A series of articles: Part 1/4
To all our fellow crypto adventurers! We’re excited to bring you this wicked article series, diving deep into the wild and untamed world of DeFi risks. As true DeFi enthusiasts ourselves, we’ve got your back and want to make sure you’re equipped to handle whatever curveballs this crazy space throws your way.
Our mission?
To help you embrace the DeFi spirit while keeping it real and safe.
We’ll break down those sneaky risks, shine a light on the potential challenges, and empower you with the knowledge to navigate this rollercoaster ride. Know that we’re here to support your endeavors and keep the good vibes flowing in the DeFi universe.
How?
In order to do so, we are employing a structured approach leveraging the MECE framework (Mutually Exclusive, Collectively Exhaustive) to represent the risks with some live examples, along with an ECR framework (Exposure, Controls, Resilience).
- Why and what is MECE?
A MECE framework is used to categorize concepts in a way that ensures clarity and completeness:
Mutually Exclusive: Categories or groups being defined should not have any overlap in their elements. Each element or item should belong to only one category and not fit into multiple categories simultaneously.
Collectively Exhaustive: The defined categories or groups should cover all possible options or elements in a given context. Every element or item should be accounted for and fit into at least one of the defined categories without any gaps.
- Why and what is ECR?
The ECR framework is a risk management framework that provides an approach to managing risk in the below structure:
Exposure refers to identifying and understanding the potential risks that the organization is exposed to.
Controls involve implementing measures to mitigate these risks that the organization is exposed to.
Resilience focuses on the organization’s ability to withstand and recover from those risks in case of any event or breach.
This article series will be covered in 4 parts, each one going over the below 4 major risks:
1- Financial Risks
2- Security Risks
3- Operational Risks
4-Regulatory Risk
So without further ado this we’ll dive headfirst into the Financial Risks that come with the DeFi territory. In the next articles, we will be going over the other three major categories of risks, and breaking them down as below.
I. Financial Risk
A. Market Risk
- Price Volatility
- Example: Fluctuations in the value of BTC due to market speculation and macroeconomic factors, changes in investor sentiment or network developments.
2. Depeg Risks
- Example: Risks associated with stablecoins like USDC and USDT maintaining their peg to the US dollar during market stress
3. Liquidity Risks & Impermanent Loss
- Example 1: Liquidity pool impermanent loss in Uniswap due to significant price divergence between the assets in the pool, resulting in reduced overall value for liquidity providers
- Example 2: Liquidity drying up in a specific liquidity pool on Curve due to users withdrawing their funds, resulting in increased slippage and difficulty in executing trades
4. Flash Crash Risks
- Example: Market manipulation causing a flash crash in a specific token, such as a “pump and dump” scheme coordinated by a group of traders
5. Slippage Risks
- Example 1: High slippage when executing a large market buy order of a low liquidity token on Uniswap, resulting in a significantly higher average execution price than expected
- Example 2: Slippage in a large sell order of a stablecoin like USDT on a centralized exchange, leading to a lower-than-anticipated realized value due to order book dynamics
6. Market Manipulation Risks
- Example: Insider trading by employees of a crypto exchange, where they utilize non-public information to trade in advance of the market, gaining unfair advantages
B. Asset Risks
1. Underperformance of Assets
- Example: Decreased value of a specific token held in a wallet due to lack of adoption or market competition
2. Concentration Risks
- Example: Compound Protocol being heavily reliant on a few major assets like ETH and WBTC, exposing it to concentration risks if the value of those assets significantly declines or faces liquidity issues
3. Counterparty Default Risks
- Example:Default by a borrower in the decentralized lending market, such as failure to repay a loan on Compound, resulting in potential loss of funds for lenders
4. Collateral Risks
- Example: Insufficient collateralization in a decentralized lending protocol like Compound, where the value of the collateral drops below the required threshold, leading to potential liquidation and loss of funds
C. Principle Loss
1. Loss of Initial Investment
- Example: Investment in a high-risk token or ICO that fails, resulting in the complete loss of the invested capital
2. Scam Risks
- Example: Participation in a fraudulent investment scheme promising unrealistic returns or benefits in the crypto space, resulting in the loss of invested funds
3. Regulatory Seizure Risks
- Example: Regulatory crackdown on an unregistered token offering or project, resulting in the freezing or seizure of funds and potential legal consequences for participants
The actual risks faced in the crypto and DeFi space can vary and evolve over time.
Please note that the examples provided are for illustrative purposes and may not represent specific instances or occurrences.
To wrap it up, my fellow DeFi enthusiasts, we’ve explored the financial risks in this article. By understanding the potential challenges, you’re better equipped to make informed decisions and protect your investments. But hold onto your hats, because in the next installment, we’re diving into the realm of security risks. So buckle up, stay curious, and let’s continue this journey into the world of risks in DeFi !
