Crypto risk management – part 1: introduction

Almost anyone who has heard about Bitcoin or Ethereum, know that it’s risky business. Some risk factors are; the immature technology, lack of real-world applications that provide real value, lack of protective regulation and price volatility against fiat currencies. In this post I’ll go through ways to manage some of these risks.

I’ll not write about how to manage the technical risks associated with cryptocurrencies. I already wrote about how to manage keys and other secrets.

Before reading further, please note that none of what I’m covering in this post is an investment advice. In fact, you should definitely not put any money into this without having done an awful lot of research on your own.

Lack of regulation

The fact that crypto trading isn’t well regulated at the moment, is causing great risks for traders who let exchanges keep custody of their funds. The lack of oversight or auditing means that exchange operators could, in theory, walk away with your funds or claim that they “got hacked by someone”.
Another risk, due to the lack of regulation, is that a government could decide to seize the operation of an exchange if they want to. If the exchange is shut down, your funds would be locked as well. One can summarise this as custodian risk.

To reduce the custodian risks with centralised exchanges one can use decentralised exchanges, where you are in full custody of your own funds when trading. Examples include Shapeshift, Radar Relay (built on the 0x protocol), Bancor or Kyber Network (not yet live).

Price volatility

I think, everyone that have heard of Bitcoin and Ethereum, have heard about the price volatility. While volatility creates economic upside opportunities, it also creates equally large (if not larger) downside risks.

It’s often thought that the reason behind the volatility is the relatively small trading volumes at this early stage of adoption. And while there might be some truth to that, I think it’s more likely that the bigger reasons are some combination of (a) no established frameworks for how to value crypto assets (b) rate of unprofessional vs. professional traders (c) unregulated insider trading (i.e. pump-and-dump schemes).

The price volatility in crypto isn’t going away anytime soon. Even if there’s significant adoption and more volume entering the markets, I believe that volatility will remain because of the other reasons I mentioned.
Therefore, building tools and methods to hedge against volatility will be important, especially because of the many new users who are entering the markets these days. The following is no longer true for the majority of users:

My Bitcoin investment from 2013 has gone up 400x, I don’t care if it drops 30%

Even if you just buy and HODL, one could argue that it’s irresponsible to let the value of your (or someone else’s) assets drop 30% in value in a single day.

So what are some methods of hedging against the price volatility? It would be easy to say; sell when the price goes down, and buy when price goes up! But this is a lot harder than what it appears to be. The volatility is just too big, and the markets are moving too fast. To be successful with this, it’s a full-time job that require plenty of experience with trading. And none of us have time for that.

Stable currency

Even if you’d trade in/out of fiat currency to manage that risk, you’d be exposed to the custody risk of using centralised exchanges. The alternative is to trade in/out of stable cryptocurrency, like the Dai token, on decentralised exchanges. That way, you are in control of custody at all times.

However, trading like this isn’t a particularly good hedging technique because when you sell, you lose upside opportunity should the asset suddenly appreciate in value when you sold.

Therefore, the key is finding techniques where you somehow limit the damage when the price declines, without necessarily selling your assets.

Shorting

The first such technique is shorting. But this usually include putting up collateral on a centralised exchange with custody risk, or borrowing money from someone. And borrowing from somone other than yourself isn’t really ideal.
The only solution that exist at the moment, that avoid both those risk, is Prism.

Options

Other hedging techniques include using financial derivatives, such as options. One can compare options to a kind of insurance. For example; if Ether trades at $900, you can buy an option contract to sell Ether at $800 for a one-time premium of e.g. $20. That way, if Ether drops to $600 you have paid a premium for the option to sell at $800. Essentially, the risk of volatility moved from the person who bought the contract to the person who issued the contract (who also earn the premium). However, if the price of Ether rise to $1000, you still get the upside return, minus the $20 of premium you paid for the option contract.

These kinds of financial instruments are of course risky by themselves. One truly need to understand how they work before using them. Traditionally, financial derivatives are only available to institutional investors. But these tools are quickly being democratised through projects such as VariabL and dYdX.

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