Introduction to DeFi Liquidity risk

Economics Design

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One major category of risk exposures for the defi industry is liquidity risk. In traditional finance, liquidity risk often refers to the uncertainty in a business’s ability to cash out assets. In defi, we define the term liquidity risk differently as risks associated with the primary market.

The liquidity risk can be seen as a composite of systematic and idiosyncratic risk, as it can be significantly affected by market and user activities. However, it can also be managed and controlled by the protocol to some extent. This includes changes in liquidity between tokens and other assets (including other tokens and the fiat currency), and uncertainties from depth of liquidity pools. Depending on the type of defi, such uncertainties may result in unwanted variations of token prices, overly high transaction costs and limitations in executing trades. In this article, we will discuss what liquidity risks are, how they can arise from multiple areas and their impact on defi protocols in the long term.

Lending and borrowing type of DeFi

For defi providing lending and borrowing services, users take up loans in forms of tokens of a particular defi upon depositing other assets as collaterals. For this type of defi, liquidity risk mainly lies within changes in liquidity between the token used for loan distribution and different assets, which may inherently affect market price and demand of the token. In situations where the loaned token faces unexpected regulations and restrictions in usage, liquidity of the token is likely to decrease with the reduced use cases. This triggers a decrease in the token’s demand and market price, which would affect operation of the defi in the long term.

Meanwhile, liquidity risk can also arise from the underlying assets of these tokens. During market downturns where asset prices generally experience large falls within a short timespan, liquidity of assets at each price level is likely to decrease as there is less demand for the asset. If demand is not being restored in time, it would potentially exert even more downward pressure on price as people are eager to move out of their positions. This would cause the total value of collateral assets deposited in these defi to decrease as well. In the more severe cases where value of collaterals falls below the minimum required rate to keep accounts active, forced liquidation would be triggered.

In addition, for defi that issue loans in forms of stablecoins upon collection of other assets as collaterals, there is also the common problem of liquidity mismatch, where liquidity of the token’s held assets and liabilities are different. During the token redemption process, users are expected to pay back loans and borrowing fees to get back assets deposited previously. However, given the high price volatility of these assets, their liquidity may have changed during the period of borrowing. This forms a risk for the defi protocol, as it needs to ensure the ability to return these assets. This type of liquidity risk is usually difficult to mitigate, as liquidity between cash and assets are affected by many factors that are out of the protocol’s control, and the digital asset collaterals deposited are usually only saved with no active management.

What Else Did You Miss?

• Trading type of DeFi

• Suggestions on measuring liquidity risk

• Conclusion

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