Risk Framework
Risk Framework in NELX Lending
The composability of DeFi allows the NELX Lending Protocol to integrate seamlessly with the broader ecosystem. However, this interconnectedness also introduces ecosystem risks. Assets used within the protocol, particularly those accepted as collateral, are critical in maintaining its solvency. Evaluating the risks associated with each asset is essential and involves three core dimensions: smart contract risk, counterparty risk, and market risk.
Dimensions of Risk
1. Smart Contract Risk
Smart contract risk evaluates the technical security of an asset’s underlying code. Only assets with rigorously audited code by reputable auditors should be considered. Even with audits, vulnerabilities can persist, requiring continuous vigilance from both users and developers.
Key factors include:
Code Maturity: Measured by the number of days and transactions associated with the smart contract.
Security Enhancements: Measures such as bug bounties to identify and address potential vulnerabilities.
Risk Mitigation:
Tokens with significant smart contract risk (rated D+ or below) should only be onboarded with measures like supply caps or isolation mode.
2. Counterparty Risk
Counterparty risk assesses the governance structure and decentralization of an asset. This includes evaluating the number of entities controlling the token’s protocol and the trust level in its governance processes, community, or managing bodies.
Highly centralized assets carry elevated counterparty risk and may require additional safeguards.
3. Market Risk
Market risks arise from fluctuations in supply and demand and the overall size of an asset pool. Effective management requires evaluating:
Liquidity: Average daily trading volume to determine how easily an asset can be liquidated without significant price impact.
Volatility: Standard deviation of logarithmic price returns over time intervals (e.g., 1 week, 1 month, 1 year).
Market Capitalization: Represents market size and exposure, providing guidance for setting liquidation thresholds and incentives.
Formula for Volatility:
Volatility = σ[ln(close(t)/close(t+1))]
Risk Mitigation:
High-market-risk tokens should only be onboarded with measures such as borrowing limitations or isolation mode.
Risk Quantification Scale
The protocol employs a standardized scale to evaluate asset risk:
A+ (Lowest Risk): Safest assets, such as Bitcoin.
D- (Highest Risk): High-risk assets, often restricted to isolation mode or excluded as collateral.
Risk Mitigation and Parameters
1. Supply Caps
Restricts the total amount of an asset that can be supplied to reduce exposure.
Formula:
Supply Cap = Liquidity Factor × Collateral Volume
2. Borrow Caps
Limits the maximum amount of an asset that can be borrowed to prevent insolvency.
Formula:
Borrow Cap = Liquidity Factor × Borrow Volume
3. Isolation Mode
Restricts high-risk assets to borrowing stablecoins and prevents their use as collateral for multiple assets.
4. Liquidation Mechanisms
Defines rules for collateral liquidation to maintain solvency:
Liquidation Thresholds:
Weighted Average (Collateral Value × Threshold Percentages)Liquidation Penalty:
Collateral Value × Penalty Rate
5. Health Factor
Measures the solvency of a position:
Formula:
Hf = (Sum of Collateral Value × Liquidation Threshold) / Total Borrow Value
By applying this comprehensive risk framework, the Nebeus Lending Protocol safeguards solvency while maintaining a robust and adaptable ecosystem presence.
Last updated