Liquidity risk at DeFi

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Cardano is close to developing the decentralized finance ecosystem, and we must be aware of the opportunities, but also the risks.

People today have access to the same mechanisms that institutions use to make money. They are available to anyone with a computer and an internet connection. Finance is being tokenized. The person is now the institution.

The opportunity to generate a peer to peer market is growing, and is already a reality. It is only a matter of time before the great leap to global massiveness occurs.

The benefits for borrowers are considerable, because by expanding the supply in the market, the price of the loan (the rate) decreases.

Credit givers see themselves more as investors than lenders, because liquidity pools form a crowdfunding, atomizing the risks of default, associating people to fund capital.

Crowdfunding is a collaborative project financing mechanism, developed on the basis of new technologies. By forming an investment fund, it dispenses with traditional financial intermediation and consists of bringing together project promoters, who demand funds, and investors or fund providers who seek a return on investment.

But with great rewards come great risks, and most individuals do not have a personal risk management team.

Risk increases as new investment instruments are created, raising the complexity of the system, and in some cases with bad designs in the financial structure.

The Achilles heel for decentralized finance is liquidity. Without liquidity, DeFi is not viable.

Worst case liquidity scenarios at DeFi

Users cannot withdraw their funds

To run the lending system in a liquidity pool, you deposit cryptocurrencies, and receive in return tokens that are issued from the algorithmic liquidity protocol that manages the system, and signifies a share ownership. The cryptocurrency reserves stored there are used to fund withdrawals. If there are no funds in the reserves, it is not possible to withdraw the deposited cryptocurrencies.

If cryptocurrencies were deposited, how is it possible that they are not there as reserves?. The simple answer is that they were borrowed, and the collateral does not cover the total of those reserve outflows.

There are many positions that involve more liquidity than is currently available. Consequently, these users cannot, at any given time, withdraw all of their funds.

The problem is compounded exponentially, as many liquidity pools are funded by other pools, i.e., there are cross investments. If tokens issued by a first protocol are needed to repay a position borrowed in a second protocol, and due to a lack of liquidity the funds cannot be accessed, the second protocol also suffers from a lack of liquidity. A liquidity shortage in one pool affects another, generating a domino effect.

Unavailability of settlement and collateral rewards

When a loan becomes insufficiently collateralized, it can be liquidated by any user. The liquidator returns the loan and collects the value of the loan plus the liquidation penalty. This penalty usually ranges from 5% to 8% of the value of the loan. If that value is not in the collateral reserve, the liquidator cannot collect, and the loan cannot be liquidated.

If we take the current reality on the Ethereum network as an example, this scenario is unlikely in the short term, as most people use a volatile asset as collateral (such as ETH) and borrow a stable one (such as USDC). In the case of liquidating a USDC loan, the protocol would use the collateral reserves to pay the liquidation penalty. This would still work, because ETH reserves currently have very low utilization rates, reflecting the uptrend in the sector. Borrowing ETH against USDC collateral is risky, similar to shorting, as few people are bearish enough on ETH to bet on the price going down.

Impermanent loss is a type of risk that is linked to liquidity, but not directly. It occurs when the price of the deposited assets is lower than when the deposit was made. The greater this change, the greater the impermanent loss. In this case, the loss means a lower value in dollars or euros, at the time of withdrawal.

The stablecoins will remain in a relatively stable price range. In this case, there will be less risk of impermanent loss for liquidity providers (LPs). When the price recovers value, the loss disappears.

Why do liquidity providers continue to provide liquidity if they are exposed to potential losses? Because the impermanent loss can be offset by trading or lending fees.

Settlements are no longer profitable

DeFi’s protocols are based on the economic incentive as a form of enforcement. If the economic incentive disappears, so does the execution.
When the value of the cryptocurrency in collateral goes down, the Total Value Locked (TVL) of a debt position, goes up. Falling prices exacerbate the high interest rate on loans and network fees.

If the netting fees to liquidate that position are higher than the liquidation penalty, the liquidator loses money. Since most DeFi platforms only allow 50% of a position to be liquidated at a time, the liquidation penalty rewards are at most 2.5% of the value of the debt. For example, in the case of Ethereum, with $100 gas, it means that only debt positions above $4,000 are profitable even to liquidate, and unsecured loans below that amount generate interest, locking the value into the protocol until they become profitable again, and further exacerbating the debt-to-liquidity ratio.

Bad actors take advantage of FUD

Free riders are creative and unpredictable, but often take advantage of market sentiment (FUD: fear, uncertainty and doubt). In times of high utilization, these problems can be artificially exacerbated.

In the event that a high-profile user, is unable to withdraw or borrow funds, the price of DeFi tokens is likely to suffer. Given that shorts can be profitable for market manipulators, it is not unfeasible that someone could use this dynamic to push a protocol to the brink in order to enrich themselves by shorting it. The lower the volume of liquidity (lower the TVL), the more likely. This could create a crisis of confidence due to limited liquidity.

Final words

To be brave is not to be reckless.

Investments have always had risks, and as the rule goes, the higher the income the higher the risk. The DeFi ecosystem has the volatility that cryptocurrencies provide, which make DeFi as dynamic as it is today.

Be smart with your investments, diversify, it is very difficult to get it completely right, don’t expose yourself more than you would be able to bear if things go wrong. Investments are not always “to the moon!”, there are many “to the hell!” cases.

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Thanks, very informative!

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