In the process of evaluating risks, technological vulnerabilities frequently take precedence in DeFi. Though equally crucial, economic risk is frequently disregarded.
Probably one of the most important components of traditional finance is risk assessment. One major benefit for users is the ability to evaluate the risks associated with a financial activity or investment before taking further action. It enables individuals to make more informed decisions by helping them comprehend the advantages and disadvantages they must contend with. In essence, risk ratings assist users in determining how well an asset class or technology fits their goals.
If DeFi is to become mainstream in the future, such ratings will be demanded by investors. The sector should prepare for such risk assessment measures and implement it voluntarily to attract more retail users to DeFi.
Challenges in risk assessment of DeFi Products
It is not an easy task to create economic risk assessments in the DeFi space, particularly since it entails evaluating and quantifying individual hazards related to a given protocol or project. Setting precedents becomes challenging because DeFi is a very young and fast-growing sector, and there are no commonly agreed standards for producing these ratings.
Though the sector desperately needs risk rating, it is not a typical occurrence in DeFi, unlike in traditional finance. Users are already rather concerned about the volatility of the cryptocurrency market and the risks that come with it. However, there are currently no well-defined risk-defining criteria that could help an average user make an honest assessment of the risk profile of any DeFi investment instrument.
Prominent DeFi lending and borrowing systems such as AAVE, Compound, and DyDx have long been the target of complaints from seasoned users who worry about the operational risks that come with the package. Concerns have been expressed, for example, about the degree of decentralization, potential manipulative components that could affect investment values, and the security of the underlying smart contracts.
A DeFi Score Methodology was first presented by ConsenSys in 2019 to assist consumers in comprehending the financial and technological risks that affect DeFi marketplaces. The intention was to establish a transparent risk rating system; nevertheless, the execution proved to be challenging. The concept, however, ultimately failed since there were too many signs for various protocols, making this method irrelevant and uncomparable.
Ratings of economic risk are necessary so that users can choose wisely where to invest or take part in DeFi activities. DeFi protocols can improve their accountability to their users and transparency by offering risk ratings.
To borrow other assets at a reasonable price, large whales can either inflate or deflate the price of an asset. This leads to unpaid debts and a liquidity problem in the protocol. Such types of rug pull events are difficult to predict.
Due to the limited liquidity and absence of regulations in this industry, powerful users can easily control the DeFi markets. Sometimes, issues with protocol liquidity could arise in the DeFi loan and borrowing procedures because to potential liquidity crises, transient losses, and ease of trading on secondary markets.
Clear Separation between Technical Snags and Risk Assessment
Technical hazards have a significant influence on DeFi, and to develop a thorough economic risk rating system, it must also take these risks into account. For example, smart contract vulnerabilities or defects might result in significant financial losses for users. Even though this is a technical risk, it should be taken into account when creating an economic risk rating system to guarantee accurate depiction.
Way Forward
Economic risk ratings can provide DeFi users and protocols with valuable insights into a systematic and uniform approach to identifying, assessing, and mitigating various potential risks linked to various projects. In the end, putting such policies into place will be a significant step towards stabilizing the cryptocurrency market in terms of general security and accountability.
Disclaimer: This article was created for informational purposes only and should not be taken as investment advice. An asset’s past performance does not predict its future returns. Before making an investment, please conduct your own research, as digital assets like cryptocurrencies are highly risky and volatile financial instruments.
