Decentralized finance (DeFi) is rapidly evolving, but insufficient transparency, a lack of shared awareness about its risks, and methods to measure and mitigate those risks continue to pose challenges to its users, according to a report by international risk assessment firm Moody’s.
Prepared in cooperation with financial modeling platform Gauntlet, Moody’s analysis identifies three risks typical for traditional lending relationships:
- valuation risk, or changes in the valuation of the loaned funds and the loan amount, including interest;
- opportunity risk, or the likelihood of a more profitable offer appearing in the future;
- counterparty risk which results from informational asymmetry between the borrower and lender who each could have better knowledge of their side of the bargain.
In general, this third gap shows up in two ways — the first being adverse selection. “A company issuing a new bond, for instance, has better insight into its financial and strategic positioning than those buying the bond,” the report said.
They argued that adverse selection in DeFi looks similar, though not identical. On the borrower side, interest rates are public, open source and verifiable, given that lending code exists immutably on the blockchain. On the lending side, due to the current DeFi state, only overcollateralized loans are possible; said the report, adding that:
“Adverse selection largely becomes a function of proper collateral valuation, which is less of a concern with sufficiently liquid collateral.”
The second conflict is principal-agent, and it arises in DeFi through the mismatch in incentives between investors in the platform, such as liquidity providers or lenders, and those who govern it.
MakerDAO, for example, which oversees the stablecoin DAI, uses the competing DAI Savings Rate and platform stability fees as its primary methods to regulate loan supply and demand,…
