From Harry Markowitz to Decentralized Finance: Navigating Systemic Risks

What if financial risk tells only part of the story?

Key takeaways:

• Harry Markowitz's pioneering work revolutionized the field of investing by introducing the concept of ‘diversification’' and laying the foundation for Modern Portfolio Theory (MPT).
• Managing financial risk has evolved into a multifaceted and complex process.
• The 2008 global financial crisis exposed the link between systemic risk and the level of interconnectedness within a financial ecosystem.
• Decentralized Finance (DeFi) shares numerous risk attributes with traditional finance while also introducing its unique risk elements primarily related to blockchain technology and its “Lego-like’ structure.
• DeFi's emergence at the institutional level requires a fresh approach to risk management. Solity Network has mapped the universe of risks in DeFi in real-time.

In 1955, Harry Markowitz revolutionized the world of investing by introducing the first formal mathematical framework for analyzing risk and its impact on investment portfolios. His research, based on the fundamental relationship between risk and reward, represented ground-breaking work and earned him the Nobel Prize in 1990. Until then, the investment world had been solely focused on choosing strategies that offered the best returns across individual assets.

Sound familiar?

Markowitz's work dramatically changed the way the world manages its wealth today. He introduced the concept of the 'efficient frontier' for investment portfolios, representing a set of optimal portfolios that offer the highest expected return for a given level of risk or the lowest risk for a given level of expected return. He showed that the risk level of each portfolio is more dependent on how assets are correlated with each other rather than the riskiness of individual components. The principle of diversification was introduced, and Modern Portfolio Theory (MPT) was born.

Since then, managing financial risk has evolved into a significant task involving a strategic, multiple-step process that occurs alongside Markowitz’s principle of diversification. Risk identification, risk assessment, risk tolerance, hedging, financial modeling, together with the implementation of risk management policies, procedures, and contingency plans to address unexpected events have become essential components of a sound risk management process. Despite these tools, financial crises continue to be a ‘regular' occurrence in markets, consistently exposing the challenges surrounding risk control and governance.

In traditional finance, market disruptions and macroeconomic factors have often been the cause of unfolding crisis. However, the global financial crisis of 2008 revealed a much more complex 'risk of risks.' The degree of interconnectedness across businesses and institutions proved to be the deepest cause of wild instability, capable of eventually bringing systemic risk at a global level.

In Decentralized Finance, systemic risk can exhibit similar attributes to traditional finance arising from unique risk factors inherent in blockchain technology, its smart contract paradigm, and the composability feature that defines this ecosystem.

As a composite of various risk primitives associated with L1/L2 chains, protocols, stablecoins, oracles, bridges, and liquidity pools, the 'Lego-like' structure of the Decentralized Finance ecosystem provides a fertile territory for systemic risk due to its high degree of interdependence and interconnectedness.

With this in mind, the emergence of DeFi and the opportunities presented by crypto as a nascent asset class for institutional finance require a fresh approach to risk management in order to promote financial stability at micro and macro levels, both in TradFi and DeFi.

At Solity Network, we are working hard to make this happen. We have introduced the first technical fundamental risk framework that enables the indexing and monitoring of the entire DeFi universe, facilitating real-time risk processing and risk modeling through AI and Machine Learning.

Do you want to learn about how we can help you manage risks in DeFi? Let's talk.

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We take this opportunity to pay tribute to the father of Modern Portfolio Theory (MPT), who passed away only in recent weeks on June 22nd, 2023.