Defining Market Risk

Market risk for a DeFi protocol refers to the risks arising from volatility in digital/crypto asset prices and liquidity that could threaten the solvency and proper functioning of the protocol.

Primary Sources of Market Risk

The following sources of market risk for DeFi protocols should be considered:

Price shocks that lead to undercollateralization when collateral asset prices drop significantly, causing the value of liabilities (outstanding loans) to exceed the value of assets (collateral deposited).

Example:

A user deposits 10 ETH as collateral to take out a $5,000 USDC loan when ETH is $500. If ETH price crashes 50% to $250, the collateral value drops to $2,500 while the loan value remains at $5,000. This leads to undercollateralization.

A sudden crash of the ETH price, where its value drops by over 50% in 24 hours, could lead to massive liquidations and potential insolvency risks for DeFi protocols relying on ETH as collateral.

Liquidity Loss: in external markets, which disincentivizes liquidators from liquidating defaulted collateral. Liquidators are needed to clear bad debt from the protocol's books.

Example:

If ETH volatility spikes, liquidators may avoid liquidating ETH collateral due to high slippage/fees exceeding their liquidation bonus. This leaves bad debt on the protocol's books. 

Another example: A sudden spike in the price of the DAI stablecoin due to a liquidity crunch, could make it difficult for borrowers to repay loans, leading to potential losses for protocols offering DAI-based services.

Liquidation cascades: where liquidations and selling of collateral impact market prices, triggering further liquidations. This creates a deflationary spiral.

Example:

A liquidator tries to sell 1,000 ETH to liquidate a loan, but this sudden selling pressure crashes the ETH price further. This triggers more ETH loans to fall under collateralized, forcing more ETH sell-offs and price crashes.

A DeFi protocol could experience a cascading liquidation event, where the sudden liquidation of one large position led to a market panic, triggering further liquidations and a rapid decrease in the protocol's total locked value.

Insolvency: Extreme market events causing multiple collateral types to fail to be liquidated, potentially leading to the insolvency of the protocol's safety module designed to cover such shortfalls.

Example:

ETH and LINK prices crash together due to high correlation. Liquidators fail to liquidate all defaulted collateral due to extreme volatility. This causes large shortfalls across assets that drain Aave's insurance fund, risking insolvency.


A DeFi protocol could be attacked through a series of loans and trades that exploit its pricing mechanism, leading to a loss of funds that could result in the insolvency of any safety module designed to protect against such losses.

For some protocol such as Aave, insolvency risk for the insurance fund (safety module) due to extreme events where multiple collateral assets fail to be liquidated, leading to large shortfalls that drain the safety module.

In summary, market risk refers to vulnerabilities in the collateral and liquidation mechanisms of a DeFi protocol with respect to volatility and liquidity in digital/crypto asset markets. Robust stress testing is needed to ensure market risk is being properly managed.

Liquidity Risk

Liquidity risk refers to the potential difficulty of converting an asset into cash or another desired asset without affecting its market price significantly. This means the risk of capital being locked into investments that cannot be exited easily in DeFi protocols. It arises when protocols or markets do not have enough liquidity for users to withdraw or exit positions without substantial price impact and slippage costs.

This risk is a crucial concern for both investors and protocols within the DeFi ecosystem due to its decentralized and often volatile nature. Liquidity risk in DeFi can manifest in several ways and has unique characteristics compared to traditional finance, stemming from the technology, market structures, and types of assets involved.

Market Manipulation

The above sources of market risk are defined in relation to market price movements, liquidity conditions, and protocol-specific mechanisms like liquidations and safety modules designed to protect against insolvency. In addition, the below should be considered:

Manipulative Practices: Manipulative practices that artificially distort true supply and demand pose a real threat to price discovery and proper functioning of DeFi markets. They can trigger inaccurate liquidations or insolvencies. DeFi markets can be more vulnerable to manipulation like wash trading, spoofing, and pump-and-dumps due to:

1. Pseudonymous participation: It is harder to track and identify malicious actors.

2. Lack of regulation and enforcement: There are few protections in DeFi against blatant market manipulation that exists in traditional finance (TradFi).

3. Market opacity: It can be difficult to discern whether significant trading volume or price movements in DeFi are organic or the result of manipulation schemes.

4. Immature market infrastructure: Practices like circuit breakers, position limits, and inter-exchange surveillance that help prevent or limit manipulation in TradFi may not exist in DeFi.

Manipulative practices could potentially exacerbate these identified risks by affecting market prices and liquidity conditions, but the document does not directly address these practices as separate categories of market risk. It is possible that such manipulative practices are considered part of the broader market dynamics that can lead to the risks described, but without explicit mention, it cannot be confirmed that the document treats them as distinct sources of market risk.

Given the nature of DeFi and its reliance on blockchain technology, the concerns about manipulative practices are valid. In traditional finance (TradFi), there are regulatory frameworks and institutions designed to detect, prevent, and penalize such behavior. The decentralized and pseudonymous nature of DeFi complicates these efforts, potentially making DeFi protocols more vulnerable to manipulation. However, addressing these concerns would require a combination of technological solutions, community governance, and possibly new forms of decentralized regulation.

Contagion

Contagion risk refers to the threat of cascading failures spreading across interconnected DeFi protocols, triggering a systemic crisis.

DeFi lending platforms and other protocols with composability amplify contagion risks as many leverage shared liquidity sources. If one protocol gets exploited or drained of capital due to a hack or crash, shorter liquidity can compromise other protocols relying on the affected platform - creating a ripple effect.

Given the complexity of measuring counterparty exposures in an algorithmic, decentralized setting, quantifying contagion risk remains challenging. However, developing appropriate stress-testing models to simulate crisis contagion scenarios can assist DeFi protocols in insulating themselves against potential future domino effects in times of turbulence.

Building out more redundancy across independent liquidity pools could make the space more resilient and robust.