DeFi Lenders Want Yield – But They Also Want Risk Control

Throughout history, eccentric individuals have pushed the boundaries of human courage, driven by a compulsion to challenge nature and upend societal norms. In the early 19th century, for example, Rhode Island mill worker Sam Patch became America’s first celebrity daredevil by transforming cliff-jumping into a public spectacle.

His 1827 leap from an 80-foot cliff over New Jersey’s Passaic Falls earned him the nickname “Jersey Jumper,” and was followed by a 125-foot plunge into the Niagara River below the famous Falls as thousands watched. Sam Patch didn’t live long enough to witness the birth of electricity, the internet, and blockchain, but if he had, there’s a good chance he’d have taken to DeFi like, well, a cliff-jumper to water.

The “R” Word

We don’t often talk about risk in DeFi these days. At least not directly. Like so much else, it’s largely been abstracted away. Everyone wants to see the swan gliding across the lake – the beautiful UX, aesthetically pleasing interface design, and neat yield-adjustment sliders. No one wants to see the feet scrabbling in the silt beneath the surface: the frantic attempts to keep hackers at bay, exploiters away, and risk within reasonable parameters.

Yet it’s there all right, underpinning everything that goes on across the DeFi landscape. Most of the time, the risk is covert: we know it’s out there, but by avoiding talk of it, we hope it will never strike. But it’s only through facing risk head-on – identifying it, discussing it, and evaluating it – that we can take measures to mitigate it. So let’s talk DeFi risk, particularly in the context of lending, given its role in powering much of the subsequent activity that takes place across the omnichain landscape.

Riding the Risk Rollercoaster

Why do DeFi lenders lend? Is it out of altruism? A desire to bank the unbanked? A need to flex onchain? No, it’s for pecuniary advantage. Money. Profit, pure and simple. The greater the reward, the greater the incentive to provide capital to borrowers. This isn’t a DeFi lending invention, of course: this principle guides all two-sided marketplaces and has done so since the dawn of human societies.

As for why lenders should be entitled to rewards, well, that part should also be obvious. Every time they put up capital, there’s a chance they won’t get all of it back. It’s an extremely small chance, but it’s a chance nonetheless. While borrowers technically can’t default in DeFi, since everything’s controlled by smart contracts, there are still umpteen other ways in which things can go wrong, from protocol bugs to hacks.

Basically, every time you lend your crypto assets – or place your own as collateral to borrow against – you’re taking on risk, and should be entitled to some kind of reward in return. Indeed, were the prospect of yield not in place, the entire DeFi lending economy would collapse as users went elsewhere in search of more productive places to deploy their capital.

Onchain lending is a multi-billion-dollar sector that generates $2M in fees a day – much of which goes to lenders whose liquidity keeps the market ticking over. It’s not just an important component of DeFi – it is DeFi, since without a healthy lending economy, much of the other onchain markets and yield sources would dry up. That high-yield stablecoin you’re staking? Half of its APR comes from lending markets. That leveraged ETH token you’re trading? Yep, that too. If DeFi is the dog, lending is the tail that wags it.

To keep lending markets liquid, protocols must wrestle with some tough choices. Yield needs to be attractive enough to coax capital, but there also needs to be fail-safes in place to protect those assets from contagion, should a particular pool encounter problems, be it with the underlying token or due to an external attack.

To maintain this equilibrium, the industry is increasingly moving towards adopting isolated lending markets, which keep such issues contained and incapable of causing wider problems. The model, popularized by Silo, has resonated with DeFi users, both at retail and institutional level. It’s an idea that’s been a long time in the making, given that the first wave of lending protocols – many still operational – have relied on a system in which losses are shared, regardless of which pool the issue originated from.

More Yield, Less YOLO

Anyone who was around during the first wave of DeFi, starting from 2020, will recall these two words with horror or nostalgia, depending on how they fared: “Pool two.” For the uninitiated, when yield farming first became a thing, Pool 2 was the highly volatile pool that offered eye-wateringly high APYs but was unsustainable. The trick was to get in early, earn 10,000% APY in a matter of hours or less, and then get out before the whole thing went to zero.

It all sounds stupid looking back on it now, but this speculative environment, characterized by food coins and “humble farmers” doing “honest work,” was the prelude to the sustainable onchain yield products we see today. The days of liquidity pools dispensing five-figure APYs are mercifully gone, but that’s not to say that the volatility has been quelled. Indeed, volatility remains a crypto feature – not a bug – and thus protocol designers must take into account sudden and violent price movement of assets and the effect this could have on other tokens they’re pooled with.

This can be particularly challenging when it comes to lending. Should a token crater in price – a rare but not unknown phenomenon – it can cause system-wide insolvency issues. Protocol users who have steered clear of these riskier assets may find themselves nevertheless on the hook for losses that are shared by all users, regardless of whether they’re in a high-volatility, high-risk pool or a low-risk stablecoin or ETH/stable option.

Risk Meets Reward

Many DeFi users are perfectly willing to take on risk. Indeed, if there were zero risk involved, everyone would be doing it, and the yield would approach zero. That’s not to say that risk should be encouraged; rather acknowledged as a side-effect of interacting with what is still experimental tech that can never be rendered 100% secure and immune from every conceivable attack vector. Even the most impregnable lending protocol can’t do anything to prevent a collateral asset from crashing.

The solution, from a developer perspective, isn’t to shrug and reason “Risk comes with the territory.” It’s to ensure that users can make an informed decision about the risks involved and that they are fairly remunerated for supplying liquidity for higher-risk assets. This is easier said than done, but the industry is at least moving in the right direction here. With V2 of its protocol, for instance, Silo supports modular interest rates, which can be raised, for example, to compensate lenders against more volatile tokens. As a result, lenders can receive better interest rates to reflect the additional risk they’re taking on.

Sam Patch – the 19th-century daredevil we were discussing at the outset – would have been a Pool 2 kinda guy. The riskier the better, as far as he was concerned. Tragically, his November 1829 leap into a river ended in disaster. Still, his legend lives on: Patch’s career, lasting just two years, inspired folk songs and even caught the attention of President Andrew Jackson, who named a horse after him. His story embodies the unpolished daring of early American entertainers, who risked everything for glory with no safety net.

Today’s DeFi users aren’t risking life or limb – simply their net worth – but that doesn’t make the prospect of loss any less painful. Thankfully, the likelihood of such users suffering a fatal L has diminished greatly over the years. And it’s thanks in no small part to enterprising protocols that have devised smarter ways to segregate risk, resulting in a safer onchain playground for everyone. 

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