Decentralized finance (DeFi) has been one of the areas of crypto most affected during the recent market downturn. From the collapse of Anchor and other DeFi protocols in the Terra network to the constant pressure in LIDO and stEth as well as the insolvency of large asset managers that were active in different protocols, there have been many events that have challenged DeFi’s entire value proposition.
Unsurprisingly, the total value locked in DeFi protocols has shrunk about 70% from its all-time high to $74 billion today and the native yields in DeFi protocols have contracted significantly. These recent shocks have drastically changed the composition of the DeFi market and the nature of alpha (above-market returns) and risk in DeFi protocols. In this article, we outline a framework for the evolution of alpha and risk management in the next phase of the DeFi market.
Jesus Rodriguez is the CEO of IntoTheBlock, a blockchain analytics provider. This article is excerpted from The Node, CoinDesk's daily roundup of the most pivotal stories in blockchain and crypto news. You can subscribe to get the full newsletter here.
Easy yields were the main narrative of the 2020-2022 rally in DeFi. An overleveraged environment for stablecoins as well as aggressive incentive programs enabled traders to capture astronomical yields without the need for sophisticated financial logic. The ease of generating alpha also induced a lack of attention to risk management mechanisms. The nature of DeFi has changed and the balance between alpha and risk in DeFi has drastically shifted.
The risk-return balance in traditional markets
Returns and risk are the core foundation of investment strategies in traditional capital markets. From a financial return perspective, most markets can be considered “efficiently inefficient” to use an adaptation of the Efficient Market Hypothesis proposed by Eugene Fama in the 1970s. While there is plenty of alpha in traditional markets, sophisticated strategies are needed to identify and capture it. Traditional markets rely on intermediaries and strong regulatory frameworks to prevent asymmetric risk conditions. Simple metrics such as value at risk (VaR) have been widely accepted as a way to quantify potential losses in a portfolio. Quantifying risk with such a simple statistical metric is only possible because traditional markets assume the existence of a robust enough infrastructure to prevent massive systemic risk. While scarce high returns and managed risk are the norm in traditional capital markets, the picture in DeFi is quite different.
The evolution of alpha and risk in DeFi
DeFi is a novel and highly inefficient financial environment whose basic building blocks, or primitives, resemble products in traditional capital markets. As a result, there are plenty of opportunities for capturing alpha and different dimensions of risk. However, in the first phase of the market, the returns were way too easy and the risks way too high. The change in composition of the DeFi space is starting to alter the relationship between risks and returns in a trajectory that is closer to other financial markets. From an evolutionary perspective, we can see three main stages in the dynamics between risk and returns in DeFi.
Phase 1: An abundance of high returns and complex risk management
The first phase in the evolution of DeFi has been characterized by relatively easy-to-capture yields and extremely obscure risks related to DeFi protocols. The proliferation of incentive programs in DeFi protocols, the leverage in stablecoins and increasing trading activity made easy yields the norm of this phase. An environment in which simple liquidity provision trades in automated market makers (AMM) or leveraged lending trades in lending protocols could consistently yield above 15%-20% obviously attracted a lot of traders and speculators, which contributed to the hype cycle of the first phase of DeFi.
The high yields of the first DeFi rush were accompanied by massive vulnerabilities and risk exposure. The complexity of many DeFi protocols opened the door to significant technical and economic hazards that are hard to mitigate. Most participants in DeFi are familiar with smart contract risk that has resulted in major exploits in protocols. However, economic risks such as whale manipulation attacks or impermanent loss cost investors millions of dollars in losses daily. The mechanisms for managing and controlling those risks are complex and require deep understanding of the technical and economic behavior of DeFi protocols. Consequently, the vast majority of trades in DeFi protocols are executed without proper risk management routines which often translates into sizable losses.
Phase 2: Scarcity of high returns and complex risk management
The recent change in the DeFi market has directly caused a contraction in the first-order yields produced by protocols. It is hard to find protocols that produce double-digit returns based on simple liquidity provision trades. However, there are still plenty of high-alpha opportunities in DeFi as the market remains one of the most inefficient environments in any asset class. Identifying most of the high-return opportunities requires more sophisticated views about the market via complex financial logic that often combines different protocols.
While capturing high returns in DeFi protocols has become more complex, risk management remains equally difficult. The correction in the DeFi space has been too quick for risk management processes to adapt. Furthermore, the increase in complexity of DeFi strategies translates into a broader range of vulnerabilities that requires more sophisticated risk management models.
Scarcity of easy high-alpha returns together with high economic risks is likely to limit the adoption of DeFi protocols to more sophisticated institutional investors and traders instead of retail investors.
Phase 3: Scarcity of high returns and simpler risk management
DeFi is not going to remain a risky environment forever. As the market evolves, it is expected that protocols will start incorporating native risk management capabilities to streamline their adoption. We are already seeing incipient ideas in this area with protocols like Bancor, Euler, Maker incorporating mechanisms for natively managing intrinsic economic risk. For example, we can imagine a next-generation AMM that automatically insures against impermanent loss or a lending protocol that better protects against liquidations. Even though some of these initial built-in risk management models have been challenged under stressful market conditions, the value of risk management as a native protocol capability remains compelling.
If DeFi protocols start natively managing common risk conditions, it would directly simplify risk management for investors, traders and other market participants because they would only have to focus on more elaborate forms of risk. This new risk-return composition of the DeFi market closely resembles traditional capital markets in which high-alpha returns are difficult to achieve but a significant portion of risk management is built into the market infrastructure.
The era of easy yields in DeFi is over
Recent market events have drastically changed the balance between high returns and risk in the DeFi space. As DeFi evolves, high yields powered by incentive programs will transition from being the norm to an exception. The asymmetry of DeFi will still provide opportunities for great returns but those would come in the form of sophisticated financial strategies. Similarly, risk management is likely to become simpler as DeFi protocols and other components of the infrastructure enable native protection against known economic risks.
From that perspective, the era of easy yields in DeFi is likely over but the new phases of the DeFi market promise a more mature economic structure and equally appealing opportunities.