Assessing Market Risk
Market Risk Assessment
A comprehensive market risk assessment for a DeFi protocol should include the following key elements:
Simulated Stress Tests: These tests evaluate the protocol under various market conditions to assess its resilience against market volatilities. The stress tests should consider extreme but plausible scenarios to understand the potential impacts on the protocol's solvency and liquidity.
Agent-Based Simulation: Utilizing agent-based models to simulate actions of various market participants, including borrowers, lenders, and liquidators. This helps in understanding the interactions within the protocol and the potential for systemic risks under stress conditions.
Historical Market Data Analysis: Analyzing historical market data to inform the simulation models. This includes studying past market conditions, such as periods of high volatility, and their impact on asset prices and liquidity. This analysis helps in calibrating the simulation models to reflect realistic market behaviors.
Risk Analysis Metrics: Developing and utilizing key metrics to quantify the risks faced by the protocol. These metrics could include the probability of insolvency under different scenarios, the effectiveness of the liquidation mechanism, and the potential for cascading liquidations.
Parameter Sensitivity Analysis: Examining how sensitive the protocol is to changes in key parameters, such as loan-to-value (LTV) ratios, liquidation thresholds, and liquidation bonuses. This analysis helps in identifying the parameters that have the most significant impact on the protocol's risk profile.
Safety/Insurance Module Efficacy: Assessing the effectiveness of the protocol's insurance/safety module (or similar mechanisms) in protecting against systemic risks. This includes evaluating the module's capacity to cover losses and prevent protocol insolvency in extreme market conditions.
Market Impact and Liquidity Risk: Analyzing the potential market impact of large liquidations and the liquidity risk associated with different assets. This involves modeling the slippage and market impact costs for both centralized and decentralized exchanges.
Recommendations for risk mitigation/risk mitigation strategies: Suggestions to improve parameters and safety based on findings.
EEA Market Risk Assessment Guidelines
Participation in standards-setting bodies
Protocol Reports SHOULD describe ongoing research efforts and collaborations with industry partners, for example in standards development organisations, focused on combating risks.
Investors with significant holdings
Protocol Reports SHOULD describe what is known of investors with a significant holding of tokens.
Known related parties
Protocol Reports SHOULD detail known related parties who transact between themselves, whose collective holding could qualify them as a key stakeholder.
Market depth and price discovery
Protocol Reports SHOULD describe market depth and price discovery mechanisms for the Protocol.
Roadmap
Protocol Reports SHOULD outline a roadmap.
Utility of the token
Protocol Reports SHOULD articulate the utility of the token beyond speculation.
Detect and prevent market manipulation
Protocol Reports SHOULD describe measures to detect and prevent market manipulation.
Competition
Protocol Reports SHOULD outline key similarities and differences to other well-known Protocols.
Ongoing Market Risk and Ecosystem Monitoring
Real-time or near-real-time DeFi ecosystem or market risk dashboards play a pivotal role in allowing investors, traders, and protocol developers to understand and mitigate potential financial losses by providing up-to-date information on various risk factors across the DeFi protocol landscape. These dashboards aggregate data to offer insights into liquidity, volatility, market sentiment, and more.
Risk dashboards and tools provided by companies such as Gauntlet, Block Analitica, IntoTheBlock, and others provide 24/7 visibility into market-level vulnerabilities to preempt incidents through data-driven risk intelligence - proving extremely valuable for mitigation.
Here's a breakdown of what these dashboards typically offer:
Value at Risk (VaR): The capital potentially at risk due to insolvencies when markets are under duress (i.e. liquidation cascade, stablecoin deviation from par). VaR captures insolvency risk for two high level categories: Broad Market Downturn, and Broken Correlation (for stablecoins and Liquid Staking Tokens). It is the expected insolvencies in a ‘worst-case’ crypto market downturn, based on historical data. (Gauntlet definition)
Liquidations at Risk(LaR): The capital potentially at risk due to liquidations when markets are under duress (i.e. liquidation cascade, stablecoin deviation from par). LaR captures liquidation risk for two high-level categories: Broad Market Downturn, and Broken Correlation (for stablecoins and Liquid Staking Tokens). It is the expected liquidations in a ‘worst-case’ crypto market downturn, based on historical data. We note that while liquidations can affect borrower UX, healthy liquidations are a critical part of a capitally efficient protocol. (Gauntlet definition)
Borrowing Power: A measure of capital efficiency, it is the total available borrows based on collateral supplied to the protocol, calculated as supplies multiplied by the collateral factors (liquidation threshold) of each asset. Updated daily. (Gauntlet definition)
Market Distribution Over Time: Supply by Market - The distribution of the supply of user funds deposited in the protocol as a time series, broken down by market and measured in USD - Borrow by Market - The amount borrowed by users in the protocol as a time series, broken down by market and measured in USD. (Gauntlet definition)
Debt Positions and Health: For protocols that involve borrowing and lending, monitoring the overall health and risk of debt positions across the ecosystem is critical.
Collateralization Ratios: Especially important for lending platforms, these ratios indicate the health of loans and the risk of liquidations.
Price Volatility: Dashboards monitor the volatility of DeFi assets, which is crucial for understanding market stability and potential price risks.
Smart Contract Risk Assessment: Given the reliance on smart contracts in DeFi, some dashboards analyze and rate the risk associated with smart contracts, including potential vulnerabilities or previous incidents.
Impermanent Loss Calculations: For liquidity providers, understanding the risk of impermanent loss in automated market makers (AMMs) is vital. Some dashboards provide tools or metrics for assessing this risk.
Protocol and Token Analytics: Comprehensive data on specific DeFi protocols and tokens, including transaction volumes, user activity, and more.
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