How to Mitigate Risks in the Crypto Market
June 8, 2021
5 minutes to read
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Investing in cryptocurrencies can be extremely risky. On May 19, more than $ 500 billion disappeared from the crypto markets within 24 hours. The accident caused some 8 billion dollars in liquidation in an event called “Black wednesdayThe cascading sell-offs saw Bitcoin plunge over 50% from all-time highs of over $ 60,000 a few weeks earlier. Just like that, over 20% of the total cryptocurrency market cap is gone.
Managing risk in crypto will always be extremely complex, and while many knew a correction was coming, very few expected it to be so drastic. But while risk management will always be more complicated in such a volatile environment, the principles of traditional finance can be applied to reduce it and avoid being caught in such situations.
Ray Dalio and risk parity
Legendary investor Ray Dalio was the first risk parity champion and used him to manage Bridgewater Associates’ $ 150 billion All Weather fund. Risk parity is an investment strategy that consists of balancing risk by investing in uncorrelated asset classes with the same fund. In doing so, funds are less exposed to potential negative events affecting the entire asset class, which crypto investors know very well.
A risk parity strategy selects different asset classes to reduce risk while generating returns with each part of the fund. To do this, fund managers need to identify different sectors with uncorrelated returns, which can be difficult. To give an example, the original All Weather fund divided its assets into four categories, each representing a possible scenario for the future of economic activity, taking into account falling or falling growth and inflation. rise.
In practice, the portfolio consisted of long-term treasury bills, equities, short-term treasury bills and commodities. By spreading the risks across these different categories of investments, returns can be maximized over time through long-term stability. In the wake of the pandemic, market conditions are extreme. Federal Reserve Chairman Jerome Powell confirming that expansionary monetary policies will continue after a year of extreme inflation, portfolio management strategies based on treasury bills will continue to suffer.
Related: How Covid-19 Caused Global Financial Inflation
Crypto and risk parity
For a long time, building a crypto portfolio based on the ideas of risk parity was simply impossible. The crypto market has been dominated by Bitcoin, the first and most valuable cryptocurrency in terms of market capitalization. If Bitcoin rose, the whole market rose. If Bitcoin fell, the whole market followed. Changes in the price of Bitcoin have been the primary determinant of the total market capitalization of the entire asset class.
These strong correlations with Bitcoin made it impossible to apply the risk parity to crypto wallets. However, over the past 12 months we have seen rapid development in one of the most exciting areas of the crypto market: DeFi. DeFi stands for decentralized finance, a blockchain-based alternative to traditional financial markets. Instead of relying on market makers, brokerage houses, and banks, DeFi uses smart contracts to enable interaction between individuals on the blockchain.
For example, on a platform like Compound, lenders can lend their assets to borrowers through an open source smart contract without trust. While they can lend crypto-native assets like Bitcoin or Ethereum, they can also choose to lend stablecoins. – cryptocurrencies whose price is linked to a real world currency such as the US dollar.
There are many different strategies possible in DeFi, each with different levels of risk and rewards, and many are tied to these stablecoins. This finally offers an excellent opportunity to apply risk parity to a crypto wallet.
Related: Everything You Need To Know About The Next Big Thing In Cryptocurrency: Decentralized Finance
High returns of crypto with reduced risks
By pairing DeFi return-generating strategies with crypto assets, the risks associated with falling crypto prices as they did on May 19 are offset by the stable APYs earned in DeFi. Platforms like Fi training offer a robo-advisor who creates a unique portfolio based on each client’s risk appetite and available funds.
These unique portfolios allocate funds to different asset classes within the cryptocurrency industry based on two factors. First, it spreads out the investments to reduce the correlation. Second, it maximizes the best returns from each of these investments based on the user’s risk tolerance level.
This is much more difficult to do on an individual basis because using a blockchain involves fees. And the Ethereum blockchain, in particular, although it is the most widely used, is extremely expensive, with transactions potentially expensive. north of $ 200. Building a diverse portfolio in DeFi is still a luxury that many cannot afford.
This greater simplicity is the key to attracting more investors to decentralized finance. This type of solution favors both small budgets by reducing gasoline costs and large institutional funds by spreading risk. As DeFi evolves, more solutions to facilitate easy, safe and profitable investments are crucial to sustaining the growth of the industry. The creator of one of the most important DeFi lending and borrowing protocols recently revealed that institutions are trying the Aave protocol.
Institutions are integrating DeFi, and more and more investors want a share of the benefits. The risk factor of their portfolios will be a key determinant of whether their first forays into the cryptocurrency world end on the first crash or whether they survive and thrive in this exciting new environment.
Related: The Biggest Problems Involving DeFi And How To Fix Them