Risk management in DeFi

INTRODUCTION

A new financial industry like DEFI requires a lot of development behind it in order to establish itself as an alternative. It must meet certain requirements so that all types of users (regardless of their wealth, location or status) can benefit, be protected, and empowered. Technology must create safe spaces, as well as opportunities and prosperity. This has been the case since the Stone Age, and DEFI will be no exception.

At this point, I won't name the numerous benefits that blockchain technology brings, nor the barriers it is breaking in favor of those who truly need to escape the prison of their fiat currency and the censorship that is constantly applied to them. Solving a problem or alleviating a pain is not an easy task, as one is swimming against the tide and against powerful forces. But DEFI is slowly fulfilling that objective, as it is not the fight of one against the system, but of the more than 2,485 decentralized financial applications that exist across all networks.

"Enabling anyone from anywhere to access financial services on equal terms, without geographical limitations and without technological friction, is a need that we are working on at belobaba.io."

RISK AND MANAGEMENT

In this article, I want to focus on the risks that are continuously present in DEFI, whether it be due to volatility, lack of financial education, constant exposure to hacks, counterparty risk, or liquidity risk. In order to address all of these risks in a new financial market, effective risk management is more necessary than ever, especially when using a decentralized financial product. It is not a minor matter to provide your capital with security and maximum efficiency.

Risk management aims to identify and evaluate these risks to mitigate uncertainty in decision-making, better calibrating the risk to which the manager/user is exposed in relation to the reward obtained. Historical memory serves as a reminder of what happens when proper risk management policies are not applied (Washington Mutual Bank, Lehman Brothers, First Republic Bank, SVB, among others), therefore, it is now our responsibility to prevent these terrible episodes from occurring in the new market. Don't think that crypto, blockchain, and DEFI are different in this regard, the aftermath of Celsius, The Arrows Capital, or Block Fi is still present.

Although decentralized finance has allowed for greater control over finances and eliminated the need for intermediaries, risk remains a reality that users must take into account. The agents that are automatically overseeing our risk in DEFI (when we talk about basic financial products) are three: lenders (those who make a deposit in a token in exchange for receiving an annual yield (APR) based on the supply and demand of that token's protocol), borrowers (those who borrow from the protocol in exchange for paying low interest rates, but with the condition of locking up another asset as collateral for their loan, which can be liquidated if their Loan to Value (LTV) exceeds the blocked value), and liquidators (those who ensure the health of the protocol by automatically and instantly settling debts when they detect that loans may be uncollectible through the liquidation threshold).

MANAGING RISK IN DEFI INVOLES SEVERAL STRATEGIES

1) One approach is to invest in DeFi indices, which represent a basket of tokens that reflect the performance of the DeFi market. By investing in these indices, rather than individual assets or protocols, investors can improve risk by being exposed to a global market rather than a single asset or protocol. An example of a DeFi index is the Index Cooperative (INDEX).

2) Evaluating the security of a protocol is another key aspect of risk management. Factors to consider include liquidity, the development team's experience, the protocol's reputation, regular security audits, and the implementation of guarantee systems to mitigate the risk of default.

3) Using cold wallets or hardware wallets to store tokens, maintaining secure passwords, limiting what you sign in an SC, or revoking permissions monthly are healthy habits to apply.?

4) Another tool for evaluating risk is DeFi Score Which provides information on the security of the code, liquidity, and governance of DeFi protocols.

5) Finally, hedging strategies through options and futures can help mitigate the risk of investing in DeFi. In most cases, investors take a long position on the asset they put to work to generate passive returns, regardless of whether or not it is managed actively. Options and futures enable investors to hedge their positions in case of a price drop. One example of a platform that offers options and futures in DeFi is Hegic.

IN CONCLUSION

Incentive-based models can help manage risk in DEFI by motivating users to take measures that reduce investment risk. Certain DEFI protocols offer incentives for users to deposit and maintain assets on the platform, which benefits both the platform and the users. By incentivizing governance participation, DEFI platforms can improve transparency and security. Incentive models can also be used to encourage research and development of better security and risk management practices in DEFI by offering rewards to researchers who discover vulnerabilities or propose solutions to improve platform security through bounty programs.

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