Crypto Risk Management: How It Differs from Managing Risks in Traditional Finance
Institutional investing in crypto is on the rise, with $7 billion poured into the crypto asset industry by family offices, hedge funds, and traditional money managers, according to Forbes.
The increase of crypto demand among traditional institutions is not always followed by the adoption of proper risk management practices – due to the complexity of the new asset class and psychological bias in a risk-off environment.
In this article, we’ll provide some insights into the main peculiarities of crypto asset risk management and show how it differs from the one in TradFinance. It will come in handy, if you are planning to switch from traditional finance to crypto or if you’re already there but need another look at crypto risk management.
Although Bitcoin’s dominance has started to decrease at the end of 2021 due to the adoption of NFTs (among other things), Bitcoin is still the world’s most popular and biggest cryptocurrency – at the time of writing, its market share is $920,706,406,318.
However, as always, investing in one crypto asset (even if the biggest one) is risky. Here’s where diversification comes into play. Also, when diversifying your crypto investment portfolio, keep in mind that most non-Bitcoin crypto assets prices are correlated and interdependent: with the rise of one crypto, another one rises too, which creates high systematic risk and vulnerability to market crashes.
2. Risk/Reward Ratio.
Crypto investing is characterized by high rewards – the reason it’s so attractive to investors. However, one must also keep in mind a number of obstacles to manage risks effectively.
a. Fixed-income products are still immature.
As in traditional finance, the crypto world still lacks well-developed fixed-income products. With the crypto market’s high volatility, crypto risks change too, which makes investors’ income variable and hard to predict.
b. High rewards = a lot of speculation.
Another aspect that makes crypto risk management unique is that high rewards attract lots of speculators willing to frequently buy and sell regardless of the projects’ fundamentals.
c. Miners and whales have the power to move the crypto market.
As we’ve explained in “The Environmental Impact of Crypto: What’s the Solution?”, crypto mining (which is validating Bitcoin transactions, by solving complex cryptography puzzles) comes with high rewards. Given their significant Bitcoin treasuries, miners have actually become one of the drivers of the crypto market.
The same goes for whales – small groups of investors that own significant amounts of crypto tokens. Data shows that around $80 billion are kept in just over 100 individual accounts. These entities can move/manipulate the crypto market based on their interests.
a. Crypto market is highly unstable, so is the crypto price.
Compared to other asset classes, crypto has very high volatility, sometimes even extreme. Just take a look at Bitcoin. In May 2021, Bitcoin cost more $30 000, in October 2021 – $66 974, and now its price is a bit more than $50 000.
To reduce the crypto price-associated risks, traders apply different investment strategies which in most cases are very simple. A stop-loss is one such example. It’s an automatic closing of a position when the market price reaches a predefined low price boundary. While being simple to implement (such order types are supported by all exchanges), there are a few important drawbacks to such a simple solution. For example, in a V-shape recovery, price reaches the SL point (in which the position gets closed, usually in loss) and then recovers fast (hence the name V-shape). The result – price moved back to the same (or even upper) levels, but the trader remains in loss.
b. The derivatives market is underdeveloped.
As with traditional finance, crypto derivatives are financial contracts between 2 parties that derive their price and value from the underlying asset and act as a way to hedge against market risks.
Crypto derivatives cover futures (the aim of which is to buy/sell an underlying asset at a specified price and a determined date in the future), options (provide an option, but not an obligation, to buy/sell an underlying asset at a defined date and at a specific price in the future), swaps (that aim to exchange cash flows at a later date, based on a predetermined formula), or forwards (customizable contracts that enable buying/selling an asset at a specified price and a defined date in the future).
In the crypto industry, derivatives are still in their infancy, which leads to a number of issues, including the liquidity, which we’ll discuss next.
4. Liquidity–Related Risks
Being a nascent and growing market, crypto suffers from the lack of liquidity, for both the underlying assets and their derivatives. The lack of token liquidity occurs when not enough token liquidity is available for trade – this usually happens when cryptocurrencies, especially new ones, are not listed on large exchanges and/or when there are not enough people willing to buy/sell them. In the absence of traders, investors face more risks as there is a possibility they will not find someone to buy or sell their tokens from/to.
Derivatives, especially in DeFi, suffer, too, from low liquidity. Lack of derivatives in existence, partially or as a whole, makes the execution of hedging and protection strategies more complicated (or impossible).
In addition, token options do not exist or suffer from very limited availability ( except for OTC markets)
5. DeFi Risks
DeFi has some unique risk factors – and therefore may require specific mitigation ways.
a. The DeFi architecture itself may be a source of risks.
Primitives that act as basic lego bricks to build crypto assets are highly interdependent. This increases a failure risk. If something goes wrong with a basic primitive (e.g. a bug, a security vulnerability), this instantly impacts the products that use that primitive
b. DeFi risks are difficult to manage.
Being very complex, yet open and lacking strict auditing and regulation standards, DeFi is vulnerable to numerous technological, financial, and regulation-related risks. They include cyber attacks and financial losses, bugs, increased transaction fees due to the increased network usage, failed transactions, financial model loopholes, malicious attacks, manipulation, and more. Many of the risks are very difficult to test, predict, and once attacks happen – identify, analyze, monitor, and, eventually, react to.
c. New trading economic models mean more risks.
DeFi is evolving fast, giving birth to new, innovative trading models not known in traditional finance. For instance, investors can profit from providing liquidity in an automated market maker. AMMs enable crypto assets to be traded automatically with the help of liquidity pools that replace traditional order books. However, all liquidity providers are exposed to impermanent loss – a potential loss caused by balance changes in the liquidity pools.
6. Asymmetric access to Data
Since blockchain products rely on blockchain transactions (by definition), access to blockchain data may create an advantage for certain entities. Software systems can be used to monitor and react to certain actions done by specific wallets or data aggregation.
Miners, who have access to transactions before they’re added to the blockchain, may take advantage of that and front-run transactions awaiting execution (MEV attacks).
Insurance in traditional finance is defined by an established ecosystem and developed products that enable protection when something goes wrong.
However, this is not the case with crypto. In the crypto world, the insurance market is still underdeveloped: there are a few insurance platforms (Bridge Mutual, Nexus Mutual, or Opyn are among the best-recognized ones) that could help protect from losses and thefts. In addition, new types of risks introduced by new trading products and models may be underinsured or even wholly uninsured by today’s market standards.
As demonstrated, some crypto risks differ from the ones in traditional finance, requiring a totally different approach to successfully manage them. Investors/asset managers need to learn and get proficient on these new types of risks prior to making significant investment decisions.