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Financial Risk
Mitigate financial risk with this analysis.

Key Risks

Price volatility

When providing liquidity in DeFi protocols, the provided asset is often not a stablecoin but an asset that fluctuates in price. For these assets, we always need a form of hedge to minimize our exposure to price fluctuations and stay delta neutral. Usually, we are hedging our exposures with dated futures, perpetual futures, or options.
Dated futures only have maintenance margin and liquidity risk.
Perpetual futures have maintenance margin, liquidity, and interest rate volatility risk.
Options have liquidity risks and suffer from theta decay.

Impermanent loss

When providing liquidity on an AMM DEX, the usual procedure is bundling up two assets together to create a trading pair. This trading pair is subject to impermanent loss which is essentially price risk that sets in when one of the pair’s assets is moving strongly in one direction. In this case, the pair’s asset:asset ratio is changing dramatically and the provided capital is now much more in one asset than the other one. This risk can be reduced with the use of futures and options and dynamic adjustment of these hedges.

Interest Rate Volatility

When interacting with lending protocols, the interest rate is often flexible and can change at any moment, depending on demand. This means that interest rates need to be actively monitored in order to prevent losses from interest rate spikes.
Another area where interest rate volatility comes into play is perpetual futures. Perpetual futures funding rates change every 1-8 hours and need to be monitored in order to prevent losses from funding rate spikes.

Liquidity

Protocol Liquidity

Assets that are deposited to a DeFi protocol are sometimes time-locked and therefore pose an illiquidity risk.

Asset Liquidity

We can only engage with assets that have sufficient trading volume and market (order book) liquidity.

Margin risk

Setting up a hedge for an asset or engaging with a lending protocol bears a maintenance margin risk. In order to sustain one’s position and prevent a liquidation from happening, there needs to be enough collateral on exchange/in a protocol. We need to actively monitor maintenance margins, especially during times of market volatility and prefer protocols with very low maintenence margins / low need to rebalance collateral.

Pegging risk

Stablecoins such as Tether USD or DAI may lose their 1:1 Dollar peg due to uncertainty around their backing or in times of extreme market volatility. This can lead to a partial or complete loss of capital when stablecoin collateral needs to be accessed.
Another aspect here is algorithmic stablecoins like Terra UST which do not have a backing but rely on a set of rules that aim to bring the value back to $1 when it deviates from its peg.
Recent examples: USDT, UST, DAI

Risk Analysis

Item
Weighting (Total of 20)
Price Volatility
8
Pegging
5
Liquidity
3
Interest Rate Volatility
2
Margin
2

Price volatility

If there is a hedge available via dated futures, perpetual futures, or options we give 8 points. If not, 0 points.

Pegging

  • No unpegging risk: 5 points
  • Unpegging risk but insurance available: 3 points
  • Unpegging risk and no insurance: 0 points

Liquidity

  • Collateral instantly available: 3 points
  • Collateral not instantly available: 0 points

Interest Rate Volatility

  • A hedge is not exposed to interest rate volatility: 2 point
  • A hedge is exposed to interest rate volatility: 0 points

Margin

  • No margin risk: 2 point
  • Margin risk: 0 points