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Explore and Identify the Risks Related to DeFi Lending Protocols

Explore the world of DeFi lending protocols—secure loans with digital assets, earn interest, and navigate risks. Safeguard your crypto assets with insightful precautionary measures.

ShahZaib Ahmed

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DeFi lending protocols guide article

DeFi Lending Protocols: An Overview

DeFi (Decentralized Finance) lending protocols are DeFi platforms which enable users to lend and borrow cryptocurrencies with intermediaries like the central banks. With these DeFi lending protocols, one can secure a loan by holding their digital assets as collateral. Such collateral is held under the secure protocols and returned to the owner after the repayment of the loan. Moreover, crypto holders can also earn interest by lending their cryptocurrencies to borrowers on the DeFi platform.

With the significant rise in the crypto industry, many people are shifting their financial paradigm to Decentralized Finance (DeFi). Following such a suit, many hackers and scammers have also lured the people and rolled out the funds of crypto users. The crypto community needs to understand how they can manage and secure their digital assets at different levels. This article aims to explore and enlighten crypto users about the rising risks associated with DeFi lending protocols and the precautionary measures.

Why Strive For Risk Management in DeFi Lending Protocols?

Efficient control and management is the crucial part of any financial field. As many people are taking an interest in Decentralized Finance (DeFi), they need to have sufficient information about the field in which they are penetrating. 

DeFi has been evidence of many security breaches, hacks and scams during the last couple of years. Therefore, the crypto community needs to be aware of such activities and the precautionary measures to protect their digital assets and associated risks. Moreover, it has been proven that risk management is a crucial element for the growth of the DeFi sector and crypto users. 

Important Indicators to Minimize the Risk Factor in DeFi Lending Protocols

Most of the attacks in the Decentralized Finance (DeFi) have been caused due to technical issues that resulted in significant financial losses. However, there are certain indicators which can help to prevent such loss are discussed below;

defi lending protocol indicators

Liquidation Indicators

Liquidations are of prime importance in terms of DeFi protocols as they aid in maintaining the stability and wellness of the lending platforms. As discussed before, users use their digital assets in DeFi lending to hold as collateral to secure loans. When the collateral value falls below the threshold point, the position of the borrower becomes uncollateralized.

To prevent that from happening, DeFi lending protocols automatically liquidate the uncollateralized positions. Moreover, lending protocols immediately sell the collateral in the open market to repay the loan. This process is carried out by the independent liquidators residing in the crypto ecosystem. Such liquidation indicators ensure that the deposits of the lenders are secure and solve the platform’s solvency. Moreover, these indicators help in mitigating the risk factors in the DeFi lending protocols.

Borrowing Indicators

Borrowing is a crucial activity when it comes to assessing the growth and current health of any particular DeFi lending protocol. Generally, more borrowing indicates a higher demand for credit and vice versa and this could boost the growth of lending protocol. 

Also Read: Decentralized Finance (DeFi) Surges and Hits New Yearly TVL Peak in 2023

Careful management of the borrowing activities can enable us to have control over risks and enable the protocol to identify the potential issues regarding the over-reliance on the borrower or any single digital asset. 

In short, lending protocols keep the overall borrowing record and adjust its policies and strategies to ensure safety and security by minimizing the associated risks. 

Lending Indicators

The indicator of Net Liquidity monitors the overall flows i.e., net flows, inflows and outflows of the liquidity into and out of the protocols. Leading indicators help to point out the vectors capable of liquidity risk prompting actions among the users of the lending protocols. 

For example, if a user is withdrawing maximum or whole funds out of the platform, he might be concerned about the security and safety of the protocol which ultimately is responsible for the crises of the protocol. But, on the other hand, it is a positive sign for the safety of the protocol, if someone inflows a high amount of funds.

This metric is very useful in providing information to spot the potential risks to the protocol. Moreover, it also adjusts its strategies to protect itself.

Leverage Indicators

In general lending strategies in which a user borrows digital assets, and resupply that asset to a lending side to potentially again borrow are known as the recursive lending strategies. By doing so, they rehypothecate the debt of the protocol. This kind of strategy has been widely used in Decentralized Finance (DeFi) to earn greater profits on the held assets. So, this kind of activity is more prone to risks and requires constant monitoring for safe and secure liquidation.

Having sufficient knowledge about recursive lending can be beneficial for the stability of the protocol and potential benefits in DeFi lending protocols. Moreover. It also guides about the potential incentives to attract maximum depositors. Collectively, it helps to assess the lending protocols efficiently. 

Health Factor Distribution Indicators

Health factor distribution indicators help to track the position of protocol closer to liquidation. If the factor is below one, that means the borrower can suffer from loss on liquidation. These factors are also helpful in providing information about the borrower’s share within health factors apart from the loans and about the range of the borrowers of the protocol. 

Also Read: What is DeFi? A Complete Guide to Decentralized Finance for Beginners

This indicator is beneficial for both liquidators and borrowers. If you look for a risky loan, that might benefit the liquidators but isn’t in the favor of the borrower during the market swings. Health factor distribution suggests a diversified loan to minimize the chances of massive liquidation over DeFi lending protocols.

Keep Track Of the Whales

The most significant point for the lenders and the borrowers is to keep an on the whale activities in the crypto market. Whales control and set the market trends and the supply of digital assets in the market. By following the crypto giants, one can minimize the risk factors and be on the safe side when it comes to DeFi lending.

Be Cautious of Risks Associated With DeFi Lending Protocols

Decentralized Finance (DeFi) is flourishing day by day and so is the case with the associated risks. If you want to minimize the risks and maximize profit, you are advised to carefully read the article and keep the indicators in mind while employing DeFi lending protocols. 

There are certain things which you should keep in mind to avoid the potential risks;

  • Do complete research about the lending protocol like its origin, history and currency reputation in the market
  • Do not inflow large amounts at the start
  • Diversify your investments
  • Stay informed about the current trends in the market
  • Adopt preventive measures in the DeFi lending protocols
  • Be mindful of the High-Yield traps

Concluding Remarks

DeFi lending protocols have eased lending and borrowing over decentralized platforms with the interference of the central banks or regulating authorities. Although people are making maximum profits by doing so in some cases, people have suffered a lot due to the lack of awareness.

With the rise in the crypto space, scammers and hackers have bluffed the people and rolled out millions under the veil of maximum interest and profits. So, one should get much awareness before entering into the web3 and DeFi space and begin with small investments.  DeFi lending protocols can be useful in minimizing the risk factors if you know how to understand and manage them well.

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