Traditional portfolio risk management theory cannot be mapped 1 : 1 in DeFi. By replacing intermediaries with smart contracts, decentralized finance introduces new forms of risks to market participants.
DeFi-native risk management models that encompass industry-specific protocol, infrastructure, and market risks need to be developed and implemented on the protocol, application, and service levels.
Treasury managers and teams should identify, monitor, track, act upon these 5 DeFi risk dimensions.
DeFi protocols are able to increase the efficiency of financial service and minimize the use of intermediaries through smart contract automation. However, this also introduces intrinsic protocol risks. For example, Compound and Aave users face liquidation risks due to volatile market movements. In addition, volatile market conditions that force liquidations on illiquid tokens may leave the protocol, and it's depositors with bad debt. Another example of intrinsic protocol risks is high slippage conditions when liquidity is removed from a pool.
Changes to external factors may also alter a protocol's behavior. Exploits such as oracle manipulations, smart contract exploits, or flash loan attacks can create cascading effects for a protocol and the wider market.
Another risk dimension teams should be aware of is infrastructure integrity. DeFi protocols are dependent on their underlying blockchain for consensus and security. Validator collusion, forks, bridge hacks, or L1/ L2 exploits are all risks to be aware of.
DeFi protocols and applications have unique governance requirements and processes that may affect the operations of a protocol or application. Common risks such as centralization of voting power, voter apathy, bribery, and spamming could increase as token prices fall.
Market risks can cause cascading effects in DeFi due in part to smart contract automation. For example, large price movements can trigger mass liquidations on lending platforms, causing massive slippage, and potentially leaving the protocol and depositors with bad debt.