What are the biggest risks in DeFi? I’ve received this question many times and it’s a legitimate concern when it comes to evaluating investment opportunities.
I’ve recently discovered Opyn, a DeFi application, built to enable users to hedge against DeFi risks. I’ve got in contact with Opyn’s team and really enjoyed chatting with them about finance, value investing, derivatives, the DeFi space, and its risks.
Since the team is very active in building solutions to hedge against DeFi risks I’ve decided to interview Zubin Koticha, Opyn’s co-founder, about the risks of DeFi.
The following is part 1 of the interview. For part 2 I’d like to get your feedback, so let me know if you have anything you’d like to ask Zubin.
For sake of clarity the interview is a transcript of a call I had with Zubin on May 4th 2020, there might be some differences from his original words.
D: Hi Zubin, what is your background? How did you get into Crypto and DeFi?
Z: Hi Daniele, Thank you for this chance to talk about what we’re doing!
I am one of those “weird people” whose intellectual passion is finance. When I say finance, I mean it as empirical study, not as much about making money. In another life I’d probably be a professor of Finance.
The most interesting aspect of finance is how countless data points and differences in opinions can converge to a single output: a market price. For me, that is absolutely fascinating.
From a young age I started learning about finance. In fifth grade, I wrote my end-of-year school report on the stock market, in middle school I started being interested in value investing. In high school, I started to do research. I was a semifinalist for an international science competition and I thought I was going to start a path in traditional finance, i.e. trading or hedge fund. I’ve soon realized that computers were a fundamental part of modern finance so I started to study Computer Science at Berkeley and I soon discovered cryptos: the perfect mix of my two passions: finance and computer science.
Going deeper into crypto I’ve realized that most of the risks that were exposed in the financial crisis of 2009, also exist in the current crypto markets. For this reason I was interested in building products to help people protect against risks they faced inDeFi. In the last year my cofounders, Alexis Gauba, Aparna Krishnan and I started to build Opyn and in February, we released the first version on Mainnet.
D: What is Opyn? What are the main benefits for investors to use it?
Z: Opyn is the risk management layer for DeFi. It is a marketplace: on one side, risk-sensitive investors can hedge against DeFi risks, on the other side, risk-seeking investors can earn a premium by offering protection to others.
Opyn is built using Convexity, an Ethereum-based protocol that allows DeFi users to create put and call options. In traditional finance, put options work as insurance. A put option gives the buyer the right to sell a particular asset at a specified price (called an exercise price) on or before a set “expiry” date. This means that no matter how low a stock's price goes, the investor has the right to sell the stock for the agreed upon price. Similarly, Convexity uses put options to provide option buyers insurance on their crypto assets.
Convexity allows options sellers to earn premiums on their collateral and allows options buyers to protect themselves against technical, financial, and systemic risks in DeFi.
D: You mentioned hedging against DeFi risks. What are the main risks an investor should be aware of before investing using DeFi applications?
Z: The current DeFi ecosystem faces 3 main categories of risks: technical, financial, and systemic.
Systemic Risk: I see this risk as the one with the biggest impact in the current ecosystem.
Most of the DeFi applications or protocols rely on the price of Ether. If the ETH price drops to an unexpected level, that could cause a domino effect on the entire ecosystem. For example, in this scenario the DAI would be under collateralized, and most DeFi protocols rely on the supply of DAI. In the same scenario, Uniswap’s pools will produce impermanent losses to liquidity providers. Many DeFi protocols and applications could be negatively impacted by such scenario. This is similar to what we saw on Black Thursday.
In the same category, we can include the Oracle risks. Oracles have a crucial role in many DeFi applications, as they provide outside data to the blockchain. Many applications rely on the same oracles, and some oracles are also even connected between each other. Having a reliable network of oracles is crucial to reduce the systemic risk.
Lastly, there might be a regulatory risk. This seems to be one of the hardest risks to predict so far, but this risk could definitely impact the whole DeFi market.
Technical risks: DeFi is still in a very early phase and technologies are not yet mature, this could lead to hacks, or technical limitations that can impact DeFi applications.
This could happen at the consensus layer, for example, if there is a hard fork like the DAO, no one can say for sure how DeFi would react.
Also there is a risk of a hack or vulnerabilities in smart contracts, even though the ecosystem is improving and best practices and code audits are making the applications less vulnerable.
Financial risks: Liquidity risks are some of the most dangerous for many DeFi applications.
DAI liquidity is an example of the aboveFor example if DAI liquidity is too low the price of DAI could depeg, drifting to above 1USD, leading to potential issues in protocols that rely on DAI’s stability. This risk was also illuminated further on Black Thursday
D: I know you love traditional finance theories. Here is the main one about risks:
In 1952 the Economist Harry Markowitz introduced the Modern Portfolio Theory studying the effects of asset risk, return, correlation and diversification on probable investment portfolio returns.
The Modern Portfolio Theory assumes that investors are risk averse, meaning that given two portfolios that offer the same expected return, investors will prefer the less risky one. Thus, an investor will take on increased risk only if compensated by higher expected returns. Conversely, an investor who wants higher expected returns must accept more risk.
In your view, do current DeFi returns compensate for the actual DeFi risk?
Z: That is a fascinating concept.
For example, If today I put DAI in Compound I can get a 0.8% return, with a very high risk (for the reason mentioned above). It’s likely that the risks of USD high yield saving accounts are lower and the higher risks on chain seems not to be reflected in the difference in returns.
However holding DAI through Compound, in the case that ETH price drops, enables the investor to liquidate people, basically there is a liquidity premium on that DAI. This expected premium and higher returns could compensate for the higher risk.
We should also mention that modern portfolio theory does not handle derivatives super well. This theory is made mainly for stocks and bonds, while in the derivatives world we think about risk-neutral pricing because all risks can be perfectly hedged. Beyond just that, it doesn’t deal with questions of liquidity super well, nor does it incorporate the findings of behavioral finance.
That being said, I think we’re going to see the efficiency of DeFi markets increase as more and more intelligent people join the field. It’s going to be super exciting to see what DeFi looks like as it matures!
I really appreciated discussing DeFi risks with Zubin. I strongly believe that the whole ecosystem needs to be aware of these risks in order to grow. A risk management layer like Opyn is the first step to better let users handle the risks.
We are going to publish a part 2 of the interview in the next weeks. If you have any questions you’d like to ask Zubin, let me know, or feel free to join Opyn’s discord.
In the meantime stay healthy and keep your investment healthy.
Best
Daniele
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This post is not an investment advice. It is strictly informative with educational purpose. It is not a solicitation to buy or sell any assets or to make any financial decisions.