Sure, You Can DeFi. But You Can't Defy Risk

Decentralized finance, or "DeFi" as it's more commonly known, is gaining traction in the business world for its speed, efficiency, flexibility and potential outsize returns. There are fundamental risks all companies should understand before entering this new financial paradigm. In this article, we explore three of those risks.

DeFi is one of the most intriguing and hotly followed technologies in financial services today. It utilizes blockchain technology and digital assets to facilitate financial transactions such as borrowing and lending, trading, insurance, asset management and payment settlement, to name a few. The total value locked in DeFi protocols — one of the most followed metrics in the industry — as of the start of November 2022 was approximately US$56 billion, which, despite a rapid run-up and sell-off from early Q1 2021 to late Q1 2022, represented a 141% compound annual growth rate over the last two years.¹

Traditional finance, or "TradFi," relies on centralized intermediaries such as banks and brokerages, for example, to execute financial transactions. In contrast, DeFi does not rely on intermediaries or middlemen. Instead, the system comprises numerous decentralized applications, or "dApps," that utilize smart contracts to facilitate financial services on a peer-to-peer basis. Because DeFi operates in modular and composable ways, it has been referred to as "money Legos" — by "stacking" the modules in distinct ways, innovative new financial products and services can be created.

The innovative nature of DeFi provides it with several advantages over TradFi. Four benefits to users include:

• DeFi is more flexible, allowing users to use interconnected financial services between various dApps. In contrast, financial services in TradFi are more monolithic and siloed.²
• DeFi provides significantly more transparency, as all transactions reside on public blockchains, where they can be audited by users. Comparatively, in TradFi, many transactions take place in private deals with limited visibility to the public.³
• DeFi facilitates disintermediation, reducing costs and providing new value-capturing opportunities to users.
• DeFi predominantly requires overcollateralization of loans, ensuring some credit risk mitigation, whereas TradFi lending may not have sound credit risk mitigation requirements.^{4 5}

Despite the aforementioned advantages, DeFi is subject to risk that all prudent users and companies should be aware of if they are planning to interact with its service offerings.

Financial Risk

For capital to flow into the crypto ecosystem and subsequently into DeFi dApps, fiat currency must be exchanged for digital assets. To facilitate capital flows, various service providers created tokens whose value is pegged to fiat currency, most often to the U.S. dollar. These tokens are commonly referred to as stablecoins, and functionally they emulate fiat currency in the crypto ecosystem.

In addition, stablecoins are often used as leverage in DeFi yield-generating strategies. A major utility of stablecoins is that they serve as a gateway to other digital assets because they can be easily exchanged for fiat currency at a predictable price. By exchanging fiat currency for stablecoins, users can subsequently purchase other digital assets very easily with their stablecoins.

Market participants generally recognize two main categories of stablecoins: collateralized and algorithmic. In the case of collateralized stablecoins, for every stablecoin that is issued, an equivalent value — usually denominated in fiat currency or in cash equivalent form — is deposited in a reserve account as collateral so that a 1:1 ratio is satisfied. For example, a stablecoin issuer will mint 1,000,000 units of a stablecoin pegged to the U.S. dollar and at the same time deposit US$1,000,000 in a reserve account at a bank, so that each newly created stablecoin is redeemable for US$1 at any time. Some collateralized stablecoins hold assets other than the backing instrument in their reserves, however, creating market risk exposure for the holders of the stablecoin.

Algorithmic stablecoins rely on smart contracts to maintain stability and their peg to fiat currency. The algorithm is designed to regulate the supply and demand for the stablecoin and a related token with a fluctuating price. The related token serves as a backing to maintain the stablecoin's peg to a fiat currency. A type of algorithmic mechanism used in a stablecoin pegged to the dollar allows users to exchange one stablecoin for US$1 worth of the related token. In the event that the stablecoin loses its peg and is being traded on the open market at a price below US$1, the algorithm facilitates arbitrage opportunities where traders can purchase the stablecoin for its market price of under US$1 and then exchange it for US$1 worth of the second related token, generating a profit.

Through this mechanism, the algorithm removes stablecoins from circulation, thus contracting their supply. Similarly, the supply of the second related token will expand via the minting of new tokens. The result of this process is that the two tokens will reach a new equilibrium, with the stablecoin regaining its pegged value to US$1. In the event that the stablecoin starts trading at a value higher than US$1, the inverse process takes effect, with the objective of restabilizing the price of the stablecoin back to US$1.

Algorithmic stablecoins are much riskier than collateralized stablecoins, especially when huge trades are involved, which can dislocate the supply, demand and price of the stablecoin and its related token. For example, large withdrawals of the stablecoin from major DeFi protocols can deplete its liquidity. This may signal to market participants that something is wrong, resulting in additional withdrawals and redemptions. This may potentially escalate to wider "bank run," where large quantities of the stablecoin are sold with such speed that the algorithmic mechanism cannot keep up, thus failing to return the stablecoin to its peg. In these extreme scenarios, both the stablecoin and its related token are at risk of potentially spiraling to near-zero prices.

Volatility Risk

As a new asset class, digital assets are subject to significant volatility due to the market's price discovery mechanisms. Unlike traditional exchanges, many decentralized exchanges do not rely on order books to facilitate trading. Instead, decentralized exchanges execute trades through liquidity pools and smart contracts. A liquidity provider can initiate a position in a liquidity pool by depositing two different digital assets of equal value (i.e., the quantity deposited multiplied by the price of one asset must equal the value of the other). Users are incentivized to provide liquidity through rewards in the form of fees and monetary incentives, allowing them to generate returns through yield-farming strategies. A common mechanism that decentralized exchanges utilize to facilitate trading is an automated marker maker, or "AMM."

A notable risk with liquidity pools that utilize AMM mechanisms is that of impermanent loss. As prices fluctuate over time due to trading activity in the market (under certain scenarios in which the two asset prices diverge directionally), the resulting value of the user's current position in the liquidity pool may be lower, as compared to a scenario in which the user had not deposited the assets in the liquidity pool. The variance between the current value of assets in the liquidity pool and the value of the digital assets in a counterfactual scenario in which they were never deposited in the liquidity pool represents the impermanent loss incurred by the user.

The loss is considered impermanent because future price fluctuations may eliminate the aforementioned variance generated by AMM mechanics. The loss is only considered permanent if the user removes their assets from the pool. It is important for users to carefully consider and evaluate the fees and monetary incentives offered by decentralized exchanges along with the risk of impermanent loss prior to engaging with such platforms.

Business Risk

As an ecosystem that is predominantly built on open-source code, DeFi is susceptible to certain idiosyncratic business risks. Like many public blockchains, dApps are typically designed to be open source, with their code being publicly accessible. As such, code can be easily copied and edited by anyone with the adequate technical expertise. Competitors can exploit this by copying a platform's code and redeploying it in an effort to gain a competitive advantage and market share.

An example of this phenomenon can be observed when a decentralized exchange gains significant popularity among users due to its features. In an effort to emulate this success, a competitor copies the code of the original decentralized exchange, redeploys it as their own, and offers better financial incentives to lure liquidity providers and users to its own platform. This process is commonly known as a "vampire attack." If successful, it will adversely impact the original decentralized exchange and may even pose an existential risk.

Even with such risks present, DeFi offers many potential benefits, and forward-thinking market participants are naturally curious about how — or whether — they should capitalize on the services it offers. Given the rapidly evolving nature of DeFi, market participants will need to consider specific risks present in this emerging technology.

In a subsequent article, we will look further into those risks.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.