Protecting yourself from DeFi Risk 🛡 (Part 2)
In the previous part, we explained the borrowing risk in DeFi and how few people understand it well. The idea is not just to understand it, but actually, protect yourself from that risk. In simple words, while the fire burns the house, ensure you have a safe home that you can go to when the time arrives! But, before that let’s understand why is managing risk is so difficult.
Picture courtesy: Blockchain Simplified
Why does it matter?
A trust-minimized model: There is no simple exchange to yield farm*; only smart contracts built on ETH with a user-friendly UI. You operate on a trust-minimized model. However, not everyone is savvy to understand or read a smart contract.Â
Lack of tooling: There are not many tools (although this is rapidly developing) to monitor price charts, long/short ratios or an order book to see the activity.Â
Interpreting data: There is the transparency of all trades on-chain, but it's challenging to visualize and interpret it. This is partly because of the lack of tooling.
All of this is so new that the one who develops some tooling around it can be rewarded well by users. There are few tools such as dune, nansen, ChartEx pro, dex tools etc that allow you to do some of those things, but they have their shortcomings.
Now, one easy way to mitigate some of this risk is to use stablecoins (digital assets that are expected to maintain a peg of $1). However, there is a downside to missing out on the upside of volatile assets such as ETH, or BTC, and this is psychologically a more significant loss to deal with yourself.
Now, those aren’t the only risks that you are taking on. There are few other risks such as smart contract risk, exit scam risk, impermanent loss, and others.
Need for protection
Now that you understand some risks, we need to protect ourselves from the downside. This is where insurance comes into the picture. Insurance as a concept is simple. You pay a certain fee (premium) to protect yourself from the downside.
To insure yourself from smart contract and similar protocol risk, you can take an insurance cover for the protocol on Nexus Mutual (KYC required)
Nexus mutual is a community-powered insurance pool that protects you from a smart contract failure, thereby protecting your downside.
If you do not like KYC, then you choose to find non-fungible token (NFT) insurance, for example, this 10 ETH insurance for Balancer pool
NFT are an excellent way to sell a claim you no longer require, and they help increase compostability in the whole ecosystem
To insure yourself from all the Liquidity provider pools on Uniswap, balancer, etc, you can buy cover from Yinsure. Â
These are mostly to protect your downside; however, say you are trying to avoid the volatility of the asset and buy stablecoins. How do you get exposure to the upside as well? Because psychologically missing out on any upside is a loss.
Enter options. They are traditionally used as a hedge for your underlying assets and offers both downside (puts) and upside (calls) exposure. Insurance, however, is limited to only the downside.
Opyn offers you a chance to gain the upside on ETH. It also offers downside protection for ETH and COMP.Â
There are few other platforms such as Hegic, Auctus that offer options for assets such as ETH, YFI, SNX, WBTC and others.Â
Defi_Dad has a great tutorial for using Hegic.
The Big Picture
Your primary goal should always be to first preserve your capital, and secondary should be to make money. One bad call and you can lose it all. Hence, always hedge yourself by protecting your downside or upside. Live another day to ride the wave while it lasts!
Until next time…