Announcing The Risk Level Index
A new feature in the bad-debt dashboard lets users compare economic risk levels of lending markets based on on-chain quantitative data
Intro
Today we are happy to announce the Risk Level Index — an index tracking changes in economic risk exposure of lending markets.
The new index enables the comparison between lending markets’ risk levels over time, letting users make more educated and data-driven decisions regarding their lending activity in DeFi. The new index is based on the SmartLTV formula — a smart contract formula that automatically calculates LTV ratios based on risk-related data feeds.
The index is a new feature of RiskDAO’s Bad Debt Dashboard, and the first markets to be included in it are the Compound v3 markets for USDC and ETH on Ethereum.
In this paper, we will elaborate on how the index is calculated and how users and lending platforms alike can use it to compare and manage the economic risk exposure of different DeFi lending markets.
A new economic risk standard
The new Risk Level Index creates a new standard for DeFi economic risk assessment based on its characteristics and purpose:
- Benchmark for Risk Exposure: The Risk Level Index serves as a benchmark for assessing and quantifying risk exposure within lending markets. It provides a standardized measure to gauge the level of risk associated with these markets.
- Diverse Risk Metrics: The index aggregates and analyzes various risk-related metrics and data, such as DEX liquidity, an asset’s price volatility, and other platform-determined factors. These metrics are combined into a single numerical value, the index, which represents the overall risk level of a market.
- Comparison Tool: Users, analysts, fund managers, developers, and DAOs can utilize the economic Risk Level Index as a comparison tool. It allows them to assess and compare the risk levels of different lending markets, much like how traditional financial indices compare the performance of various stocks or asset classes.
- Historical Tracking: The index can provide historical data, enabling users to track changes in risk exposure over time. This historical perspective helps stakeholders make informed decisions and monitor “industry standard” risk levels.
- Standardized Measurement: By encapsulating complex risk-related data into a single numeric value, the Risk Level Index offers a standardized measurement of risk exposure, making it easier to understand and work with for a wide range of users.
In essence, the Risk Level Index encapsulates the economic risk exposure of DeFi lending markets into a single numeric value, facilitating risk assessment, comparisons, and historical risk analysis that wasn’t available for DeFi lending participants previously.
SmartLTV Formula recap
Loan-To-Value (LTV) is a pivotal concept in maintaining the equilibrium between risk and accessibility. It’s a measure that ensures that lending platforms can provide loans securely without taking undue risk, that might result in the accumulation of bad debt.
SmartLTV is a smart contract formula, that offers a simplified yet robust method for LTV ratio calculations based on quantitative data, minimizing the human factor in the process.
The formula takes into account the following market parameters:
- σ is the price volatility between the collateral and debt asset (normalized to the base asset price).
- β is the liquidation bonus.
- ℓ is the available dex liquidity with a slippage of β.
- d is the debt cap of the borrowable asset.*
- c is a confidence level factor. The higher c is, the odds for insolvency are decreasing.
You can read the full research paper on the formula here.
*Debt Cap can refer to either the Borrowing Cap where such a parameter exists in the lending protocol, or to the Supply Cap multiplied by the LTV ratio of the asset.
The Risk Level Index
The SmartLTV formula includes a confidence level factor (c) which is a single constant parameter that aims to represent all the implicit and explicit assumptions made within any risk assessment framework through a single numeric value.
The Risk Level Index (r) is calculated as 1/c to represent the increased risk exposure of a market as the confidence level factor of a market decreases.
The Risk Level Index tracks changes in r which represents the market risk exposure levels as the LTV remains constant while market conditions fluctuate. Having a risk index is important to any financial market but for DeFi lending this is even more crucial due to their dynamic nature.
Though crypto market conditions change rapidly, the LTV ratios set by lending platforms are not adjusted as frequently. This gap opens up a risk vertical that most users are not aware of. Even the more sophisticated DeFi actors who are aware of the risk would find it hard to calculate and track due to the complexity and lack of transparency in the methods used to set the LTV on most platforms.
Once the LTV is set, changes in other parameters of the function will result in a change in r values. Tracking the historical values of r enables mapping the risk levels users are exposed to, comparing different markets’ risks, and even adjusting risk parameters more dynamically.
The Risk Level Index UI
On the bad debt dashboard users can find a new column for the risk index, which shows a weighted average of all markets within the platform. Clicking on the r value will open a new page tracking historical values of r on that platform.
The first graph shows the weighted average of r across all markets over time, which helps getting a general perception of the risk level for the platform.
For each market, users can choose the time frame for the computing of DEX liquidity (ℓ) and Volatility (σ) to be used in the index formula. 7, 30, and 180-day spans are available from the drop-down menu. A table summarizing the average risk level of each market across the last 7, 30, and 180 days is shown next to the graph tracking the historical values of the index, making it easier to compare the different markets on average performance. The first markets tracked by the index are Ethereum Compound v3 markets which include a USDC (for COMP, WBTC, WETH, UNI, and LINK collaterals) and a WETH market (for wstETH and cbETH).
A few illustrative examples of how shifts in market conditions would influence the Risk Level Index:
- A decrease in DEX liquidity for an asset (ℓ) corresponds to a higher r value, indicating higher risk within the same LTV ratio.
- Enforcing a lower debt cap (d) for a market by a lending platform, while maintaining other parameters equivalent, will result in a lower r, signifying a lower risk exposure.
- In situations where two different markets maintain the same LTV ratio for assets with different price volatility (σ), dissimilar r levels emerge. The asset with greater volatility will receive a higher index value, indicating a higher risk level for that market.
Risk Level Index in numbers
Example #1
Looking at Compound v3 (Ethereum) USDC market graph, a jump in the chart can be observed between July 31st and Aug 1st -
What happened: On July 31, Compound Governance Proposal 169 was executed, raising the supply caps of all assets but COMP in the Ethereum Compound v3 USDC market. The collateral factors (LTV) didn’t change, exposing these markets to higher risk, as indicated by higher r values.
Note that WBTC caps were raised by 50% (from 12k to 18k), resulting in ~24% increase in r values (from 2.07 to 2.57). Still the spike in the WBTC chart is relatively low due to an initial low r value.
As a reference, WETH caps were raised in ~42% (from 350k to 500k), resulting “only” in ~20% spike in r values (from 11.35 to 13.71), but the spike on the chart is more visible due to the higher net numbers.
Example #2
On the WETH market, a drop is observed between Aug. 22nd and Aug. 23rd on both wstETH and cbETH -
What happened: On August 22 Compound Governance Proposal 176 was executed, cutting the liquidation bonus (β) in half for both assets, taking it from 5% to 2.5%, resulting in lower risk levels.
Conclusion
The Risk Level Index encapsulates the economic risk exposure of DeFi lending markets into a single numeric value, facilitating risk assessment, comparisons, and historical risk analysis that wasn’t available for DeFi lending participants previously. The index sets a new standard for economic risk management in DeFi which can be used by anyone.
We encourage the community to share feedback on this new index. Devs are welcome to commit new PRs to add more markets to the index here.
About RiskDAO
RiskDAO was initiated by B.Protocol as a service DAO focused on providing an open-source risk assessment framework, associated audits, and dashboards to stress test, monitor, and manage risk in DeFi lending and borrowing protocols as well as L1 and L2 networks.
