One of the areas of crypto most adversely hit by the recent market collapse has been decentralised finance (DeFi). From the demise of Anchor and other DeFi protocols in the Terra network to the constant pressure in LIDO and stEth as well as the bankruptcies 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 dropped by almost 70% from its all-time high to $74 billion today, and native yields in DeFi protocols have contracted dramatically. These recent shocks have drastically changed the composition of the DeFi market as well as the nature of alpha (above-market returns) and risk in DeFi protocols. In this article, we outline a framework for the future development of alpha and risk management in the next phase of the DeFi market.
Easy yields were the main narrative of the 2020-2022 rally in DeFi. An overleveraged environment for stablecoins, combined with aggressive incentive programmes, allowed traders to capture astronomical yields without the need for sophisticated financial logic. The ease of generating alpha also led to a lack of attention to risk management mechanisms. Now that the nature of DeFi has changed, the balance between alpha and risk in DeFi has also drastically shifted.
The risk-return balance in traditional markets
Returns and risk are the fundamental building blocks 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 robust regulatory structures to prevent asymmetric risk conditions. Simple metrics such as value at risk (VaR) have gained widespread acceptance as a means of quantifying 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. Unlike traditional capital markets, where scarce high returns and managed risk are the norm, 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 fundamental building blocks, or primitives, are similar to products in traditional capital markets. Hence, there are plenty of opportunities for capturing alpha and different dimensions of risk. However, in the early stages of the market, the rewards were way too easy and the risks way too high. Changes in the DeFi space’s composition are starting to shift the relationship between risks and returns in a trajectory that is closer to other financial markets. From an evolutionary perspective, there are three major stages in the dynamics between risk and returns in DeFi.
Phase 1: An abundance of high returns and complex risk management
The initial phase of the evolution of DeFi was characterised by relatively easy-to-capture yields and extremely obscure risks related to DeFi protocols. The proliferation of incentive programmes in DeFi protocols, the leverage in stablecoins, and increased trading activity have made easy yields the norm in 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 drew a lot of traders and speculators, contributing to the hype cycle of the initial 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 has opened the door to significant technical and economic hazards that are hard to mitigate. Most DeFi participants 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 complicated and require deep understanding of DeFi protocols’ technical and economic behaviour. As a result, the vast majority of trades in DeFi protocols are executed without effective risk management routines, resulting in significant losses.
Phase 2: Scarcity of high returns and complex risk management
The recent change in the DeFi market has resulted in a decrease in the first-order yields produced by protocols. It is difficult 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 these high-return opportunities will require more sophisticated views about the market.
While capturing high returns in DeFi protocols has become more difficult, risk management remains equally difficult. The rapid correction in the DeFi space, combined with the increase in complexity of DeFi strategies mean there is a broader range of vulnerabilities, requiring more sophisticated risk management models.
Scarcity of easy high-alpha returns, along with high economic risks will 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 begin to incorporate native risk management capabilities to streamline their adoption. Bancor, Euler, Maker are protocols that have already incorporated mechanisms to manage intrinsic economic risk.
We can imagine a next-generation AMM that automatically insures against impermanent loss or a lending protocol that provides enhanced protection against liquidations. While 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 can natively manage common risk conditions, risk management for investors, traders, and other market participants will be significantly simplified because they will only have to focus on more elaborate forms of risk. This new risk-return composition of the DeFi market is similar to traditional capital markets in that high-alpha returns are difficult to capture 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 radically altered the balance between high returns and risk in the DeFi space. High yields powered by incentive programs will become the exception rather than the norm as DeFi evolves. The asymmetry of DeFi will still provide opportunities for great returns, but only through sophisticated financial strategies. Similarly, risk management will 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 upcoming phases of the DeFi market promise a more mature economic structure and equally appealing opportunities.
