From Risks to Risk Parameters

For each asset, or token, it has its own market risk that profiles its price uncertainty. Even though there is no unique classification applied to DeFi, the most commonly used types of market risk are:

1. Liquidity

2. Volatility

3. Market Capitalization

Liquidity

Liquidity is yoked to the market volume. It is a vital factor that incurs liquidation. The risks can be mitigated with several liquidation parameters, e.g. the protocol will provide higher incentives when the liquidity level gets lower.

Volatility

The price change of collateral heavily driven by Volatility will influence the overall solvency of the protocol. When the collateral value falls below the amount of borrowing, additional levels of liability coverage are required. For example, Collateral Factor will decide at which point liquidation process will occur, and whether a liquidator can get profits from repaying the loan.

Assets with higher volatility like Altcoins usually have lower Collateral Factors, driving smaller borrowers' borrow limit and buffer zone for price drop, which are prone to trigger liquidations. The counter example are the less volatile assets like ETH, stable coins and other mainstream coins, which have the higher Collateral Factors and allow borrowers to borrow more against them.

Market Capitalization

Market capitalization illustrates the size of the market. When collaterals are liquidated, market cap is a key factor to be considered as it affects liquidation parameters: the smaller the market cap, the higher the incentives.

Overall risk, or systemic risk, is the integration of liquidity, volatility and market capitalization. Overall risk is a major element to affect reserve factor.

Overall Risk

The overall risk (systematic risk) derives from three primary sources of risk, i.e. Liquidity, Volatility, Market Capitalization, thereby implying key risks within the protocol, which has a direct impact on Reserve Factor.