Opinion: Risk in a time of DeFi Farming

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Understanding risk is fundamental to human existence.

Not just the ability for individuals to be able to imagine the consequences of actions yet to be undertaken, the concept of risk is incredibly significant for wider society too. 

As we’re currently finding out in the face of the Covid-19 pandemic, thinking through ‘what happens if…?’ enables us to (hopefully) protect the vulnerable while allowing the rest of us to slowly get back to normal – at least the new normal.

Risk shouldn’t be a subjective discussion, though. One of the key developments over the past 100 years has been our ability to define risk with ever more mathematical precision. And that’s why so much of the current Covid-19 debate revolves around testing policy, R numbers, and mortality rates. 

However, the problem with numbers – any numbers – is that we always overestimate their accuracy, particularly in the face of new and unforeseen circumstances.

Back to Covid-19. At the start of 2020, an average European male 85 years or older would have had around a 15% chance of dying during the year. But by March, that risk factor was widely assumed to have doubled to 30%.

Less existential but in some ways equally important is the manner in which risk has been applied to financial markets. In general, it’s been a highly positive development, allowing companies, individuals, and national states to better understand the world and how to create and secure their future prosperity. 

But there have been plenty of bumps along the way, usually caused by very clever people overestimating their ability to understand and quantify risk in increasingly complex situations.

Of course, the most famous example was the 2008-2009 Credit Crunch, in which US mortgage debt was combined, packaged up and spread in such a complex fashion throughout the financial world, no-one could accurately calculate its overall risk profile.

Yield farming
The cycle looks set to repeat

Despite that, it was sold using standard debt risk definitions. The result was a horrible mismatch in terms of what companies thought their financial risk was, and what it actually was. 

Labeled ‘Systemic Risk’, this sort of risk is very hard to calculate. It’s not the risk that any individual home loan will go bad, rather that such risk is distributed endemically throughout the financial system in such a manner that anyone involved in any aspect of the system is now at a massively increased risk.

And it’s this sort of risk that worries me when it comes to DeFi and the current craze for Yield Farming.

Yield farming

Yield Farming is the ability of users to perform certain actions in order to gain financial performance, not directly from this activity but due to secondary revenue flow. 

The current focus has been triggered by the launch of new governance tokens which are earned by using the Compound and Balancer dapps (with others to follow). This has resulted in people artificially increasing their activity in these dapps to maximize the rewards they can gain. 

Yield farming
Compound showing an explosion in activity during June 2020

This is typically accomplished by depositing, trading and borrowing tokens in a complex manner, and then repeating this behavior. The big problem with this is – as we regularly see – the risks inherent in any single DeFi dapp are multiplied in an exponential manner the more dapps that are included within what is typically an automated system of transactions.

Throw into the mix the ability of any single user to access very large amounts of token value for almost no cost using flash loans (loans that are opened and closed within a single transaction), and the risk profile of the entire DeFi sector could look increasingly like the world financial system in late 2008.

And that’s even before we start to consider other high-risk vectors outside of DeFi and even the Ethereum blockchain. Obvious examples would include the actual collateral backing the Tether stablecoin (market cap currently $25 billion) and, more generally, any issue that would impact the price of Bitcoin, which remains the key driver of price velocity throughout crypto.

Of course, this isn’t to be alarmist. It is merely to encourage everyone to reconsider their personal appetite for risk, as well as their exposure to risk beyond the individual tokens and products they’re directly using. 

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As ever, I think the sensible view remains only to invest in crypto and blockchain what you can afford to lose, which boils down to what would your reaction be if all your crypto value went to zero overnight?

Yes, the risk of this happening is small. But the truth is, no-one knows how big.

As always we will continue to monitor developments as they unfold. For now, make sure to bookmark DappRadar and sign up to our newsletter to receive regular updates directly to your inbox.

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