What is Ecosystem Risk?
Gauntlet Blog Post
With the fast-moving nature of crypto, all DeFi protocols take on a certain level of risk to get off the ground quickly and provide a functional service to their users. This risk can appear in a variety of ways, such as:
Lack of liquidity (Solend)
Fluctuations in market prices (USDC during SVB crisis)
Liquidation cascades (Black Thursday)
High borrow utilization preventing healthy liquidations (USDT utilization spikes)
Risk management can also break down due to adversarial actions by users, like price manipulation exploits (Mango, Moola) that intentionally create insolvencies. All of these scenarios can result in significant losses to a protocol and its users, and in extreme cases wipe out a protocol entirely.
On the other hand, if a protocol’s safety features are too limiting, it may lose market share to other protocols that offer a more flexible product. Since protocols compete in a variety of areas, risk management should be aware of how different parameters affect efficiency. For example:
Interest rates (see: Gauntlet’s methodology)
Borrow and supply caps (see: Gauntlet’s methodology)
Collateral ratios (see: Aave Impact Study)
Naively, many view high-risk protocols as the optimal option for achieving high returns — but as an investor, it’s critical to understand what these risks entail, how they may affect your returns, and what you can do to mitigate them.
Protocol Market Risk
Poor risk management in a protocol can lead to a suboptimal balance of risk versus return — a healthy amount can be advantageous, but too much will leave assets exposed. Taking an aggressive approach to risk will leave a protocol unprotected and vulnerable to manipulations, insolvencies, and price drops — all harmful to users and long-term success. With a conservative approach to risk, a protocol may not be competitive in the market and can delay growth.
The bottom line, inadequate risk management can lead to a suboptimal balance of risk and return long-term.
Market Risks for L2s
Just like a protocol, Layer 2 (L2) blockchain extensions are also vulnerable to risks of similar dynamics — excessive risk on an L2 can lead to a contagion of threats that can significantly impair users. L2s compete with similar chains to attract and attain users by providing efficient transactions and resourcefulness, which is often achieved by taking on varying levels of risk.
While they are built off of the Ethereum blockchain and obtain a certain level of security, many projects created are novel and exploratory in the space and therefore should be addressed with a healthy skepticism.
Again, substandard risk management practices can lead to an unhealthy balance of risk and return.
Solutions
Managing risk at the ecosystem layer is more complicated due to the wide range of stakeholders and the exponential risk involved, but just as important as the protocol layer. L2 communities should have visibility into critical risk metrics and engage with protocols and developers in response to emerging risks and opportunities to stay ahead of the game.
Sophisticated quantitative analysis can be a major benefit for communities seeking long-term growth and resilience, through the identification and reduction of risk and threats. Gauntlet provides an expertise that hasn’t been seen in blockchain technology — delivering insight to protocols across all of DeFi, to enable smart decision-making and safe investing.
Our team creates value for clients by helping them to monitor, understand, and optimize economic risks — producing quantitative analysis and DeFi knowledge to address market-risk management, incentive optimization, and asset allocation needs.
