Lending Protocol Market Risk

Like all financial applications, DeFi lending protocols have market-related risks. Every lending protocol takes on non-zero risk to earn revenue and maintain an active marketplace. This risk is realized when the cost to liquidate defaulted or underwater positions outweighs the interest income earned.

Secured with Over-Collateralization

Protocols often require over-collateralized borrowing to align risk between borrowers and lenders. In permissionless decentralized networks with no form of identity, over-collateralization is needed to provide lenders a layer of protection.

To protect users and protocols from losses, a borrower’s collateral can be sold if a loan falls below the liquidation threshold. However, even for over-collateralized loans, there is always a risk that asset prices move too abruptly to remain fully solvent. To mitigate this, protocols have backstops to cover losses and use active management to control risk levels.

Risk Reward Trade-Offs

Reward or return comes at the expense of risk. Increasing expected returns by lowering collateral requirements can result in higher chances of realized loss. On the other hand, steps to reduce risk usually involve a compromise to expected returns.

When risk appetites turn more conservative, a reactive impulse may be to cap, disable, or delist all but the most liquid major assets as collateral. While prudent collateral standards are integral to risk management, limiting user options can restrict a protocol’s growth and addressable market.

Striking a balance between protocol objectives and risk appetite can be optimized through parameters and governance.

Managing Market Stress

A protocol’s risk exposure also depends on external conditions. In volatile and low-liquidity environments, the chance of loan insolvencies can increase, provided no action is taken. Many protocols take measures to reduce risk to maintain a consistent risk profile through market stress. These measures often include adjusting risk parameters to increase collateral requirements.

The risk is more acute in volatile market conditions, but risk reward trade-offs are still relevant. Reducing the likelihood of insolvencies to zero is appealing, but it is practically impossible without severely restricting protocol usability. In many cases, avoiding the long tail of small losses is very costly for earned income without offsetting insolvency risk reduction. A sustainable approach finds an optimal balance of reward and protocol growth with managed but non-zero insolvency risk. By finding an appropriate balance for their risk tolerance, protocols can ensure that market stress does not cause undue disruption for users.