Tom Dunleavy: Proper risk assessment in DeFi requires disaggregating risk premia, inflated yields mislead investors, and curators play a key role in managing collateral markets | Unchained

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Key takeaways

Proper risk assessment in DeFi requires breaking down risk premia based on various factors.
DeFi yields are often inflated due to subsidization, not reflecting true market conditions.
Curators manage collateral markets by segmenting risk based on liquidity and credit profiles.
DeFi can isolate risk through primitives like Morfo, aiding in pricing and risk allocation.
The framework for assessing risk in DeFi involves understanding loss given defaults and assigning individual risk premiums.
Crypto lacks legal safeguards, leading to rapid and significant consequences when issues arise.
Smaller, more manageable primitives in DeFi can enhance transparency and reduce risk.
Risk assessment in DeFi involves multiple layers, including expected losses from hacks and exploits.
Recovery rates in broader DeFi are significantly lower than in specific pools, with minimal recovery from exploits.
New risks such as rehypothecation and collateral risks from exotic composability are becoming significant in DeFi.
Understanding the differences in risk management between traditional finance and DeFi is crucial.
DeFi should focus on improving transparency and simplicity in its systems to better manage risk.

Guest intro

Tom Dunleavy is head of venture at Varys Capital. He calculated that fair risk-adjusted DeFi yields should sit around 12.5% following $606 million in exploits. His analysis challenges whether current lending rates for blue-chip collateral adequately compensate for DeFi-specific risks.

Disaggregating risk in DeFi lending

The correct pricing of risk in DeFi lending should involve disaggregating risk premia based on various factors.

— Tom Dunleavy
Disaggregating risk premia can improve yield assessments in DeFi.
I saw the hack and I said you know it it’s it’s obvious to me at least that we’re not assigning risk premia correctly.

— Tom Dunleavy
Understanding risk assessment in DeFi is crucial for comparing it to traditional finance.
Why don’t we disaggregate that and step through what the correct risk premia in my view potentially could be based on some level of data that we’ve seen.

— Tom Dunleavy
Proper risk assessment can lead to fairer compensation for lenders in DeFi.
The insight provides a framework for evaluating risk in DeFi.
Disaggregating risk premia is essential for improving market stability.

The issue of inflated DeFi yields

DeFi yields are often artificially inflated through subsidization rather than reflecting true market conditions.

— Tom Dunleavy
Subsidization affects investor expectations and market stability in DeFi.
If they were higher it was generally because there was some subsidization with points or other mechanisms.

— Tom Dunleavy
Understanding how yields are determined in DeFi is crucial for investors.
We would classify as maybe not true yield for the underlying asset.

— Tom Dunleavy
Inflated yields can mislead investors about the true profitability of DeFi investments.
The claim highlights a significant issue affecting DeFi’s credibility.
Proper yield assessment is necessary for sustainable growth in the DeFi space.

Curators’ role in managing collateral markets

Curators manage collateral markets by segmenting risk based on liquidity and credit profiles.

— Tom Dunleavy
Curators play a crucial role in risk management within DeFi.
One of our main responsibilities is to underwrite the collateral markets that we expose the vaults to.

— Tom Dunleavy
Understanding liquidity is essential for effective risk assessment in collateral markets.
Larger assets with better credit risk profiles we would call prime.

— Tom Dunleavy
Curators segment risk to manage different types of assets effectively.
Longer tail or less liquid assets with an element of credit risk we would call high yield.

— Tom Dunleavy
This insight provides a clear explanation of curators’ operational framework.

Risk isolation through DeFi primitives

DeFi can isolate risk through primitives like Morfo, which aids in pricing and risk allocation.

— Tom Dunleavy
Risk isolation improves risk management compared to traditional finance.
Primitives like Morfo allow isolation of risk, making it easier to price that risk.

— Tom Dunleavy
Understanding risk isolation is crucial for evaluating DeFi’s financial dynamics.
This actually makes it easier to price that risk and to allocate accordingly.

— Tom Dunleavy
DeFi mechanisms like Morfo enhance the accuracy of risk allocation.
Risk isolation can lead to more accurate pricing in DeFi.
This insight highlights the benefits of specific DeFi mechanisms for risk management.

Framework for assessing risk in DeFi

The framework for assessing risk in DeFi involves understanding loss given defaults and assigning individual risk premiums.

— Tom Dunleavy
Understanding loss given defaults is crucial for evaluating DeFi risk.
The framework is loss given default and how often these are going to default.

— Tom Dunleavy
Assigning individual risk premiums helps in accurate risk assessment.
Depending on what you’re looking at

— Tom Dunleavy
Comparing DeFi risk assessment to traditional finance provides valuable insights.
This framework is essential for understanding DeFi’s financial dynamics.
Proper risk assessment can lead to better yield optimization in DeFi.

The rapid consequences of crypto’s lack of legal safeguards

Crypto lacks the legal safeguards present in traditional finance, leading to rapid and significant consequences when issues arise.

— Tom Dunleavy
The absence of legal safeguards differentiates crypto from traditional finance.
Crypto doesn’t have that dependency because you depend on the settlement layer.

— Tom Dunleavy
Quick finalization of transactions can lead to rapid consequences in crypto.
If something goes wrong it goes wrong big and immediately.

— Tom Dunleavy
Understanding these differences is crucial for managing risk in crypto.
It propagates extremely fast.

— Tom Dunleavy
This insight highlights a critical risk factor in the crypto space.
The lack of legal safeguards can lead to significant challenges in crypto.

Enhancing transparency and reducing risk in DeFi

DeFi should focus on smaller, more manageable primitives to enhance transparency and reduce risk.

— Tom Dunleavy
Smaller primitives can improve transparency in DeFi systems.
Having primitives that are smaller in surface more difficult to manipulate.

— Tom Dunleavy
Simplicity in DeFi systems can lead to better risk management.
Do fewer things but just consistently and better.

— Tom Dunleavy
Transparent pricing around risk is essential for DeFi’s growth.
That allows is actually more transparent pricing around risk.

— Tom Dunleavy
This opinion provides a strategic viewpoint on improving DeFi systems.
Focusing on simplicity and transparency can enhance DeFi’s credibility.

Quantifying risk in DeFi lending

The risk assessment in DeFi involves multiple layers, including expected losses from hacks and exploits.

— Tom Dunleavy
Understanding expected losses is crucial for DeFi risk assessment.
You start with that risk free rate and then you add on let’s call it technical expected loss.

— Tom Dunleavy
Hacks and exploits contribute to increasing default rates in DeFi.
Historically it’s been about point five to unfortunately this year we’re looking to towards a 2% annualized rate on default.

— Tom Dunleavy
Quantifying risk is essential for managing DeFi lending effectively.
This insight highlights the components of risk assessment in DeFi.
Understanding risk layers can lead to better yield optimization in DeFi.

Recovery rates and new risks in DeFi

The recovery rate in broader DeFi is significantly lower than in specific pools, with many exploits resulting in minimal recovery.

— Tom Dunleavy
Recovery rates vary significantly across different DeFi pools.
Recovery rate… in broader defi that’s actually not the case right.

— Tom Dunleavy
Minimal recovery from exploits highlights a critical issue in DeFi.
North Korea is not returning anything and then you have whitehat and others who maybe return 10 to 20% historically.

— Tom Dunleavy
Understanding recovery rates is essential for evaluating DeFi risks.
New risks such as rehypothecation and collateral risks from exotic composability are becoming increasingly significant in DeFi.

— Tom Dunleavy
Emerging risks could impact the stability and security of DeFi protocols.
There are a few new risks which we’re starting to appreciate right now.

— Tom Dunleavy
Identifying new risks is crucial for stakeholders in the DeFi space.