Risk in DeFi (Part 2/3): Evaluating the financial risk of decentralized financial (DeFi) products
Great rewards are rarely gained without great risks.
Unfortunately, many fans and users of decentralized financial (DeFi) products underestimate the risk that comes with the impressive interest rates offered by automated lending protocols.
Part 1 of our series focused on ways attackers might manipulate users into compromising their security.
The second installment of our “Risk in DeFi” series will examine financial risk.
Financial risk involves comparing the potential risk and reward associated with various investment opportunities with the goal of constructing a successful portfolio in accordance with a person or organization’s tolerance for risk.
Read on to learn more about how the traditional world of finance thinks about risk and how to apply those insights when looking into DeFi solutions.
Before we explore financial risk, here’s a quick refresher on the other forms of risk to consider.
Forms of Risk in DeFi
When working with DeFi solutions, it’s also important to consider the technical and procedural risks involved.
Technical risk means evaluating potential vulnerabilities in the hardware and software behind a product or service. With decentralized applications (dApps), it’s important to consider
Procedural risk can be considered similar to technical risk but instead of looking at the product or service, procedural risk examines the ways in which users might be manipulated into using the product in unintended ways that could compromise their security.
Financial risk can be defined as the potential for something to lose money.
As mentioned earlier, financial risk is about assessing the potential risks and rewards of an investment relative to other available investment opportunities.
Finance explores issues like risk in three different contexts: personal, corporate, and public.
Personal finance studies how individuals and families make and manage their money.
Corporate finance examines how businesses make and manage money.
Public finance looks at how governments raise and distribute funds.
DeFi solutions may be applied in any of these contexts but for our purposes, we’re going to focus on DeFi in the context of personal finance as that’s the subdomain in which it’s made the most progress so far.
So, how do professional traders and investors think about risk?
Technical and fundamental analysis are two of the tools we commonly hear about.
Technical analysis involves using mathematical indicators to create charts exposing patterns used to identify investment opportunities.
Fundamental analysis refers to the process of examining an investment’s value proposition and different metrics and ratios used to assess the financial health of the proposition, typically in the context of determining the value of a business.
In addition to the protocols defined by various technical and fundamental investment strategies, investors have a variety of indicators they use as a baseline for comparing different investment opportunities.
The risk-free rate of return typically refers to the long-term yield on U.S. Treasury bonds, the interest on which is viewed as a “risk-free” investment. Investors subtract the “risk-free rate” from the potential return they think they can realize on an investment as a baseline for comparing the returns on the investment with the return from a “risk-free” investment.
Investment Opportunities: CeFi vs DeFi
Now that we’ve talked about how “centralized finance” (CeFi) thinks about risk, let’s talk about the investment opportunities available in DeFi.
Stablecoins and DeFi lending protocols are the main investment opportunities recognized in DeFi. Prediction markets and limited forms of derivatives are also available but DeFi lending protocols tend to be the product that leads individuals to explore DeFi as an investment opportunity.
While stablecoins are typically used by digital exchanges and traders as a way to have a digital currency denominated in fiat that can be used to make trades, lending protocols allow users to deposit cryptocurrency as collateral and receive interest and pay interest to borrow digital assets.
Automated lending protocols have received a lot of attention in the blockchain space recently for offering impressive interest rates, as high as ~15%.
Those who invest in the stock market typically look to the S&P 500 as a benchmark for the performance of their portfolios because people accept it as a good representation of the performance of the overall stock market.
The return on the S&P 500 roughly falls between 7% and 10%, on average but using lending protocols is more like investing in bonds or other products in the money market.
Financial instruments in the money market consist of short-term investments in debt, which include things like bonds on corporate or government debt that typically offer higher interest than a savings account but lower returns than the stock market.
High-interest savings accounts usually max out around 2%, which is also generally considered the benchmark for annual inflation on U.S. dollars. In other words, investors generally assume the dollar will be worth 2% less at the end of a year than at the start.
An investment can grow in terms of the amount of money being accrued but if that growth is less than the rate of inflation, the investment is considered to be losing value or purchasing power.
Ready to DeFi?
You’re almost there!
While it’s exciting to see a novel use case for distributed ledger technology gain traction, it’s important to remember that great rewards rarely come without great risks.
In addition to comparing the potential rewards associated with DeFi investment opportunities with those in CeFi, it’s critical to consider whether or not you’re up to the task of evaluating and responding to the procedural and technical risks associated with DeFi solutions.
We’ve got one more article on how to consider the technical risks associated with DeFi investment opportunities.
If you’re interested in shaping the user experience of our privacy-enabled Lend & Earn product, please sign-up on our website at https://plutusdefi.com/. 😀