In DeFi technological vulnerabilities often take precedence in the risk evaluation process. Economic risk is often neglected but equally important.
Risk evaluation is probably one of the most essential aspects of traditional finance. Being able to assess the risks of an investment or financial activity before delving deeper into it is a significant advantage for users. It helps them better understand the pros and cons they face and adjust their decision-making accordingly. Basically, risk ratings help the users gauge the suitability of a particular tool or asset class in relation to their priorities.
However, while risk rating is a common phenomenon in traditional finance, the same cannot be said for DeFi, despite the industry’s acute need for it. There is already a great deal of anxiety among users regarding crypto market volatility and associated threats, which makes it all the more important to have well-defined risk ratings that could help people make up their minds about investing in particular assets or protocols.
The History of DeFi Risk Rating Protocols
The idea of creating risk rating protocols in DeFi is not exactly new. There have been occasional efforts in this direction for several years now. Experienced users of popular DeFi lending and borrowing platforms like Compound, DyDx, and Fulcrum have often voiced their concerns regarding inherent risk factors that may impact their operations. For instance, questions have been raised regarding the security of the underlying smart contracts, degree of decentralization, and potential manipulative elements that might impact investment values.
Back in 2019, ConsenSys introduced a DeFi Score Methodology that would help users understand the technical and financial risks that impact DeFi markets. The aim was to create a risk rating framework and promote transparency, but the implementation turned out to be clumsy. However, the idea ultimately didn’t pan out – there were too many indicators for different protocols, which led to a lack of relevance and comparability with this method.
For DeFi platforms, it is essential to have a clear demarcation between technical and economic risk rating protocols. The entire DeFi space is heavily dependent on technology, which is why technological vulnerabilities often take precedence in the risk evaluation process. Economic risks, on the other hand, focus on assessing and quantifying the financial risks associated with various DeFi protocols and projects.
That is why companies in the DeFi space need to adopt a focused approach while creating relevant risk ratings for all their products.
The Hurdles of Creating Economic Risk Ratings
Creating economic risk ratings in the DeFi space is no easy feat, especially because it involves assessing and quantifying individual risks associated with a particular protocol or project. There are no widely accepted standards regarding creating these ratings, and since DeFi is a relatively new and rapidly evolving space, setting precedents also becomes difficult.
DeFi is heavily impacted by technical risks, and to create a comprehensive economic risk rating system, it needs to factor in technical challenges as well. For instance, vulnerabilities or flaws in smart contracts can cause huge financial losses for the users. While this is a technical risk, it is still something to be considered when devising an economic risk rating framework to ensure proper representation.
Economic Risk Ratings: What and Why
Economic risk ratings are essential for users to make informed decisions about where to invest or participate in DeFi activities. By providing risk ratings, DeFi protocols can enhance their transparency and accountability to their users.
While devising such ratings, here are some of the economic risks that should be considered:
Pump and Dump Attacks: Pump and dump attacks take place by either inflating or deflating the price of an asset to borrow other fairly-priced assets. As a result, there is a liquidity issue within the protocol and unpayable debts.
Market Manipulation: DeFi markets are easily manipulated by influential users because of the low liquidity and lack of regulation in this sector.
Protocol Liquidity: Potential liquidity crises, impermanent loss, and ease of trading on secondary markets can impact protocol liquidity, causing trouble in the DeFi borrowing and lending processes
These risks often get sidetracked by technical issues in the DeFi space, and as a result, most users and protocol builders do not foresee issues like asset collapse or even protocol hacking. Setting up well-defined economic risk ratings will create a more secure and structured DeFi environment that is free from manipulative tactics.
Obviously, it is difficult to find a one-size-fits-all solution for creating an economic risk rating framework, which is why extensive research needs to be conducted. The goal is to create a standardized framework, but that doesn’t mean protocols have to compromise on customizations. Depending on the nature of the protocol and activities conducted, the risk ratings can be modified and updated.
There is still a long way to go when it comes to user awareness in the DeFi space, and for a risk rating system to be effective, users themselves must also be vigilant about economic risks to prevent potential exploits and ensure the security of funds.
Economic risk ratings stand to help DeFi users and protocols alike to get insight into a structured and standardized way to monitor, evaluate, and address a number of potential dangers associated with different projects. Ultimately, implementing such measures will be a big step towards stabilizing the crypto space in terms of overall security and accountability.
Kate Kurbanova is a Sydney-based 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.