Deploying a DeFi Defense in a Bear Market
How to Use Simulations, Benchmarks and other Methods to Weather the Selloff
By: Jordan KrugerOp-ed
It’s no secret that the recent retrenchment in the crypto market has left many — even industry veterans — in a state of shock. In 2022, the term “DeFi Summer” is earning a connotation that is 180 degrees out-of-phase from the heady days that inspired the term just two years ago.
This means that the entire cryptocurrency sector is undergoing stress testing at levels unseen since the COVID-driven crash in March 2020, a time before most DeFi protocols existed. Cascading liquidations continue to crater major crypto assets, with many overleveraged and underwater.
Much of DeFi was built out during the DeFi Summer of 2020 and, therefore, the sector was saddled with many inaccurate, underlying assumptions. So what can we learn from the current environment and what does it take to build sustainable DeFi services?
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The security principle of “defense in depth” comes to mind: The idea of deploying multiple measures to ensure robustness and availability. Too often, the message in DeFi begins and ends with “We’ve been audited!” But there is so much more:
DeFi works when potentially unhealthy activity (debt positions, token peg, yield strategies, etc.) is not passed to the end user. Protocols should actively track, report, and catalog performance and health of assets, pools, strategies, positions, and so on 24/7/365.
In practice, this looks like dashboards with real-time reporting and historical trend documentation, triggering alerts when something of note happens (i.e., when a loan goes underwater). Bonus points for implementing redundancy across this reporting in case certain individual nodes or bots are taken offline.
Automated Rebalances and Servicing:
“Keeper bots” can listen in on these alerts and perform maintenance and upkeep required. In a yield aggregator, this looks like shifting collateral ratios and migrating weight out of unprofitable strategies. In a lending market, this looks like adversarial liquidations that keep debt from going from dangerous to defaulted.
Strategy risk can also be mitigated by an intentional approach to which types of assets interact with one another — what types of loans are taken against which types of collaterals. Some assets are highly correlated, while others are not. For example, one can limit loans to stablecoins and “like” assets (such as ETH collateral; LINK loan) to alleviate any multiplied risk where the collateral may dump while the loan simultaneously pumps.
Conservative Collateral Benchmarks:
The name of the game in DeFi is capital efficiency, but not all strategies to increase efficiency are equal. Collateral rates in lending markets and CDPs must be conservative enough to absorb debt and close positions without incurring losses to the protocol. In a yield aggregator, all strategies that take advantage of loans or leverage should follow generously over-collateralized benchmarks. This insulates strategies from erroneous wicks or flash crashes.
While less true today, many DeFi projects approached auditing as a kind of marketing exercise just as much as a quality-assurance one, mostly to be able to answer in the affirmative if a community member asks the drive-by question “Are you audited?” But there is auditing and there is auditing, and you can’t stop at one. (For what it’s worth, Vesper’s more than two-dozen strategies have been audited more than fifty times altogether, using several auditing firms.)
Why wait for a bear market? Running simulated stress tests in real-time will allow projects to predict any potential liquidation events and better proactively defend pool deposits.
Real-time APY Polling:
Building out on-chain analytics across all protocols allow you to estimate APY in real-time. This helps a DeFi project to more fluidly reroute funds out of low APY strategies immediately when recognized, and for lending markets, diminish “loan arbitrage” with more efficient, dynamic routing of TVL through the deposit and borrow side of these protocols
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Of course, these practices are no panacea — nothing is in DeFi today. But the bear market gives us an opportunity to consider the duty of care that DeFi’s participants have in the decentralized ecosystem we want to build.
For certain, the DeFi experiment has been a thrilling, real-money test of a better way to deliver financial products and services. Just as the reversals of 2000 and 2008 gave us the second age of the web and the first age of crypto, respectively, so too will crypto inherit a stronger and more robust second age coming out of the present moment. This starts with having the right assumptions, putting resilience rather than greed at the center of everything we do.
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