You can’t have borrowing without lenders. And you can’t have lenders if there aren’t suitable incentives in place to tempt them to part with their capital. It may sound like enticing lenders to do their thing is simply a case of cranking the APR up to a level to bring sufficient capital onstream to satisfy borrowing demands. And that’s certainly one half of the battle. But the other half, which is easily overlooked, is equally weighty: risk.
Many things in life come down to a matter of balancing risk and rewards, and never is this binary more pronounced than in the context of lending – particularly crypto lending, where the game theory that DeFi frameworks permit creates some intriguing dilemmas that users must wrestle with. The industry also brings into sharp focus the question of who’s responsible for what happens when DeFi lenders get burned, such as through smart contract hack: the user or the protocol?
For philosophers, moralists, developers, and financiers alike, DeFi is the perfect crucible for weighing the risk/reward duality that defines lending.
How Lending Defines DeFi
DeFi has reshaped how crypto holders engage with lending markets, offering unprecedented opportunities for yield through platforms that bypass traditional intermediaries. Yet, beneath the promise of high returns lies a precarious reality: lenders often face risks that are presented far less clearly than the rewards used to lure them in.
From smart contract vulnerabilities to liquidity shocks, the lack of granular control over risk/reward profiles, means that users are forced to take an educated guess every time they entrust their assets to a lending protocol. Because DeFi, lest we forget, doesn’t come with insurance by default. You get hacked onchain, it’s on you. It’s one of many risks that users begrudgingly accept as the price of playing within a high-stakes playground where the rewards are as high as the hazards.
DeFi lending has expanded rapidly over the last five years, driven by retail investors seeking yields far surpassing traditional savings accounts, with up to 15% APY not uncommon. The sector is dominated by protocols like Aave and Compound that pool assets into shared liquidity markets, enabling borrowers to access funds by posting collateral while lenders earn interest. However, this model harbors systemic risks.
Lending, Liquidation, and Taking the L
One recent study notes that DeFi’s reliance on over-collateralization, where borrowers lock up more value than they borrow, mitigates credit risk but exposes lenders to volatility-driven liquidations. If collateral values crash, as seen in the 2022 TerraUSD collapse, entire pools can destabilize, amplifying losses for all participants.
The absence of lender agency compounds the issue. In shared-pool systems, depositing funds means accepting exposure to every asset in the pool, regardless of individual risk tolerance. Even when things don’t go badly wrong, there’s always the potential for them to go mildly wrong, with impermanent loss a constant menace when asset prices shift. meaning lenders may face unrealized losses.
All of which is not to say that DeFi lenders are constantly taking the L – in fact actual losses are few and far between. The issue is that when they do occur they can be catastrophic and for the risk-averse it’s not always easy to gauge the level of risk before entering.
For example, how do you determine which of the audited protocols you’re considering has been audited the best? Or determine which pool weighting is least susceptible to impermanent loss? Calculating reward, in comparison, is a doddle. Risk analysis is a minefield. It also doesn’t follow that higher lending reward correlates with higher risk; there may be a connection, but it’s by no means as simple as playing it safe and plumping for the lower APY. So what’s the solution to the pitfalls of balancing risk/reward management in DeFi lending?
Lowering Risk Without Lowering Rewards
Measuring risk in traditional finance is relatively straightforward. Credit risk is determined through a structured process that assesses the likelihood of a borrower defaulting on a loan and the potential loss to the lender if default occurs. In DeFi, the borrower defaulting is virtually impossible, since the need for collateralization makes it impossible for borrowers to obtain assets they can’t cover. This is one of DeFi lending’s greatest strengths.
Its greatest weaknesses, as we’ve observed, are what we can call “third-party risk,” ranging from hackers to volatile assets, all of which have the potential to leave lenders out of pocket. While there’s no single solution that can eliminate lending risk altogether, this can be significantly reduced through tackling the main causes of lending loss, starting with the dual-token pooled model. There are alternative systems out there and, in the case of projects such as Silo Finance, they’re actively seeing use by lenders looking to preserve their precious capital.
Silo is one of the primary pioneers of isolated lending markets, a departure from the pooled-asset norm. Unlike conventional DeFi lending protocols, where a single breach could ripple across all markets, Silo creates two-asset pools such as ETH-USDC that segregate risk. Lenders deposit into a specific “silo” bearing only the risk of that market’s base asset. With $270 million in TVL and over 50 markets across Ethereum and four Layer 2 networks, Silo has facilitated hundreds of millions of dollars in loans without incident.
Silo V2, now in beta rollout on Sonic, takes this further with programmable lending markets. These allow customization, such as deploying idle capital to DEXs for added yield, while preserving isolation. This protects against system-wide hacks since a breach in one silo doesn’t touch others. The upcoming launch of Silo Vaults will optimize liquidity across these markets, addressing a trade-off where segregated pools can underperform shared ones in yield efficiency.
DeFi Lending Without the Downsides
It’s worth remembering that DeFi, including its multi-billion dollar lending sector, is still very new. This isn’t its final form and the algorithms and yield strategies currently in favor are only going to improve. Isolated markets, for example, sacrifice some liquidity efficiency, potentially capping yields compared to pooled systems during bull runs. But the attainable yields this model can deliver will increase as new revenue streams become available, from RWA-collateralized stablecoins to new DeFi primitives that draw upon innovations such as restaking and cross-chain swaps.
Elsewhere in DeFi, diversifying validator reliance, improving UX, and stress-testing against black swan events will all play a part in making the onchain landscape, including lending markets, more robust. The stakes for web3 are high since if lenders lack tools to calibrate risk and reward, trust erodes and capital dries up, stunting innovation. DeFi’s ideal path is one where verticals such as lending balance profitability with prudence, ensuring web3’s promise doesn’t falter under mismanaged risk.
Image by WOKANDAPIX from Pixabay
