Financial Risk

Users of lending protocols face significant financial risks. In addition to the risk related to pooling crypto assets in a protocol, two key risks are shortfall events and illiquidity events.

Pooling

When you contribute crypto assets to a pool, whether for lending or staking purposes, you are effectively placing those assets under the governance of the smart contracts that operate the pool. This means you agree to the automated enforcement of the rules defined within those contracts.

As your assets are managed by these smart contracts, you forfeit immediate control and direct benefits derived from these assets, except for specific functions that the smart contract code allows.

This arrangement may lead to situations where your crypto assets are not instantly accessible due to conditions such as predetermined lockup periods, 'unbonding' phases, or other withdrawal restrictions, during which the value of your assets could either increase or decrease, potentially missing out on other financial opportunities or suffering a loss in asset value.

Furthermore, even in cases where swift withdrawals are allowed, unexpected events including liquidity crises, security incidents, or exploitations may cause delays or temporarily halt withdrawals. Such events have the potential to significantly impact the value of your deposited assets, up to and including total financial loss.

In both of the below scenarios, participants in lending protocols should be aware of these inherent risks and must recognize that the ability to recover funds cannot be entirely assured.

Shortfall Events

Shortfall events occur when the total value of the crypto assets effectively borrowed from a protocol exceeds the value of the total assets provided as collateral by borrowers. This situation indicates that the lending protocol may not be able to recover the full amount of borrowed assets, effectively rendering the protocol insolvent.

Shortfall events can result from various factors, including smart contract vulnerabilities, delayed liquidations, or oracle manipulation.

Although these events are not expected under normal operating conditions, they represent a serious risk that can be mitigated, but never fully eradicated, through effective risk management strategies.

Illiquidity Events

Illiquidity events describe scenarios where the protocol's utilization rates reach 100%, preventing lenders from withdrawing their deposited assets promptly. A protocol's utilization rate reaching 100% indicates that all of the assets deposited by lenders are currently being borrowed by other users. In such a scenario, there are no free or unutilized assets left in the protocol to be withdrawn immediately by lenders wishing to reclaim their deposits.

Thus, despite the protocol being solvent—holding enough collateral to cover all borrowings—repayment of borrowed assets may not occur as quickly as lenders desire. Lenders must wait until:

1. Borrowers repay their loans, freeing up assets to be withdrawn.

2. New deposits are made into the pool, increasing available liquidity.

3. The interest rates are adjusted to incentivize borrowers to repay loans sooner or discourage additional borrowing until the balance between supply and demand is restored.

Illiquidity events, while temporarily restricting asset withdrawal, do not imply insolvency but highlight the need for liquidity management within the protocol to accommodate withdrawal requests.