This article aims to provide an overview of risk in decentralized finance (DeFi). If you are unfamiliar with DeFi, do read our introductory article on DeFi and cryptocurrency before reading this article.
Risks in DeFi
Every investment process necessitates proper risk management. The nascence of DeFi makes investing in this space much riskier than in traditional finance (TradFi), as we were reminded of in the unprecedented Terra debacle when many investors lost a sizeable portion of their portfolios within 48 hours. Therefore, while looking for lucrative opportunities in the DeFi world, investors need to know how to detect and manage risk to maximize returns and protect their assets against costly losses.
What Is Risk?
At its core, risk measures the probability of an unfavorable outcome occurring. It is a quantifiable estimation usually expressed in terms of standard deviation. Risk presents itself in various aspects of everyday life as a form of potential loss.
In investing, risk refers to the probability of an investment outcome diverging from its expected, favorable result. This divergence usually results in financial loss.
Risk appetite refers to the level of risk that an investor is willing to undertake in their investments. It differs between individuals, depending on several factors such as age, income level, income stability, and the number of dependents. For example, a retired individual with one dependent may undertake less risk to protect their retirement funds. On the other hand, a younger individual with a stable income and no dependents may choose to adopt a higher-risk investment approach.
Click here to discover your risk appetite!
Example of a Risk Appetite Assessment Between Two Individuals
|Profile||-Goal: Wealth growth|
-Investment Horizon: 30 Years
-Number of Dependents: 0
-Low financial obligations
|-Goal: Wealth preservation|
-Investment Horizon: 10 Years
-Number of Dependents: 1
-Moderate financial obligations
-No income (retired)
|Risk Appetite||-High risk appetite|
-Willing to take more risk
-Requires less compensation for
|-Low risk appetite|
-Willing to take less risk
-Requires higher “risk premiums” to
compensate for the additional risks
|Crypto Investment Approach||-Smaller-cap altcoins|
-Leveraged yield farming
-Leveraged trading through perpetuals
|-Blue chip tokens|
-Overcollateralized stablecoin staking
Given varying risk appetites, investors should approach financial markets with investment strategies tailored to their risk profiles. Dabbling in crypto or DeFi is inherently risky, but we can segregate the risk-taking approaches in this space. For example, risk-averse investors can adopt a safer investment strategy by acquiring blue-chip tokens like Bitcoin (BTC) and Ether (ETH), which are generally considered safer investments due to their large market capitalization. In DeFi, investors also deem staking and lending protocols as relatively safe options for generating stable returns. On the other hand, investors with a higher risk appetite can consider liquidity providing, which is riskier but offers higher yields. Before picking an investment strategy, investors must understand the relationship between risk and returns.
Risk and Returns
“High risk, high returns” is a common phrase that investors use to describe the relationship between risk and returns. It is essential to understand that the risk level commensurates with the return level. This tends to be the case for most investments outside of arbitrage opportunities, where investors can make returns with little to no risk.
Figure 1 depicts the relationship between an asset’s return and risk, measured in standard deviation. Historically, investing in higher-risk assets generates a higher return. The disparity between risk and returns represents a crucial concept known as the “risk premium”, defined as the additional return you are compensated for by taking on additional risk.
We can also identify the relationship between risk and return in various DeFi investment strategies. Compare holding stablecoins versus blue-chip tokens such as BTC and ETH. The latter poses a higher risk as it is subject to price risk. By holding onto these blue chips, investors are compensated with a risk premium in the form of price appreciation compared to holding stablecoins with no price risk. There is a distinct trade-off between risk and return.
However, price risk is not the only form of risk present in DeFi. Due to the open-source nature of blockchain technology, DeFi protocols are also vulnerable to security and smart contract risks. The prevalence of blockchain exploits and crypto attacks has never been higher than in the past year. In March 2022, the Ronin Network was hacked for over 173,600 ETH and 25.5 million USDC in one of the largest crypto heists in history. This was just one out of the numerous crypto exploits that happened in 2022. Therefore, it is essential for investors to exercise due diligence and do your own research (DYOR) before investing in the DeFi space.
Risks in the DeFi Space
Now that we have understood the basics of risk, we shall explore the different risks specific to DeFi.
|Type of Risk||Description|
|Price Risk (Delta Risk)||The risk that the underlying token invested falls in value|
|Liquidation Risk||The risk of being liquidated on levered positions, especially during volatile periods|
|Counterparty Risk||The risk of the counterparty defaulting on their contractual obligations|
|Protocol/Smart Contract Risk||The risk of the protocol that you are interacting comes under jeopardy due to smart contract exploitations and rug pulls|
|Impermanent Loss||The risk that either one of the tokens in a liquidity pool pair value changes drastically, resulting in a change in the dollar value of the token|
|Regulatory Risk||The risk that a change in laws and regulation will materially affect a token, project, or the overall crypto market|
|Slippage Risk||The risk that the price of executing a trade differs from the expected price|
|Security/Procedural Risk||The risk of putting a user’s assets in jeopardy due to wallet hacks or phishing attacks|
What Is Next?
Risk management is an essential but often overlooked skill in the financial markets. Without a proper risk management strategy, investors with substantial profits can lose everything in a couple of bad trades. To maximize returns and protect their digital assets, investors should be aware of the underlying risks in DeFi and take the appropriate measures to curb them. To learn more about DeFi risk management, stay tuned to our upcoming articles as we deep-dive into the different DeFi risks and uncover methods to manage them.
At Treehouse, we want to empower people to confidently navigate DeFi, and this includes helping users with understanding and assessing risk properly. In case you missed it, check out our recommended list of risk-related pieces!
- How to Make Sense of Metrics in DeFi
- The Truth About Audits in DeFi
- How to Manage Your Defi Risks With This Framework
New to DeFi? If you found this useful, check out our other Learn DeFi articles to dive deeper into the wonderful world of DeFi! Alternatively, browse our Insights section to read more in-depth analyses on the DeFi space. You can also try out our flagship product, Harvest, to get a comprehensive analysis of your DeFi assets. Lastly, subscribe to newsletter updates in the box below!