19 June 2024

Understanding and Mitigating Economic Risks in DeFi Lending Platforms

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The DeFi sector provides unparalleled opportunities for capital management.

However, exercising this freedom requires conducting thorough research and evaluating the risks associated with depositing funds into a particular protocol.

And the fact that this market is rather opaque in its structure and lacks in the way of sophisticated risk management tools means that the task of assessing said risks often falls directly on the shoulders of users.

This poses no small amount of complications as under normal circumstances users should not have to perform their own risk management.

But there is an undeniable gap in security solutions in the DeFi market that leaves them doing just that.

With this in mind, I have put together a list of economic risks in DeFi lending protocols with their comprehensive analysis and ways to assess whether a particular project is taking steps to protect itself against them.

Risk classification and overview

First things first let’s start with properly defining what market and economic risks are.

Market risks mainly involve dealing with external factors, such as market crashes, liquidity crises and systemic risks that can impact the entire DeFi ecosystem.

Included among the main market risks are the following.

  • Liquidity risks where users are unable to immediately withdraw their deposits in case of a bank run
  • Interest rate risks where interest rate rises too high, incurring losses for borrowers
  • Liquidation risks where borrowers lose some of their collateral value during liquidations
  • Liquidation cascades where a negative impact on prices can cause smaller price movements to become larger, triggering a feedback loop

Economic risks, on the other hand, denote anything related to deliberate manipulation of the market state for profit.

The main types of economic risks to consider are as follows.

  • Pump attacks An inflation of an asset’s price, which is then used as collateral to borrow other fairly-priced assets. The manipulated price eventually returns to normal, leaving the protocol and its liquidity providers with a lot of debt that can’t be repaid.
  • Dump attacks – These operate on the same principle as pump attacks but are based on borrowing an underpriced asset.
  • Forced liquidation attacks A price manipulation that increases the value of a loan asset or decreases the value of collateral and triggers large liquidations, damaging the borrowers.

By closely monitoring for these factors, DeFi participants can make informed decisions and diversify their portfolios to safeguard their investments.

On the other hand, risk-conscious protocols must also be aware and ready for such extreme conditions in order to implement risk management strategies in a timely manner and better protect the funds of their users.

How can DeFi protocols go about mitigating these risks

Withdrawal rate limits

Most economic exploits happen in a matter of minutes and can lead to the whole TVL (total value locked) of a protocol getting drained.

The impact of such attacks could be mitigated by limiting the rate at which the funds can be withdrawn from the protocol.

This time-delaying measure ensures the potential losses will not be too severe before protocol administrators can take action to address the issue.

Borrow and supply caps

Establishing borrow and supply caps means that a protocol can set limits on its exposure to certain assets.

This helps to make sure there is enough liquidity for healthy liquidations while mitigating the impact of related risks.

This can be particularly useful when dealing with assets that have relatively low liquidity or that are new and thus not yet fully understood in terms of their risk profiles.

By implementing hard limits on the maximum amount of funds that users can borrow or supply, a protocol avoids becoming overexposed to excessive activities, which could deplete its liquidity reserves and potentially lead to insolvency or instability.

Isolated pools

An isolated pool refers to pooling assets into small groups with no operations between two different ones allowed.

In other words, a user cannot deposit collateral into pool one and borrow assets from pool two.

By restricting users from borrowing one volatile asset against another, protocols gain a great way to minimize a questionable asset’s scope of influence.

In the event of an attack, only one pool’s deposits would be at risk rather than the whole protocol.

Do your due diligence and don’t forget the community

Implementing any of these measures stands to prevent an individual user or group from dominating a DeFi protocol’s liquidity pool and creating an imbalanced risk profile.

With such safeguards in place, a project can maintain a healthy and sustainable liquidity environment, mitigating liquidity risks and promoting overall stability.

Community members also possess the ability to shape a protocol’s defensive measures by providing developers with crucial feedback from users and influencing them to make better-informed decisions, including introducing limits and methods that we covered above.

At the end of the day, remember that there are no truly risk-free DeFi protocols.

It ultimately falls on you to decide how safe you feel about any particular protocol’s operations – but that doesn’t mean you can’t take steps to minimize potential dangers.


Kate Kurbanova is a co-founder of Apostro, a risk management firm focused on economic attacks. She is a professional who leverages established traditional financial practices to enhance DeFi risk management.

 

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