Economic Risk Management - The Path Towards Permissionless DeFi Lending

Introduction

Though smart contracts security has become the main focus of any DeFi-related protocols, the passing year has proven that billions of dollars can still be wiped out without any smart contract hacks when it comes to DeFi lending activity.

The crash of Luna/UST, and the depegging of several other stablecoins, as well as “highly profitable trading strategies” on Mango markets and others, have shown that DeFi lending requires, on top of the smart contract security, a tighter economic risk management in order to mitigate this kind of vulnerabilities.

However, managing economic risks in DeFi is manual, complex and currently is usually done with low transparency. The lack of tools for developers to build more risk-aware dapps is yet another barrier to be crossed, which for now results in high-touch governance engagement requirements.

In this article, we will discuss how B.Protocol’s Risk Oracle is revolutionizing economic risk management for DeFi lending and how it can be used to pave the road for less DAO-active risk management, and eventually lead the way toward permissionless lending.

The Challenges of Economic Risk Management in DeFi

Economic risk management in DeFi is complex, requires trust in the risk managers, and involves a lot of manual parameter updates with DAO votes. Setting the right risk parameters, such as Collateral Factors (aka Loan To Value, Liquidation Thresholds, or Collateral Ratios), lending and borrowing caps, interest rate curves, and other parameters of a lending platform can make the difference between a safe yet competitive market and a rekt one.

Lenders and borrowers need to trust the capabilities of the team or the DAO to manage these economic risks with the right balance. As these tasks are complex, it takes time for platforms to gain the trust of users that they can actually achieve the right balance and manage it according to the changing dynamics of the markets.

Moreover, even the most trusted lending platforms in DeFi today, who use in-house teams as well as 3rd party services for risk management, rely on off-chain reports and dashboards for their risk assessment processes which requires a lot of governance work from DAOs. This norm creates a higher barrier of entry for new platforms as younger communities usually find it harder to manage their governance processes effectively and in a timely manner.

The leading DeFi lending platforms by TVL, Aave and Compound, had dozens (!!!) of governance votes related to risk parameters of new and listed assets during 2022. Some of them take weeks if not months to discuss and pass a vote.

Although the “ethos of DeFi” calls for full transparency, most of the available risk frameworks that are used in DeFi lending are not open-sourced. This lack of transparency makes it impossible to verify the recommended results by the platform and its dev team or DAO, which need to trust whatever calculations were made behind closed doors and private repos.

B.Protocol’s Risk Oracle

B.Protocol’s Risk Oracle provides on-chain risk feeds for DeFi platforms. Its first release provides basic risk-related data, such as an asset’s current and historic DEX liquidity and an asset’s volatility, which are published on the blockchain. Developers can embed these risk parameters directly into their smart contracts to assess in an automated and ongoing manner the risks involved with a specific asset, and the markets and pools where it is listed.

Risk Oracle is using the risk framework that was developed by RiskDAO, a sub-DAO that was launched by B.Protocol and other researchers and devs as a service DAO focused on risk assessment and risk management. The unique approach of RiskDAO, besides its mathematical model, was its full transparency — RiskDAO’s framework is open source since launch, enabling anyone to verify the recommendations that are published on customers’ dashboards. Lending platforms such as Gearbox, Vesta Finance, and others have been using the services of RiskDAO to get better insights into their platform’s risk exposure while forging users’ trust in the platform.

Use Cases for B.Protocol’s Risk Oracle

Lending markets are the third biggest category of applications in DeFi TVL (as recently liquid staking has crossed its TVL), and one that requires the most rigorous economic risk management. As such it is one of the key DeFi applications that can benefit from the Risk Oracle. By relying on on-chain feeds of liquidity and volatility of assets, lending markets can adjust their risk parameters, such as collateral factors and borrowing caps, with minimum need for intervention of governance processes.

A lending market DAO can pre-approve the risk parameters according to its risk appetite, and set or update the CF and caps automatically according to the changes in market conditions as they are reflected in the feeds of the Risk Oracle. Another way to reduce the governance work required for updating the risk parameters is by using the Risk Oracle for “sanity checks” of internal or external risk team recommendations. The recommendations can be executed automatically after a short time lock if they do not deviate significantly from the Risk Oracle feeds.

The Risk Oracle can also help lending markets set a barrier for listing new assets based on their risk score, reducing the risk of introducing new assets that may not be a good fit for the lending market’s desired risk exposure or setting transparent “risk trenches” for users.

You can read the way VMEX Finance are planning to use Risk Oracle in their upcoming lending markets, or listen to the talk about this integration here.

Conclusion

Economic risk management is crucial for the long-term sustainability of DeFi lending platforms. However, managing economic risks in DeFi is complex and expensive, and there is a lack of tools for developers to properly manage economic risk. B.Protocol’s Risk Oracle provides on-chain risk feeds for DeFi platforms, reducing complexity, improving transparency, and saving time and money for lending platforms, allowing users to make more informed decisions about their funds. In an upcoming series of posts, we will dive into the different aspects of risk management in DeFi lending which the Risk Oracle can improve and solve.