According to the report of the international risk assessment company Moody’s , decentralized finance (DeFi) is rapidly evolving, but a lack of transparency, a general lack of awareness of the risks involved, and methods for measuring and mitigating those risks continue to pose challenges for users .
Moodys analysis prepared in collaboration with financial modeling platform Gauntlet , identifies three risks typical of traditional lending relationships:
- assessment risk or change in the assessment of borrowed funds and the amount of the loan, including interest;
- opportunity risk or the likelihood of a better offer in the future;
- counterparty risk arising from information asymmetries between the borrower and the lender, each of which could better know their side of the transaction.
In general, this third gap manifests itself in two ways: the first is adverse selection. “For example, a company issuing new bonds has a better understanding of its financial and strategic position than those who buy bonds,” the report says.
They argued that adverse selection in DeFi looks similar, though not identical. On the borrower side, interest rates are public, open source, and verifiable given that the credit code is immutable on the blockchain. In terms of lending, due to the current state of DeFi, only overcollateralized loans are possible; the message says, adding that:
“Adverse selection largely becomes a function of the proper valuation of collateral, which is less important with sufficiently liquid collateral.”
The second conflict is principal-agent, and it arises in DeFi due to a mismatch of incentives between the platform’s investors, such as liquidity providers or lenders, and those who manage it.
MakerDAO , for example, which oversees the DAI stablecoin, uses DAI’s competitive savings rate and platform stability fees as its main methods of regulating the supply and demand for loans, the report explains. .” This, according to Moodys and Gauntlet, “directly affects the price of MKR, often to the detriment of investors.”
The analysis acknowledges that given the rapid development and rise in popularity of DeFi, it is difficult to properly quantify risk.
They claim they can identify several “critical aspects” of risk that tend to affect all DeFi protocols, although not equally. These measurements can then be “split” into:
- Systemic risks or risks that affect most or all of the DeFi ecosystem – these include currency, regulatory, and blockchain risks. The impact of these risk factors can vary significantly by platform.
- Idiosyncratic risks, or risks affecting one protocol or a group of protocols – these consist of security contract, governance, collaboration, and oracle risks. They are, by their nature, usually unique to a particular platform.
This leads to the most important factor in understanding a platform’s exposure to risk: mitigation practices, said Moodys and Gauntlet, explaining that:
While all DeFi platforms may depend on similar primitives, namely the presence of a smart contract-enabled blockchain and crypto-accessible collateral, the economics lie in the design of the protocols, the quality of the smart contracts and ongoing maintenance by developers, and the dynamic provisioning of keys. parameters of management companies significantly affect the quantitative assessment of risks.
The analysis concludes that consistent risk modeling for DeFi should take into account all identified sources of risk for protocols: contract, market/currency stability, oracle/external dependencies, governance, regulation, and collaboration.
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