Decentralized finance (DeFi) is a revolutionary movement that aims to democratize and disintermediate traditional financial services. By leveraging blockchain technology and smart contracts, DeFi enables novel ways for users to access and provide liquidity, such as staking, market making, lending, farming protocol incentives, and fee sharing from protocol earnings. These new opportunities to earn yield are native to the blockchain and thus come with their own unique risk vectors.
Managing risk is the next frontier for DeFi. To invest smarter in DeFi, one needs to understand all the risks of a particular DeFi investment. However, DeFi also faces several challenges and threats, such as highly inflationary projects, smart contract exploits, questionable decentralization, and outright fraud. These factors have raised doubts about the sustainability and security of DeFi. In this paper, we propose and establish a common framework for risk assessment in DeFi.
At Exponential, we take risk seriously. We believe that risk is not something to be avoided, but rather something to be understood and managed. Risk is hard because the devil is in the details, and any small thing can kill your investment. That’s why we don’t rely on intuition or gut feeling, but on rigorous analysis and research.
This is how we do it: we use a framework that asks all the relevant questions that need to be answered before investing in any DeFi project. These questions cover aspects such as governance, tokenomics, security, liquidity, smart contract design, and more. We do the research in detail, using both qualitative and quantitative methods, and we objectively quantify the chances of loss based on historical data and simulations. We also monitor the performance of our risk framework on an ongoing basis, and adjust or update our risk criteria accordingly.
We hope this will help our community look into the hard subject of risk with more confidence and clarity. We believe that by applying this framework, we can reduce the uncertainty and complexity of DeFi investing, and unlock its full potential for exponential growth.
Before we dive into the details of our framework, we want to share our overall approach to risk in DeFi. We believe that risk is not a static or linear concept, but a dynamic and multidimensional one. Risk can come from many sources and affect many aspects of a DeFi project, and it can change over time and in response to external events. To go beyond what’s obvious and try to imagine the worst (principle of max pain), we use a catch-all holistic framework that covers all the possible angles and scenarios. This way, we can anticipate and prepare for any potential risk event that may occur in DeFi.
We believe that risk is not a subjective or relative concept, but an objective and absolute one in terms of its potential impact on users. Risk is not only a matter of opinion but also a matter of fact. Risk exists objectively and can be measured and quantified, but it also depends on how users perceive and evaluate it. Risk is not something that can be ignored or dismissed, but something that must be acknowledged and addressed. As such, we need to apply a high standard of quality when evaluating risks in DeFi. We view DeFi as the infrastructure for the future of money, and we want to ensure that they are safe and reliable for everyone.
Finally, we recognize that risk is not a simple or isolated concept, but a complex and interconnected one. Risk can arise from many factors and affect many outcomes, and it can interact and amplify with other risks in unexpected ways. Therefore, we need to recognize the complexity, composability and interconnectivity of DeFi, and account for the systemic and emergent risks that may arise from the interdependencies between different DeFi protocols. We use a graphical representation of DeFi to illustrate how any risk event can propagate and affect the whole ecosystem. This way, we can avoid being blindsided by unexpected or cascading risk events that may affect the whole DeFi ecosystem.
In summary, this is the Exponential approach to risk in DeFi. We believe that by following this approach, we can better understand and manage the risks that users face in this rapidly evolving space.
Our risk framework captures the composability of DeFi. This means that we do not simply average the risks of each component in a DeFi liquidity pool, but rather compound or multiply them across the chain, protocols, assets, AND pool level. This gives a more accurate and comprehensive risk score for each pool. To achieve this composability, we estimate a probability of failure for every risk type based on its frequency and severity. These risk probabilities are proprietary to Exponential and will be reevaluated periodically. For the purposes of this paper, we have assigned a relative risk score from 1 to n for each risk type, where 1 indicates the lowest risk and n indicates the highest risk. Since the exact numerical value of the risk score is not disclosed in this paper, the 1-n scale is only for relative comparison within each risk type and is not meant to be compared across different risk types. These risk types are then grouped into four main categories that form the basis of our framework.
Our framework consists of four main components: risk categories, risk types, risk scores, and risk ratings.
The first component is the risk categories, which are the broad areas of risk that we consider in DeFi. We have identified four risk categories: chain risk, protocol risk, asset risk, and pool risk. Each category represents a different dimension of risk that can affect a DeFi investment.
The second component is the risk types, which are the specific aspects of risk that we measure and analyze within each category. We have defined a set of risk types for each category based on our research. Each risk type captures a particular feature or characteristic of a DeFi protocol or liquidity pool that can influence its risk level. Within each risk type are risk items that relate to scoring that particular risk type (e.g. TVL and maturity are used to score Chain Maturity).
The third component is the risk scores, which are the numerical values that we assign to each risk type based on our estimation of its probability of failure. We use both qualitative and quantitative methods to estimate the probability of failure for each risk type based on historical data and simulations. We also update our estimates periodically to reflect the latest developments and changes in DeFi.
The fourth component is the risk ratings, which are the qualitative labels that we assign to each DeFi protocol or investment based on its overall risk score. We use a scale from A to F to rate the overall risk level of a DeFi investment based on its total risk score across all categories and factors. We also provide a breakdown of the ratings by category and factor to show the strengths and weaknesses of each DeFi pool.
This is just a glimpse of what our whitepaper has to offer. Check out the full in-depth version here.
To learn more about Exponential, check out these useful links: