You cannot have a loan without lenders. And you cannot have lenders if there are no appropriate incentives in place to try to separate from their capital. This may seem attractive the lenders to do their thing is simply a case of exceeding the APR at a level to provide sufficient capital in condition to meet loan requests. And it’s certainly half of the battle. But the other half, which is easily neglected, is just as heavy: the risk.
Many things in life come down to a question of risks and rewards balancing, and it is never this more pronounced binary than in the context of loans – in particular cryptographic loans, where the theory of games that DEFI frames allow creates intriguing dilemmas with which users must fight. The industry also emphasizes the question of which is responsible for what is happening when the lenders DEFI are burned, for example via an intelligent contract hack: the user or the protocol?
For philosophers, moralists, developers and financiers, DEFI is the perfect crucible for weighing the risk / reward duality that defines loans.
How the loan defines deffi
DEFI reshaped how crypto holders engage with the loan markets, offering unprecedented performance opportunities thanks to platforms that bypass traditional intermediaries. However, under the promise of high yields is a precarious reality: lenders are often faced with risks which are presented much less clearly than the awards used to attract them.
Vulnerabilities of intelligent liquidity shock contracts, the lack of granular control on risk / reward profiles means that users are forced to make an informed assumption each time they give their assets to a loan protocol. Because DEFI, lest we forget, do not see with default insurance. You are hacked on Onchain, it’s about you. This is one of the many risks that users reluctantly accept like the price of the game in a high playground where the awards are as high as the dangers.
Challenge ready Even developed quickly in the past five years, motivated by retail investors looking for traditional savings accounts, with up to 15% of APY not very rare. The sector is dominated by protocols like Aave and Compound which pool the assets on the shared liquidity markets, allowing borrowers to access funds by displaying guarantees while lenders arouse interest. However, this model is home to systemic risks.
Loans, liquidation and take the L
A recent study notes The fact that DEFI was dependent on the over-collateralization, where the borrowers lock up more value than they borrow, attenuate the risk of credit but exposes lenders to liquidations focused on volatility. If the collateral values crash, as can be seen in the collapse of the Terrausd 2022, whole swimming pools can be destabilized, amplifying losses for all participants.
The absence of a loan agency worsens the problem. In shared pool systems, the deposit of funds means accepting exposure to each active in the swimming pool, regardless of tolerance to individual risk. Even when things are not mistaken, there is always the potential for them to make a slightly wrong, with an impermanent loss a constant threat when the prices of the assets change. This means that lenders can deal with unpaid losses.
All this does not mean that the lenders defi constantly take the L – In fact, the real losses are rare. The problem is that when they occur, they can be catastrophic and for the reverse of risks, it is not always easy to assess the level of risk before entering.
For example, how do you determine which of the audited protocols you are considering was the best audited? Or determine what swimming pool weighting is the least sensitive to impermanent losses? The calculation of the reward, in comparison, is child’s play. Risk analysis is a minefield. Nor do not follow that the higher loans reward is correlated with a higher risk; There may be a connection, but it is by no means as simple as playing it safely and plumping for the lower APY. So what is the solution to the traps of the balance between risks / rewards in deffi loans?
Lower the risk without lowering the rewards
Measuring risk in traditional finance is relatively simple. Credit risk is determined by a structured process which assesses the probability of a borrower who has failed on a loan and the potential loss for the lender if the defect occurs. In Defi, the borrower has failed is practically impossible, because the need for warranty prevents borrowers from obtaining assets that they cannot cover. It is one of the greatest forces of Defi Lending.
It’s the biggest weaknessAs we have observed, what we can call the “third party risk”, ranging from pirates to volatile assets, who all have the potential to leave lenders of their pocket. Although there is no unique solution that can completely eliminate the risk of loan, this can be considerably reduced by attacking the main causes of loss of loan, starting with the model grouped to Double Token. There are alternative systems and, in the case of projects such as Silo Finance, they actively see the use by lenders who seek to preserve their precious capital.
Silo is one of the main pioneers of the isolated loan markets, a difference compared to the norm of the grouped asset. Unlike conventional DEFI loan protocols, where a single breach could collapse in all markets, Silo creates pools with two assets such as ETH-USDC that separate risk. Landers are deposited in a specific “silo” only the risk of the basic assets of this market. With 270 million dollars on TVL and more than 50 markets on Ethereum and four layers of layer 2, Silo facilitated hundreds of millions of dollars in loans without incident.
Silo V2, now in the beta deployment on Sonic, goes further with programmable loan markets. These allow personalization, such as the deployment of inactive capital to DEX for additional yield, while preserving isolation. This protects against the hacks on a system scale because a breach in a silo does not touch others. The upcoming launch of Silo Vaults will optimize liquidity on these markets, addressing a compromise where separate pools can underestimate those shared in efficiency of yield.
Defi ready without the disadvantages
It should be remembered that DEFI, including its loan sector of several billion dollars, is still very new. It is not its final form and algorithms and performance strategies in favor will only improve. The isolated markets, for example, sacrifice a certain efficiency of liquidity, potentially capping the yields compared to the systems grouped during the bull races. However, the accessible yields that this model can provide will increase as new income flows will be available, stablescoins collateralized by RWA with primitive challenges that rely on innovations such as recourse and cross -exchanges.
Elsewhere in DEFI, diversifying the reliance of the validator, the improvement of the UX and stress tests against the events of Cygne Noir will all play a role in the creation of the landscape of Onchain, including the more robust loan markets. Web3 issues are raised because if lenders lack tools to calibrate the risks and reward, confidence is crumbling and driving capital, delay in innovation. The ideal path of DEFI is that where verticals such as loans to the balance of profitability with caution, guaranteeing the promise of web3 does not weaken under poorly managed risk.
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