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Investing in cryptocurrencies can be extremely risky. On May 19, more than $500 billion disappeared from crypto markets in 24 hours. The crash provoked some $8 billion in liquidations in an event called “Black Wednesday.” The cascading liquidations saw Bitcoin plunge more than 50 percent from its all-time highs of over $60,000 a few weeks before. Just like that, more than 20 percent of the total cryptocurrency market cap vanished.
Managing risk in crypto will always be extremely complex, and while many knew a correction was coming, very few expected it to be this drastic. But while risk management will always be more complicated in such a volatile environment, principles from 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 champion of risk parity and used it to manage the All Weather fund from Bridgewater Associates to $150 billion. Risk parity is an investment strategy that consists of balancing risk by investing in uncorrelated asset classes with the same fund. By doing so, funds are less exposed to potential negative events affecting the whole asset class, something crypto investors know very well.
A risk-parity strategy picks different asset classes to reduce risk while still generating returns with every part of the fund. To do so, fund managers have to identify different sectors with uncorrelated returns, which can prove difficult. To give an example, the original All Weather fund split its assets between four categories, each representing a possible scenario for the future of economic activity, accounting for falling or rising growth and inflation.
In practice, the portfolio included long-term treasuries, stocks, short-term treasuries and commodities. By spreading risks over these different categories of investments, returns can be maximized over time as a result of long-term stability. In the wake of the pandemic, market conditions are extreme. With Federal Reserve Chair Jerome Powell confirming that expansionary monetary policies will continue after a year of extreme inflation, portfolio-management strategies based on treasury bonds will continue to suffer.
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 cryptocurrency and most valuable in terms of market capitalization. If Bitcoin went up, the entire market went up. If Bitcoin went down, the entire market followed. Changes in Bitcoin price were the foremost determinant as to the total market cap of the entire asset class.
These strong correlations to Bitcoin made any application of risk parity to crypto portfolios impossible. However, in the last 12 months, we’ve seen rapid development in one of the most exciting sectors of the crypto market: DeFi. DeFi stands for decentralized finance, a blockchain-based alternative to traditional financial markets. Instead of relying on market makers, brokerages and banks, DeFi uses smart contracts to allow peer-to-peer interaction between individuals on the blockchain.
For example, on a platform like Compound, lenders can lend their assets to borrowers through a trustless, open-source smart contract. While they can lend crypto-native assets like Bitcoin or Ethereum, they can also choose to lend stablecoins — cryptocurrencies whose price is tied to a real-world currency like the U.S. dollar.
Many different strategies are possible in DeFi, each with varying levels of risk and rewards, and many are linked to these stablecoins. This finally offers an excellent opportunity to apply risk parity to a crypto portfolio.
Crypto’s high returns with lowered risks
By partnering DeFi yield-generating strategies with crypto assets, the risks associated with crypto prices falling as they did on May 19 are offset by the stable APYs earned in DeFi. Platforms like Formation Fi propose a robo-advisor that creates a unique portfolio based on each client’s risk appetite and available funds.
These unique portfolios allocate funds to different asset classes inside the cryptocurrency sector based on two factors. First, it spreads out investments to reduce correlation. Second, it maximizes for the best returns in each of those investments based on the user’s level of risk tolerance.
This is much more difficult to do on an individual basis because using a blockchain implies fees. And the Ethereum blockchain, in particular, while it’s the most widely used, is extremely expensive, with transactions potentially costing north of $200. Creating a diverse portfolio in DeFi is still a luxury many can’t afford.
This greater simplicity is key to attracting more investors to decentralized finance. This kind of solution both favors small budgets by reducing gas fees and large institutional funds by spreading risk. As DeFi evolves, more solutions to favor easy, safe and profitable investments are crucial to perpetuate the sector’s growth. The creator of one of the most prominent DeFi lending and borrowing protocols recently revealed that institutions were trying out the Aave protocol.
Institutions are incorporating DeFi, and more and more investors want a share of the benefits. The risk factor of their portfolios will be a key determinant as to whether their first forays into the world of cryptocurrency end at the first crash or survive and thrive in this new, exciting environment.