White Paper
Prioritizing Your DeFi Risk Management Efforts
October 16, 2024
Part 2 of a series focused on implementing a robust risk management program for your DeFi activities
In the complex and ever-evolving landscape of decentralized finance (DeFi), understanding and managing risk exposure is crucial. Building the foundation of a world-class risk management program requires the identification of the specific risks your organization faces and assessing how well you are equipped to handle them. Establishing a risk framework and then prioritizing the risks for your DeFi operation, provides the foundation to build an effective risk management program.
In this second part of our series, we delve into how Ledger Works applies a risk rating criteria across the DeFi Risk Framework described in the first part of the series to perform a comprehensive risk assessment specific to the unique nuances of a given organization. The process of conducting the risk assessment leverages traditional risk management methodologies, which may be familiar to some but are specifically designed for the DeFi context.
The Importance of Risk Assessment
Before diving into the details, it’s essential to grasp why a thorough risk assessment is indispensable. By evaluating the risks you are currently exposed to, you gain a comprehensive understanding of your vulnerabilities and strengths. This insight enables you to make informed, strategic decisions about where to focus your risk management efforts, improve existing protections, and identify areas lacking in oversight. The assessment process provides you with valuable, actionable information that is critical for safeguarding your protocol and optimizing its performance.
Performing the Risk Assessment
The Risk Framework described in the first part of the series provides the starting point for the risks to be assessed. The risk rating criteria then considers a range of potential impacts across operational, regulatory, financial, and reputational domains and attempts to standardize the numeric rating of those risks from high to low.
1. Self-Rating with the Risk Severity Rating Scale
We begin with an exercise where the potential impact of individual risks are rated based on our Risk Rating Scale. The numeric ratings are categorized into four tranches:
- High (7–9): Serious negative consequences that could significantly impact your business reputation, protocol value, or regulatory standing. This includes critical failures that hinder essential business functions.
- Medium (4–6): Risks that may cause some operational disruption, asset damage, or potential regulatory scrutiny, impacting protocol performance and business reputation.
- Low (1–3): Risks with minimal impact on normal operations, protocol value, or performance, which can be absorbed under typical conditions.
- N/A (0): Risks that do not apply to your current protocol, business operations, or circumstances.
2. Analyzing the Results
Once the initial self-assessment has been completed, we analyze the results to identify key areas where a given organization is well-protected and where additional controls or monitoring may be needed. The analysis typically includes a visual representation across the Risk Framework allowing organizations to easily understand your risk landscape at a high level and make informed decisions about specific areas of focus.
Figure 1: Example of the Risk Assessment results mapped across the risk categories and for specific High, Medium, and Low risks.
3. Actionable Insights
One of the most beneficial outcomes of the risk assessment process is to determine if the current, actual risk exposure is aligned with the desired risk appetite. The assessment also serves to help prioritize mitigation activities to ensure that the areas with the highest value receive the greatest attention. By pinpointing gaps in the current risk mitigation efforts and considering options, we help fortify your defenses and optimize protocol performance.
Bringing it All Together: From Risks to Controls
Having spent considerable time describing risks in Part 1 and Part 2 of this blog series, we will now bring the overall program ideas together. Risks, or the identification of what could go wrong, is the key first step for a risk management program. As described in Part 1, A world-class risk management program will start with a comprehensive risk universe to identify all significant risks faced. This risk universe will be documented in the form of a risk framework. Once established, as described in Part 2, a process to identify the specific relevance of risks and the overall priority of those risks will be assessed to create a risk-prioritized framework to guide risk management efforts. This process will be periodically refreshed, e.g. annually, and can often consider not only the inherent risk of the business but also the residual risk faced after considering existing practices in place to address each risk.
Finally, as we will discuss here in Part 3, in an effort to reach a target risk posture for the DeFi business, a set of practices must be implemented to address vulnerability to these risks, including detecting, preventing, or correcting exploitation of the risk, or in some cases transferring, e.g., insurance, or accepting the risk.
The implementation of a risk program’s specific practices to manage risk involves the design, implementation, and monitoring of control objectives and control activities, including ideally a continuous controls monitoring environment to manage the overall control environment and create actionable intelligence to protect and enhance your organization.
Moving Forward
With the risk assessment in hand, the next step in the risk management process is to determine specific ways to execute the risk mitigation and optimization strategies. Stay tuned for Part 3 of our series, where we will explore “Operationalizing Your Risk Management Program” through our enterprise solution’s Rules and Control Activities. In this third installment, we will provide an in-depth look at how our solutions translate risk management strategies into actionable operational processes.
For more information on how our Risk Framework can benefit your DeFi operations, revisit Part 1 of our series and get ready for the final blog in our series to complete your risk management journey.
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:
Part 1: Protecting Your DeFi On-chain Operations with a World-Class Risk Management Program