
4) Interconnectivity
Broadly interconnected financial techniques generally is a nightmare from the danger perspective as any situation can have quite a few cascading results. Nonetheless, interconnectivity is a pure step within the evolution of financial techniques.
The present DeFi ecosystem is rather more interconnected than its predecessors. We’ve restaking derivatives in EigenLayer being tokenized and buying and selling in swimming pools in Pendle or getting used with leverage in Gearbox. The result’s that danger circumstances in a single protocol can quickly permeate by way of completely different key constructing blocks of the DeFi ecosystem, which makes danger fashions extremely difficult to construct.
Transitioning from Technical to Financial Danger
Hacks and exploits have been the dominant danger theme in DeFi for the previous few years, however that is perhaps beginning to change. The brand new technology of DeFi protocols just isn’t solely extra modern but additionally rather more strong from the technical safety standpoint. Auditing corporations have gotten smarter, and protocols are taking safety rather more significantly.
As an evolving monetary system, the danger in DeFi appears to be transitioning from technical to financial. The massive scale, quick progress velocity, rising complexity, and deep interconnectivity are shifting DeFi into unexpected territories from the danger perspective. With solely a handful of firms engaged on danger in DeFi, the problem is now to catch up.
