Decentralized risk management: optimizing risks with a decentralized approach
Financial risk is an umbrella term covering market risk, credit risk, liquidity risk, operational risk, and investment risk. The management of these risks protects businesses and firms from economic shortcomings that could make them lose capital.
Since the 2008 market crash, more equity risk managers and governance managers have been in-demand to handle risk management. As a result, traditional companies have advanced in their risk management practices.
But during the 2008 crash, Bitcoin was invented, and now the blockchain space has also advanced in finance thanks to DeFi (decentralized finance).
What is decentralized financial risk management?
A decentralized approach to financial risk management primarily involves using smart contracts to automate decisions and decentralized solutions to tackle risk. Crypto markets are very volatile, so risk measures are essential to keep a decentralized project healthy — an article by Messari discovered that a bear market would present financial difficulties for DeFi treasuries due to a lack of decentralized risk management.
DAOs (decentralized autonomous organizations) play a significant part in operational and investment risk. DAOs can determine how their treasury is used through a consensual vote.
Examples of DAOs or smart contracts employing decentralized risk management best practices are hedging downside risk with options, delta-neutral hedging, usage of stablecoins, and audits.
Centralized vs decentralized risk management
Both management types have their benefits, and they can dynamically co-exist within a DAO and a traditional company. But the one benefit decentralized risk management comes with is a much less overhead as a smart contract and DAO can autonomously conduct the tasks of a risk manager.
While DAOs may be flexible and efficient, their openness dilutes the quality of expert decision-making as the member voting weight in DAO proposals is based on governance tokens pledged. Therefore, the proposals and advice of financial experts within a DAO can be undermined due to a lack of supporting votes.
However, this doesn’t apply to decentralized projects like DEIP.
The DEIP project is geared towards building the Web3 ecosystem for the creator economy. Within its architecture, it has a unique DAO called the DEIP council. It’s a system where a council has limited participation, and members use their stake to compete for a seat. After 12 months, members must compete again for a seat.
Members can also take someone’s seat by putting forward a higher stake. These DAO practices ensure the treasury management is in good hands and people are incentivized to manage it well, as bad decisions could cost them their position.
The application of decentralized risk management is new, but growing
As DAOs and DeFi have only existed for less than ten years, there hasn’t been much development in the utilization of decentralized risk management. But as more institutional players enter the space, they’ll look to incorporate a decentralized version of their risk management strategies to protect their company or DAO from bear markets.
In due time, we’ll see use cases pop up that incorporate an amalgamation of DeFi and hedging strategies.
The growth of decentralized financial risk management practices could effectively change the business practices of future crypto companies, so they have a greater chance of surviving when the markets plummet.
A decentralized approach could be the next gamechanger for crypto and potentially present a better centralized vs decentralized risk management conversation.
