👩🔬Methodology
Our Methodology for the Accurate Quantification and Qualification of Risks
The composability of DeFi enables the FluidNFT Protocol to connect with the rest of the ecosystem. However, it also exposes the protocol to financial contagion. FluidNFT uses isolation pools to protect against cross-collection risk, and Dutch auctions to mitigate liquidation cascades. Still, each currency and NFT collateral comes with an amount of risk. To safeguard the solvency of the protocol we investigate three different levels.
First we look at the smart contract security and counter-parties in governance. If these risks are too high, the assets will be disqualified from the protocol. Then we look at market risks, which can be managed via the protocol's parameters.
Risk Scale
Our risk scale ranges from lowest risk A+ for the safest assets of the protocol (e.g. Ethereum as a currency and CryptoPunks as a collateral) to the highest risk D-. NFTs with the highest risk factors will not qualify as collateral to shield solvency.
Risk Factors
Smart Contract Risk
Smart contract risk focuses on the technical security of an asset's underlying code. If this is compromised it will threaten the solvency of the protocol. Projects must have undergone audits to be considered. We assess maturity based on the number of days and the number of transactions of the smart contract as a representation of use, community and development. These proxies show how battle-tested the code is.
Smart contract hacks have already resulted in millions of losses and so NFTs with the highest smart-contract risk D and below, cannot be used as collateral. To protect collateral, currencies with a risk rating below B- will not be integrated in the protocol.
Counter-party Risk
Counter-party risk assesses qualitatively how and by who the asset is governed. Specifically for NFTs we observe execution risk; how much of the assets value depends on its creator(s) continuing to execute well over time, the capitalisation of holders, and the degree of holder decentralisation; that no single of group of holders may disproportionally affect the market. The counter-party risk is measured from the level of centralisation corresponding to the number of holders within the collection and the trust in the creator or project over time.
NFTs with high counter-party risk below D+ disqualify as collateral.
Market Risk
Market risks are linked to the market size and fluctuations in offer and demand. These risks are particularly relevant for NFTs used as collateral within the protocol. If and when a loan defaults a liquidation auction is triggered. The markets then need to hold sufficient volume to absorb these liquidations without triggering liquidation cascades.
Currency Risk
Currency risk is evaluated against smart contract, counter-party and market risks. To safeguard collateralised NFTs, only those a risk rating of B- and above can be integrated within the protocol.
Valuation Risk
Valuation risk relates to error appraising NFT valuations. Specifically, NFTs with overestimated valuations may be used to extract value from lending pools and lead to the accumulation of bad debt within the protocol.
Liquidity Risk
Liquidity risk is the risk of there being insufficient liquidity for business-as-usual operations. That lenders would have to wait for borrower repayments until being able to withdraw their capital.
Risk Assessment
Historical data is extracted via third party APIs and combined with on-chain data. The methodology to link historical data to risk factors is based on rigid criteria for each factor.
Risk Quantification Criterion
The historical data is computed through our risk model resulting in risk ratings from the lowest risk A+ to the highest risks D-; quantifying the risk and severity of capital loss over a set period.
Risk Models
Collateral Risk Model
Our Collateral Risk Model is continually being trained and optimised on new data sources. We use best of breed technologies, combined with the latest AI research, and bench-mark against our data providers to ensure we provide the most accurate results.
Currency Risk Model
Our Currency Risk Model is based on the excellent risk analysis from AAVE, as per the table below:
A+
A
A-
730
730
730
500,000,000
100,000,000
10,000,000
100,000,000
1,000,000
500,000
ETH
Centralised
$14,900,000,000
$10,000,000,000
$5,000,000,000
$20,000,000,000
$10,000,000,000
$2,500,000,000
0.005
0.015
0.025
B+
B
B-
365
365
1,000,000
350,000
350,000
100,000
50,000
25,000
Permissionless
Centralised
$500,000,000
$250,000,000
$100,000,000
$700,000,000
$500,000,000
$100,000,000
0.038
0.051
0.064
C+
C
C-
C-
365
365
100,000
100,000
25,000
10,000
2,500
Controlling functions
Controlling functions
$50,000,000
$30,000,000
$15,000,000
$50,000,000
$30,000,000
$15,000,000
0.079
0.094
0.109
D+
D
D-
365
25,000
Centralised with audit
Centralised
Opaque
$10,000,000
$5,000,000
$10,000,000
$5,000,000
0.124
0.139
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