The Evolving Risk Landscape in DeFi: What Should Projects Account for In Risk Management Strategies?

8 Jun 2024

The DeFi sector is experiencing renewed momentum, with venture capitalists pouring over $1 billion worth of investments into crypto projects in March 2024 alone. The bigger part of this money was funneled into DeFi-related initiatives, reflecting growing confidence in the sector.

Moreover, the total value locked in DeFi protocols has surged dramatically since the beginning of 2024, climbing from $54 billion all the way to $104 billion over the last 6 months.

However, this rapid growth leaves many wondering about the risks accumulating within the DeFi ecosystem. Are they being adequately addressed, or are they left to escalate unchecked? In order for the DeFi space to sustain its momentum and credibility, these concerns must be addressed.

In this article, I would like to give my own take on the nature of the existent risks and what DeFi protocols can do to mitigate them.

What are the key risks associated with the modern DeFi ecosystem? How have they transformed?

One of the first major complications that comes to mind is the shortage of professionals capable of effectively regulating risks within the DeFi ecosystem.

Today, the DeFi sector faces a challenge reminiscent of the 2008 banking crisis, where the sudden need for risk regulation outpaced the availability of skilled individuals. The DeFi protocols are indeed developing, and the value locked in them continues to grow, but the number of experts who possess proficiency in both risk management and DeFi is very low. The specific nature of DeFi risks further complicates the situation, demanding specialized knowledge that is currently scarce.

Another thing to point out in terms of risks is the ongoing belief among many market participants that DeFi-related risks, in their majority, have transitioned from technical to economic ones.

I can’t say that I agree with this stance. The reality is that technical risks remain significant. The expansion of the DeFi industry means that more funds are locked in protocols, and that, in turn, only creates more incentives for hackers to set sights on this market. The allure of substantial rewards makes DeFi protocols prime targets for cyber-attacks, emphasizing the ongoing importance of addressing technical risks.

In fact, data for Q1 2024 shows that over $300 million worth of funds were lost in hacker attacks.

So, while economic risks have undeniably emerged due to the sector’s rapid growth and the above-mentioned absence of experienced professionals, these do not diminish the persistent technical threats that DeFi faces.

Moreover, the rapid expansion of DeFi protocols introduces another layer of risk related to the readiness and adaptability of development teams. It is not rare for teams to struggle when it comes to recruiting individuals with the necessary skills to manage both the technical and economic aspects of their protocols.

The shortage of specialized staff means that some risks might be overlooked. For instance, a team focusing more on economic risks by hiring economists at the expense of technical security specialists may inadvertently elevate the potential for technical vulnerabilities.

The intertwined nature of these risks necessitates a comprehensive understanding and robust management strategies, which are currently hindered by the lack of adequately skilled professionals in the DeFi space. To sustain the growth and integrity of DeFi, it is imperative to develop a workforce equipped to handle both the technical and economic dimensions of risk management.

What Should DeFI Projects Prioritize in Their Risk Management Strategies?

The first essential thing is to undergo regular and comprehensive audits of smart contracts. This helps identify and eliminate technical vulnerabilities that could be exploited by malicious actors. By engaging reputable auditing firms to scrutinize their code, DeFi projects can ensure that their protocols operate as intended.

The next major step is hiring highly specialized professionals. DeFi companies need experts who understand the nuances of financial risks, which are particularly relevant in the decentralized finance space. Such specialists can provide valuable insights into how market fluctuations might impact DeFi protocols and can develop strategies to mitigate these risks.

For instance, understanding liquidity risk can help in maintaining adequate reserves to meet withdrawal demands, while expertise in interest rate risk is vital for lending platforms to manage and adjust rates appropriately to ensure sustainability and profitability.

Conducting internal analytics and continuously tracking risks specific to their products is also crucial, as different DeFi products face different types of risks. Lending products, as I mentioned above, are primarily concerned with interest rate risks, since fluctuating rates can affect both the cost of borrowing and the returns on lending.

Meanwhile, DeFi exchanges need to manage currency risk due to the volatility of cryptocurrencies traded on their platforms.

By identifying and monitoring these specific risks, DeFi companies can develop tailored strategies to manage them effectively. This involves building internal metrics, establishing acceptable risk appetites, and setting up policies that align with their risk management objectives.

When implemented comprehensively, these measures can help build a robust risk management framework that not only protects the company but also fosters a trustworthy environment for users and investors. And this, in turn, stands to support the overall growth and sustainability of the DeFi ecosystem.