White Paper

Protecting Your DeFi On-chain Operations with a World-Class Risk Management Program

October 15, 2024

Part 1 of a series focused on implementing a robust risk management program for your DeFi activities

In the rapidly evolving landscape of decentralized finance (DeFi), market participants have found it challenging to effectively and efficiently manage financial, operational, and cyber risk. This effort has been hampered by vulnerabilities created by the rapidly changing technology and business processes, as well as the many adversaries attempting to take advantage of these vulnerabilities.

A world-class DeFi risk management program requires tools and techniques designed for DeFi’s specific operating environment. And at the foundation of a risk management program’s tools and techniques is a risk framework with a clear set of standards. As DeFi continues to reshape traditional financial paradigms, the lack of universally accepted standards poses significant challenges in ensuring security, interoperability, and regulatory compliance. At LedgerWorks, we recognize that establishing a robust risk management framework is essential to navigating these complexities and fostering sustainable growth within the DeFi ecosystem.

In response to this pressing need, LedgerWorks is proud to announce our pioneering initiative in creating risk management standards tailored specifically for DeFi operations. These standards address the unique challenges and opportunities inherent when operating decentralized financial systems, providing a foundation for enhanced transparency, risk management, and innovation. Our approach not only aligns with established, global risk management best practices but also sets a new benchmark for excellence in the DeFi sector.

In this blog, we will delve into the rationale behind our initiative, the meticulous process of developing these standards, and the transformative impact we anticipate for the DeFi community. The series starts with defining the DeFi risk universe, performing the risk assessment, and developing mitigation strategies for the highest priority risks as part of an ongoing, proactive risk management program.

Join us as we explore how LedgerWorks is leading the charge in defining the future of DeFi through rigorous, internationally recognized standards that promise to elevate the entire industry.

A Comprehensive Risk Framework

Figure 1: LedgerWorks’ Defi On-Chain Risk Framework is a comprehensive set of DeFi-specific risks organized across three primary categories: People, Protocol, and Market.

The LedgerWorks DeFi On-Chain Risk Framework provides a comprehensive set of risks for organizations across the DeFi ecosystem. The risk framework is structured into three primary categories: People Risk, Protocol Risk, and Market Risk. This approach ensures a holistic evaluation of potential opportunities and vulnerabilities and a context for developing strategies to mitigate them.

People Risk

In the realm of DeFi, People Risk considers the vulnerabilities stemming from human behavior in both operational and compliance aspects of protocol management. This encompasses the risk of operational failures due to inadequate responses to market conditions, as well as the potential compliance issues arising from failures to adhere to regulatory standards, impacting both protocol reliability and legal integrity.

The People Risk domain includes the following risk subcategories:

1. Operations:

  • Failure of On-Chain Protocol Operations: The reliability of on-chain processes is crucial. Any failure in protocol operations can disrupt services and affect user trust.
  • Failure to Respond to Market Conditions: DeFi protocols must be agile, adapting to market fluctuations and evolving conditions to maintain functionality and relevance.

2. Compliance:

  • Violation of US Bank Secrecy Act Obligations: Compliance with anti-money laundering (AML) and counter-terrorist financing (CTF) regulations is essential. Non-compliance can result in legal repercussions and loss of operational integrity.
  • Violation of DeFi Regulatory Obligations: Adherence to emerging DeFi-specific regulations ensures that protocols remain within legal boundaries and avoid regulatory scrutiny.

3. Key Management:

  • Effective Management of Protocol Keys: Secure management of cryptographic keys is vital for protecting the integrity and security of the protocol. Poor key management can lead to unauthorized access and significant security breaches.

Protocol Risk

Protocol Risk in DeFi considers whether the on-chain systems or smart contract components that have been built are functioning as intended. This includes ensuring that smart contracts perform configurations correctly and securely, such as managing deposits and lending are properly set, and transaction processing and DAO governance mechanisms operate without disruption or unintended consequences.

The Protocol Risk domain includes the following risk subcategories:

1. Smart Contract:

  • Authorized Smart Contract Updates with Adverse Impact: While updates are necessary for evolution, they must be carefully managed to avoid unintended consequences that could compromise protocol functionality.
  • Unauthorized Smart Contract Updates: Unauthorized changes can lead to vulnerabilities and exploitation, undermining the trust and security of the protocol.
  • Failure of Smart Contract to Function as Intended: Smart contracts must perform as designed. Failures can result in operational disruptions and loss of user funds.

2. Deposit Pool:

  • Failure of Protocol Configuration to Effectively Manage Deposits: Proper configuration is essential to manage deposits efficiently and prevent issues such as liquidity shortages.
  • Operational Disruption from Depositor Activity: High levels of depositor activity or unusual deposit patterns can cause disruptions in protocol operations.
  • Failure of Incentives to Optimize Deposits: Incentives must be structured to attract and retain deposits effectively. Poorly designed incentives can lead to suboptimal deposit levels.

3. Credit Facility:

  • Failure of Protocol Configuration to Effectively Manage Lending: Proper configuration is necessary to manage lending activities and mitigate risks associated with credit exposure.
  • Failure of Incentives to Optimize Lending Activity: Incentives must encourage lending participation. Ineffective incentives can result in reduced lending activity and market inefficiency.

4. Execution:

  • Failure to Optimize Transaction Processing: Efficient transaction processing is critical for maintaining performance and user satisfaction. Failures can lead to delays and increased costs.
  • Failure of Protocol Configuration to Address Extreme Execution Environments: Protocols must be resilient to extreme conditions, such as high transaction volumes or market stress, to maintain functionality and reliability.
  • Failure or Manipulation of DAO Governance Mechanisms: Decentralized Autonomous Organizations (DAOs) rely on governance mechanisms to function effectively. Failures or manipulation can undermine decision-making and protocol integrity.

Market Risk

Lastly, Market Risk involves monitoring external factors that affect not just a given organization but also the broader crypto ecosystem. This includes the performance of critical components such as price oracles, validators, liquidity providers, and cross-chain bridges, as well as managing the impacts of changes in market liquidity and volatility. Effective Market Risk management requires vigilance over how these external elements and market dynamics can have first and second order influence over protocol stability and operational continuity.

The Market Risk domain includes the following risk subcategories:

1. Counterparty:

  • Failure of Price Oracle to Operate as Expected: Accurate price oracles are essential for reliable pricing and decision-making within DeFi platforms. Failures can lead to inaccurate pricing and financial losses.
  • Failure of Validator to Operate as Expected: Validators play a crucial role in maintaining the integrity of blockchain networks. Failures can compromise network security and reliability.
  • Failure of Liquidity Provider to Meet Liquidity Needs: Liquidity providers must deliver on their commitments to ensure market efficiency. Failures can lead to liquidity shortages and market disruptions.
  • Failure of Bridge to Operate as Expected: Bridges facilitate cross-chain interactions. Failures can disrupt interoperability and affect protocol performance.
  • Failure of Liquid Staking Providers to Operate as Expected: Liquid staking providers must effectively manage staked assets. Failures can impact staking rewards and protocol stability.

2. Liquidity:

  • Insufficient Token Availability to Maintain Efficient Market: Adequate token availability is essential for market efficiency. Insufficient supply can lead to increased spreads and reduced market activity.
  • Price Collapse from Oversupply and/or Low Demand: Market dynamics can cause price volatility. Oversupply or low demand can lead to significant price fluctuations and instability.

3. Volatility:

  • Business Disruption Due to Elevated Market-Wide Volatility: High levels of market volatility can impact DeFi operations and lead to business disruptions. Managing volatility is crucial for maintaining stability and operational continuity.

With a broad view of the DeFi risk landscape, organizations are equipped to consider the most impactful and pressing areas of risk exposure. In the following parts of this series, we will use our risk framework to perform a risk assessment to prioritize opportunities and threats as well as develop strategies to mitigate and exploit risks through a proactive, programmatic approach. Stay tuned as we continue to share insights on how LedgerWorks is setting new standards in DeFi risk management.

Moving Forward

Based on understanding risk and a DeFi risk framework, the next step in the risk management process is to establish a set of risk-based priorities to focus your program development efforts. Stay tuned for Part 2 of our series, where we will explore “Prioritizing Your DeFi Risk Management Efforts.” In this second installment, we will provide an in-depth look at how to leverage build on this risk framework by conducting a risk assessment to prioritize your risk management program efforts.

About Ledger Works

Ledger Works helps our customers focus on growing their Web3 business while we run their Risk Operations. Today, more than ever, our customers’ success requires effective Risk Management. As your strategic risk partner, we help optimize financial performance while minimizing the risk of loss. By leveraging real-time computational rules, continuous execution of deterministic and simulation models, and real-time market surveillance, Ledger Works empowers businesses to turn risk into a competitive advantage.

For more information, visit: https://www.lworks.io

Contact: Press@lworks.io

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Read our 3 part series on how to operationalize a world-class risk framework to protect, prioritize, and operationalize DeFi on-chain risk:
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Part 1: Protecting Your DeFi On-chain Operations with a World-Class Risk Management Program

Part 2: Prioritizing Your DeFi Risk Management Efforts

Part 3: Operationalizing Your Risk Management Program

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