DeFi lending platforms have grown in popularity over the past few years. But what are they? They are decentralized finance protocols that let crypto users lend and borrow digital currencies without the involvement of middlemen like banks.
Most DeFi lending platforms require borrowers to deposit some crypto as collateral before securing loans. Once the loans are fully repaid, the borrowers receive their collateral back.
The DeFi space has attracted millions of investors who have poured hundreds of billions of dollars. But not all of them fully understand the risks associated with this nascent industry. In this article, we will discuss various indicators for monitoring risk in DeFi lending protocols.
Why is Risk Management in DeFi Essential?
DeFi is the most targeted crypto sector by exploiters. This calls for the need for proper risk management. Additionally, although billions of dollars have been lost to exploiters, economic risks have also caused a loss of money in the DeFi space.
To manage economic risks, certain indicators must be applied. These indications include:
All DeFi protocols execute liquidations since they help to keep the lending platform stable. As mentioned earlier, borrowers provide collateral to obtain a loan. If that collateral drops in value, then the borrower’s loan becomes undercollaterized, and this can be a big problem.
To prevent bad debt and default on the lending platform, all undercollaterized loans are usually liquidated. The borrower’s collateral is sold off to repay the loan. This process is done by an independent liquidator operating on the protocol. Selling off borrowers’ collateral helps to secure deposits of liquidity providers (lenders) and keep the lending platform solvent.
DeFi protocols can mitigate the risk associated with undercollaterized loans using the Liquidators indicator, which shows the activities of liquidators and their effectiveness. By using this indicator, a lending protocol is able to identify which types of collateral get liquidated the most. The platform can use the information to adjust the collateral requirements for particular loans to reduce liquidation incidents.
There is a need for DeFi lending protocols to monitor borrowing activity as it helps to assess the growth and health of the platforms. If the borrowing activity is high, it would indicate that the demand for credit is also high, and this can be a good sign that the platform is growing.
By monitoring borrowing activity, a DeFi platform can identify issues like an over-reliance on one borrower or a single asset. This helps the protocol to adjust lending policies or even collateral requirements to mitigate the risks associated with the identified risks.
Health Factor Distribution Indicator
This indicator shows how close a borrower’s loan is to liquidation. In case the health factor is determined to be below 1, then the chances of the loan being liquidated are high. If most loans are closer to liquidation, the solvency of a lending platform is at risk. This makes the protocol unattractive to investors who want to provide liquidity.
Further, the health factor distribution indicator shows whether loans are evenly distributed among borrowers or whether the lending protocol relies on a few borrowers who take loans of huge amounts. In case the loans are evenly distributed, then the possibility of being liquidated all at once reduces. This is a positive sign of the health of a DeFi lending protocol.
Net Liquidity Flows Indicator
This indicator typically monitors the net flows, inflows, and outflows on a particular lending protocol. Also, it helps in identifying factors that may cause players on the lending platform to take certain actions. For example, concerns over the lending platform’s safety can prompt depositors to withdraw their funds, thus causing liquidity issues, while the platform’s stability can lead to massive inflow of funds.
That said, DeFi lending protocols use the Net Liquidity Flows Indicator to identify and address issues that pose liquidity risks.
As the DeFi space continues to evolve, we believe the tools discussed above can help the nascent industry move in the right direction.
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