By Risk is the carbon monoxide of Web3: all around us and yet invisible.
We know it exists, and we face it every day as we saddle up and enter the trenches or prepare to hunt for yield in the DeFi pastures, yet we can’t look it in the eye.
All we can do is protect ourselves as best we can and pray it doesn’t find a chink in our armor through which to attack.
But while the average DeFi user can do little to halt this silent killer of lending positions and liquidity pool deposits, devs aren’t as toothless.
As the ones who design the token models, write the code, and commission the audits, they have the tools to prevent risk from running rampant.
Some of this is common-sense stuff, such as using battle-tested libraries as opposed to homespun code to control critical functions.
But other risk-mitigation approaches call for more radical measures – like a return to the drawing board to rethink the very way DeFi is designed.
As an examination of just one DeFi primitive – lending – shows, risk doesn’t have to be suffered as a constant specter.
There are ways to keep risk permanently at bay, if not banish it altogether.
But to achieve that, DeFi developers need to be bold – even if it means doing things differently to how the leading lending protocols operate.
DeFi’s contagion problem
One of the problems with onchain markets in their current form is that they don’t have effective measures to contain risk.
As a result, what can start as a single issue affecting holders of a particular token can have knock-on effects, causing protocol- or even industry-wide losses.
To cite just one recent example, let’s consider Hyperliquid’s perps protocol, which in March was exploited – but not hacked – through an attack that targeted the $JELLY token.
While a full post-mortem of the incident isn’t required here, what is relevant is to note who was affected by the exploit. Put it this way: it wasn’t just $JELLY holders.
The token’s surge in price, causing short positions to be liquidated, was too great for the Hyperliquidity Provider (HLP) vault to absorb. As a result, users of the vault were left on the hook for millions of dollars in losses.
They thought they could simply hold HYPE and earn yield on protocol activity, but ended up farming themselves.
The lesson from all this should be obvious, but requires restating nonetheless, since until it’s heeded, incidents like this will continue to occur: keep systems isolated.
Contain the contagion. Ensure that what happens in one pool doesn’t impact users in others. DeFi might be interconnected, but that doesn’t mean that risk should be given carte blanche to roam wherever it likes.
This is particularly true of lending, given its prominent role as the backbone of much of the other onchain activity in DeFi. If lending fails, everything else risks failing too.
Cautious users don’t deserve risky tokens
All crypto tokens carry a degree of risk, from the most illiquid memecoins to highly liquid stablecoins.
The level of risk that each investor is willing to take on is unique to them. It’s their prerogative to dive into a pool containing a highly volatile token pair with all the upside, downside, and everything in between.
But what happens in risky pools should stay within that containment zone – not reverberate through to the supposedly low-risk stablecoin pools offered by the same protocol.
For most of their history, DeFi lending pools have operated on a socialized loss model.
This means that when things go right – which is the vast majority of the time – everyone enjoys the upside.
Pools operate as expected, LPs earn fees, governance tokens juice the rewards, and stakers earn even more.
Capital is deployed, liquidity unlocked, and users can put their assets to use in whatever happens to be their DeFi thing – perps or memecoins, or rebasing stablecoins.
The downside to this socialized model is that, on the rare occasion when things go wrong, it’s not just the users in one pool that are affected: it’s everyone.
Protocol-wide, and sometimes chain-wide, since major seismic industry shocks have knock-on effects – aftershocks if you will. So what’s the solution to allowing lending protocols to enjoy the benefits of collaboration – deeper liquidity, attractive yield, and access to a broad range of borrowing assets – without the well-documented downsides?
The answer to that question varies greatly between lending protocols, but an examination of the leading DeFi lenders shows that concerted efforts have been made to address this problem.
Silo, for example, has popularized risk-isolated pools for lending and borrowing.
These do exactly what they sound like, ensuring that lenders only take on the risk of the market they’ve elected to deposit into.
This may sound obvious, but such approaches remain the exception rather than the norm.
Most lending platforms are still reliant on the legacy model in which all lenders are exposed to everything that happens across all pools.
Separate risk, separate reward
One of the issues with legacy lending platforms, in which risk is equally shared by all users, isn’t just the fact that this unfairly brackets more cautious users in with self-styled degens, who embrace risk head-on.
There’s also the fact that the rewards aren’t fairly distributed either. It stands to reason that users willing to take on more risk, such as through lending volatile crypto assets, should be entitled to a greater share of rewards.
Particularly if they’re the ones carrying the can in case things go wrong.
In newer lending protocols such as Silo, this has been taken into account: interest rates are modular, allowing higher interest rates to compensate lenders against more volatile tokens.
This isn’t just about fairness, incidentally: it’s about creating a flexible incentivization program that ensures there is sufficient liquidity in every pool for lending and borrowing purposes.
We’re often told that DeFi is about enfranchising the disenfranchised or words to that effect.
Allowing everyone to participate in global money markets, regardless of gender, nationality, credit rating, or income.
DeFi doesn’t care who’s behind the wallet, which in theory makes for a highly egalitarian system.
The provision of pools in which lenders can control the borrowing rate aligns with this narrative.
This is power to the people in action, one pool at a time.
Risk will never be fully eliminated from DeFi. It is, to return to our original analogy, much like carbon monoxide.
Nowadays, we have detectors that can warn us of its build-up, but that hasn’t entirely prevented tragedies from occurring – it’s just made them much rarer.
DeFi users are realistic about risk. They don’t shirk from it. All they ask is for a fair fight.
To be responsible for their actions – and not left on the hook for those of others. Isolated lending pools play a small but vital role in ensuring that happens.
In the process, they ensure that the reward is proportional to the risk that each lender is willing to take on.
It’s a better deal for everyone: risk-averse users don’t get rekt, while risk-on users get the reward that’s rightly theirs.
The post Can Web3 lenders dial in and set the yield for risky tokens? appeared first on Invezz
