Concentration Risk

Concentration risk is another facet that needs to be added to DeFi risk models. Traditional exchanges look at the liquidity of instruments in a portfolio to limit exposure to heavily concentrated or illiquid assets. The idea of prominent concentrated positions adding more risk is relatively simple. Bigger positions and less liquid assets can cause price impact, making it harder to liquidate safely, which can cause bad debt.

Concentration Charge works similarly to those seen in the trad-fi markets: It's a charge added to the filtered historical simulation VAR price risk calculation to account for the price impact risk of liquidating positions.

Part one calculates the Concentration Threshold or the amount over what can be safely liquidated in 1 day without causing price impact. Any amount over what can be liquidated in one day without price impact is called “Excess Quantity.” Therefore, the concentration charge liquidates a portfolio in a way that aligns with the concentration threshold to ensure no excess quantity exists that causes price impact and toxic debt.