In this article, we break down the most important economic risks to consider when using a DeFi lending protocol in combination with a common yield strategy scenario.

Scenario — Supervised Lending

Let’s illustrate these risks using a supervised lending strategy. In this scenario, a user might deposit a stable, low-yield asset like Bitcoin and borrow Ether, which they then deploy into other yield-generating activities such as providing liquidity in Automated Market Makers (AMMs).

Types of Risk In DeFi Protocols

Liquidation Risk

In DeFi borrowing, there’s always a danger of liquidation — this happens if your collateral’s value falls too much compared to your debt. Reaching the liquidation threshold without having repaid or topped up your collateral can lead to significant losses through either partial or full liquidation, which can happen automatically at any time.

Available Liquidity Risk

When you deposit into a lending market, you face the risk of the market’s liquidity being fully borrowed out. This situation can prevent you from withdrawing your funds to repay the loan, effectively locking your liquidity within the protocol. Keeping an eye on major deposits and liquidity trends can help assess the risk level.

Slippage Risk

Slippage Risk is the financial risk associated with incurring losses from a transaction or trade in decentralized finance (DeFi) due to the difference between the expected price and the actual executed price. This risk is commonly linked to liquidity issues within a trading environment, where insufficient market depth can cause larger than expected price movements when a trade is executed. Slippage can significantly affect the cost and outcome of transactions, highlighting the importance of liquidity management in DeFi platforms.

Recall Risk

Recall risk is about the ease of retrieving borrowed assets. Moving assets across chains or locking them up in another protocol can hamper your ability to retrieve them to repay a loan, thus increasing your risk of liquidation.

Depeg Risk

Depeg risk refers to when the value of assets in AMM pools shifts away from their intended value, relative to other assets, currencies, or commodities. Such shifts can lead to capital losses and complicate the repayment of borrowed amounts.

Pool Distribution Risk

Pool Distribution Risk refers to the financial risk associated with rapid changes in the composition of assets within an automated market maker (AMM) pool. This risk arises when the proportion of different assets in the pool shifts significantly, impacting the conditions for entering and exiting the pool, especially when transactions involve only one side of a currency pair. Changes in asset distribution can lead to imbalances, potentially leading to depegging of assets or increased slippage costs. These dynamics can affect the predictability and stability of the pool, complicating investment and withdrawal strategies.

Concentration Risk

Concentration Risk refers to the financial vulnerability that arises when one or a few entities control a large portion of the assets in an automated market maker (AMM) pool. This concentration can lead to increased slippage or liquidity risks if these major contributors decide to withdraw their assets abruptly. Such withdrawals can significantly alter the liquidity dynamics of the pool, impacting the ability of other participants to execute transactions efficiently and potentially leading to financial losses.

Conclusion: Navigating Risks with Expert Tools

Understanding and managing these risks is crucial for anyone participating in DeFi, and many of these risk become more complex to navigate as capital increases. Our platform provides detailed risk analysis tools that help you navigate the complex dynamics of DeFi protocols more safely and effectively.

If you’d like to dive into these risk metrics yourself, we offer a free version of our DeFi Risk Radar for many of the top DeFi protocols. For automated risk management or specific questions, feel free to contact us.