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- Smart Contract Risk - exploits and malfunction
- Asset Risk
- Bridge exploits
- De-peg of stable coins
- Strategy risk (VaR of a given strategy)
For each of these categories we compute a % of value at risk in the span of 1 year. For example, we might find that we are exposed to an average of 1% loss due to smart contract hacks.
The individual values are then summed to produce a total value at risk (or VaR) for a given strategy. The result can also be seen as a fair insurance premium for the strategy. The resulting VaR can then be used to find the risk-adjusted return of a strategy.
An aggregator vault's score is calculated by using the same technique for each of its underlying strategies and weighing each VaR by its strategy's percentage capture of the vault's total TVL.
Finally we convert the total vault or strategy VaR to a 0-10 risk score for intuitive UI display.
Smart contract exploit risk is currently probably the biggest risk for users interacting with DeFi. As a first step we analyze the DeFi exploit data to find an average probability of losing funds. We then gather data about the protocols used in a given strategy. This information may include # of audits, longevity, team etc. This allows us to fine-tune the average probability of loss to specific protocols.
Asset risk, and in particular, bridge hacks and de-pegs are other major DeFi risk factors. We identify exposure to bridged assets and use historical bridge hack data to assess potential losses. De-peg probability is also taken into account when dealing with stable assets.
When strategy borrows funds it is exposed to liquidation risk. Under normal circumstances the strategies mitigate this risk, however in extreme market conditions, such as drastic price moves can lead to liquidations. We analyze asset liquidity and volatility to estimate liquidation risk.
In some instances a strategy may also trigger a cascading liquidation or asset price crash. We model these types of scenarios and monitor the relevant metrics in order to avoid such scenarios.
Strategies that bet on volatility may also require back-tests to analyze value at risk given various market conditions. We use traditional methods to analyze back-test data to estimate the potential losses a strategy may suffer.