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Understanding and Mitigating Economic Risks in DeFi Lending Platforms

Understanding and Mitigating Economic Risks in DeFi Lending Platforms

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The DeFi sector provides unparalleled opportunities for capital management.

However, exercising this freedom requires conducting thorough research and evaluating the risks associated with depositing funds into a particular protocol.

And the fact that this market is rather opaque in its structure and lacks in the way of sophisticated risk management tools means that the task of assessing said risks often falls directly on the shoulders of users.

This poses no small amount of complications as under normal circumstances users should not have to perform their own risk management.

But there is an undeniable gap in security solutions in the DeFi market that leaves them doing just that.

With this in mind, I have put together a list of economic risks in DeFi lending protocols with their comprehensive analysis and ways to assess whether a particular project is taking steps to protect itself against them.

Risk classification and overview

First things first let’s start with properly defining what market and economic risks are.

Market risks mainly involve dealing with external factors, such as market crashes, liquidity crises and systemic risks that can impact the entire DeFi ecosystem.

Included among the main market risks are the following.

  • Liquidity risks where users are unable to immediately withdraw their deposits in case of a bank run
  • Interest rate risks where interest rate rises too high, incurring losses for borrowers
  • Liquidation risks where borrowers lose some of their collateral value during liquidations
  • Liquidation cascades where a negative impact on prices can cause smaller price movements to become larger, triggering a feedback loop

Economic risks, on the other hand, denote anything related to deliberate manipulation of the market state for profit.

The main types of economic risks to consider are as follows.

  • Pump attacks An inflation of an asset’s price, which is then used as collateral to borrow other fairly-priced assets. The manipulated price eventually returns to normal, leaving the protocol and its liquidity providers with a lot of debt that can’t be repaid.
  • Dump attacks – These operate on the same principle as pump attacks but are based on borrowing an underpriced asset.
  • Forced liquidation attacks A price manipulation that increases the value of a loan asset or decreases the value of collateral and triggers large liquidations, damaging the…

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