Risk factors

Understanding Smart Contract Risk

What is Smart Contract Risk? Smart contract risk involves assessing the technical safety of the code underlying any digital asset. For an asset to be considered for the Aave protocol, its code must have undergone thorough examinations by reputable auditors. However, even with such precautions, smart contract risk cannot be fully eradicated. Users must stay alert to any potential risks and continually evaluate them.

How Can Smart Contract Risk be Minimized? Although it's impossible to eliminate smart contract risk entirely, certain measures, like implementing bug bounties, can significantly reduce it. The maturity or trustworthiness of a smart contract can often be gauged by its age and the volume of transactions it has processed. Factors such as usage frequency, community engagement, ongoing development, and, in some cases, proven reliability, serve as indicators of the contract's resilience against bugs and vulnerabilities.

The Consequences of Ignoring Smart Contract Risk Neglecting the dangers posed by vulnerable smart contracts has led to the loss of billions of dollars in the past. Consequently, tokens associated with high levels of smart contract risk (rated D+ or lower) are considered highly dangerous as collateral. To mitigate the risks associated with these tokens, stringent precautions, like setting supply caps or employing isolation modes, are advisable.

Counter-party Risk

Counter-party risk evaluates the degree of governance and control over an asset, focusing on decentralization and potential vulnerabilities. The risk level is influenced by how centralized the control is—considering both the number of individuals governing the protocol and the distribution among token holders. Trust in the governing body, whether an entity, project, or community, also significantly impacts counter-party risk.

Market Risk

Market Risk Evaluation

Market risks involve the assessment of asset pool sizes and the volatility of supply and demand. It's crucial to maintain adequate volume in the market to support liquidity during sell-offs, which could lower asset value due to slippage.

Key Metrics for Evaluating Market Risks:

1. Liquidity Risk: Measured using average daily volume (E[volume]), indicating the asset's market availability.

2. Volatility Risk: Determined by the standard deviation of logarithmic returns (σ[ln( close(t)/close(t+1) )]), aligning with standards by key industry players like Bitmex and Gauntlet.

Assessment Intervals: Risks should be analyzed over 1 week, 1 month, 3 months, 6 months, and 1 year periods.

Market Behavior: Tokens may face volatility spikes, sometimes experiencing up to a 50% price change within short timescales. Price increases could necessitate readjustments in parameters to mitigate risk in new transactions.