CEO of Arcadia, securing blockchain technology, one money lego at a time.
Decentralized finance (DeFi) has emerged as the flagship concept and use case for blockchain technology and cryptocurrency. DeFi is the use of smart contracts and other decentralized technologies to enable forms of financial transactions in a censorship-resistant manner while enabling disintermediation from traditional counterparties. DeFi is often seen as an avenue to introduce transparent and equitable treatment for participants in a verifiable manner within its financial systems.
With over $40 billion locked in DeFi protocols, the sector is both growing and becoming something to watch. However, as these technologies chart new territories, they also introduce profound risks that have been learned and still sometimes challenge conventional financial systems. Among these, an often unthought-of threat goes undiscussed: economic risk.
Understanding Economic Risk In DeFi
Economic risk in DeFi is more insidious than its traditional finance counterpart. It encompasses a range of potential vulnerabilities and attack vectors stemming from poorly designed financial models or rapidly evolving protocols that haven’t been battle-tested. For instance, the case of Mango Markets and its exploiter highlights how attackers can manipulate market conditions (or, in the case of Mango Markets, both market conditions and price sources) to create substantial losses for users.
In 2022 alone, more than $1 billion in losses could be attributed majorly to these inherent economic risks, often occurring in concert with smart contract vulnerabilities. These figures aren’t just numbers but a call to action for stakeholders in the DeFi ecosystem to address these underlying, systemic issues.
Nowhere are these economic risks more evident than in DeFi lending markets, representing more than $18 billion of the industry. These markets, characterized by their automated collateral use and absence of traditional safety checks like underwriters, expose users to unprecedented risk levels.
A striking example is when collateral that backs loans loses liquidity, rendering it less than anticipated to provide for the loan’s value (this value is provided through liquidation mechanisms). This situation was starkly highlighted during the Curve Finance-related lending debacle where an individual with substantive holdings of the Curve Finance asset CRV had a significant amount of value put at risk for liquidation, as insufficient market liquidity to account for the loan nearly led to the creation of millions in bad debt.
Furthermore, these protocols’ automated and permissionless nature means that setting appropriate collateral requirements is often hit-or-miss, leading to potential systemic failures.
During the de-peg of the Terra stablecoin, lending markets Venus Protocol and Blizz Finance both incurred bad debt due to the rapid price decline, showcasing the domino effect triggered by such overlooked economic risks. Blizz Finance notably attempted to update its protocol to mitigate this collateral risk during the de-peg of the stablecoin but was blocked by automated processes that prevented it from solving the problem before incurring substantial losses.
Mitigating Economic Risk: Strategies And Challenges
While there’s no one-size-fits-all solution, certain strategies have been instrumental in curbing the fallout from these economic risks within DeFi. These include rigorous economic modeling to assess the viability of collateral types, comprehensive risk assessment protocols, and continuous scrutiny of loan-to-value (LTV) ratios and interest rates.
However, these strategies are not without their challenges. The decentralized nature of these platforms means information asymmetry and governance issues are rampant, often leading to mitigation measures being either too little or enacted too late (as in the case of Blizz Finance). Moreover, the reliance on external information via oracles introduces additional layers of complexity and potential failure points, as seen in the case of Mango Markets.
Enhancing Security Through User Education And Safeguards
While economic models play a crucial role in quantifying and navigating the financial risks inherent in emerging DeFi platforms, they represent just one facet of a broader need for mindfulness. Achieving a good financial security posture extends beyond models and metrics; it demands implementing informed processes that promote user awareness and prudent interaction with DeFi protocols.
Protocols need to be intentional about the types of assets they accept, recognizing that some carry a higher inherent risk than others. By establishing clear criteria for acceptable collateral and even instituting mechanisms for emergency freezes in crisis scenarios, platforms can significantly reduce vulnerability to rapid market fluctuations and predatory economic attacks.
The addition of hard rules into the addition of collateral is an unused route that can sometimes prevent the use of governance takeover or lobbying from being utilized as easily. Moreover, integrating economic risk as an acceptable scope into bug bounty programs encourages a community-driven approach to identifying and preventing potential financial losses. This collaborative defense strategy leverages collective expertise and fosters a sense of shared responsibility for the platform’s overall health.
Communication channels also play a critical role. Open forums and discussion platforms where risks are thoroughly dissected before significant protocol actions (like introducing new collateral types or substantial code changes) promote a culture of transparency and informed decision-making. These dialogues empower users, giving them insight into the potential repercussions of their transactions and encouraging them to take a more active role in risk mitigation.
By coupling stringent asset protocols with an emphasis on education and community involvement, DeFi platforms can build a more comprehensive shield against the multifaceted threat of economic risk, safeguarding individual users and the greater DeFi ecosystem.
Navigating The Future Of DeFi
As the emerging world of DeFi grows, builds and attempts to calcify the dream of a more accessible, transparent and equitable financial world, it must learn the lessons long since learned by the broader financial world and the lessons that are unique to the space. In this relentless pursuit of innovation, our collective commitment to integrating these hard-earned insights will be the cornerstone upon which the realm of a safer, equitable, decentralized financial world can exist.
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