How to Effectively Manage DeFi Risks

Even though decentralized finance (DeFi) is on the right track in terms of growth and adoption, the space is still full of risks, uncertainty and volatility. One of its biggest advantages over centralized finance is the availability and accessibility of financial data. Since transactions are public, blockchain offers a unique opportunity to understand market sentiment through data analysis.

This innovative prospect is known as on-chain analytics. In simple terms, it is the practice of analyzing the fundamentals, utility and transaction activity of a cryptocurrency and corresponding blockchains to predict future price movements and a wider range of market metrics.

Iakov Levin is the founder and CEO of Midas.Investments, a custodian CeDeFi (centralized decentralized finance) crypto investment platform.

On-chain analysis provides an overview of the digital financial system for better decision-making and helps answer critical questions: Who holds the most assets? Are holders of a particular token sitting on profit?

Any form of investment requires extensive analysis of market sentiment and capital positions. There is always a challenge in traditional business analytics because market data is not always transparent.

On the other hand, the transparent nature of DeFi means that there is a lot of accessible data. However, for such data to be actionable, it must be refined, organized and transformed into understandable information.

The on-chain analysis approach bridges this gap. This creates an effective practice for measuring necessary data and metrics and simplifying potentially complex investment decisions.

Moreover, it can be a powerful practice to identify protocols with high liquidity and security risks. We are only in the early stages of on-chain analysis. However, the emergence of more innovative data brokers and analytics solutions could bring next-generation on-chain analytics more comprehensive visibility to the entire DeFi industry.

It is important to remember that we should not rely on chain analysis alone. This more often than not gives the whole picture of market transactions where we see the skeleton data of transactions without understanding their context. There is a risk that one may not see the bigger picture as to what is driving the current market sentiment – ​​and how long it can be sustained.

The crypto and DeFi spaces are highly strategic. Recently, we’ve seen tweets or announcements from influential public figures that pump specific tokens significantly above their projected value, and small changes in regulations completely destroy a token’s floor price. These prospects are relatively frequent in the DeFi space, which cannot be predicted through on-chain analysis.

Focusing too narrowly on micro-details can cause the broader strategic narrative to be lost. While such analytics effectively provide critical insights into each transaction, they cannot provide a broader context by connecting every activity across the blockchain.

However, such pitfalls of on-chain analysis can be addressed in the future when we see more and more wallets being marked across the exchanges, making it possible to make investment decisions in a much more balanced and efficient way.

The most critical on-chain metrics that investors tend to rely on are liquidity indicators and their changes over time. On-chain analysis aims to provide insight into how liquidity spills over time from one protocol to another. For example, if a network experiences high liquidity, some associated protocols and tokens can be predicted to lose value.

There are several different analysis tools tailored to different levels of investors. The most basic one is Nansen, which allows users to dig deep into what is happening within wallet addresses across the blockchain. Nansen helps identify token flows between major players, where money is moved and deposited, which non-fungible tokens (NFT) are positioned for higher prices, and more.

Then there’s Dune Dashboard, where users (usually advanced traders) can write SQL queries to identify and track required metrics and turn them into comprehensive visual charts. There are also other popular tools tailored to specific blockchains, such as Etherscan, Santiment and Messari.

On-chain analytics has become a powerful tool over the last few years, especially for investment firms and venture capital funds. Many have built their own advanced chain analytics systems to identify more in-depth metrics and effectively manage their clients’ risk positions. Several startups have also entered the blockchain data analytics market, working as data brokers and providing actionable blockchain analytics data to top venture capitalists (VC) and investors.

The future of on-chain analytics looks promising. This intense demand for on-chain analytics will continue to grow as Web3 services are expected to increase by 700% in the next five years. As more VCs and hedge funds use these analytics to make sustainable decisions and more data brokers enter this space, the current challenges of on-chain analytics will be addressed through innovation.