Black Swans, Grizzly Bears and the Perils of Price-Action. How Risk Can Be Managed On-Chain

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CryptoMode On-chain Risk Management

Not all swans are white. Sudden market destruction is not the distant generational fear it used to be. Since Nicholas Taleb’s seminal treatise on ‘Black Swans’, which, for the sake of simplicity we shall loosely define as “an unexpected event of great magnitude and consequence”, investors have been more cognizant that sometimes things don’t always go to plan – and the charts don’t always shimmy and sway to a particular pattern. 

Remember Covid? This was by far the seminal Black Swan event of our generation, affecting the entire planet, and by which the repercussions will be felt for years to come. The typical market reaction to a Black Swan event of this nature is ultimately uncertainty, which generally manifests as wild volatility. 

Oh wait, then there was that thing in 2008… what was that called again?

Volatility in the market, including violent and rapid onset downswings, is a feature and a bug – particularly when it comes to crypto. 

Why Volatility Is a Feature of Crypto

Crypto’s relative immaturity, evolving technology and sweeping plethora of new and upcoming projects means that, more than any other market, volatility is a built-in. Burning house memes and braggadocio about surviving 90% losses (subsequently recovered) is all part and parcel of the crypto lingo. A 10% loss in traditional markets would be classically considered a brutal loss, whereas in crypto, such red days are shrugged off with not much more than a sigh, and even a redoubling of intention by unfazed Hodlers to stack Sats and ‘buy the dip.’

Yet such extreme, persistent volatility is an enemy of market maturity. Even if the market could nurture projects under such circumstances, which, remarkably, so far the crypto space has proven to be able to do, the functionality of certain coins and their ability to disrupt certain sectors is hampered by the price-action they suffer. 

This is generally because this inherent volatility can put-off otherwise intrigued investors and institutional players who can’t afford to have that kind of risk either on their books or as part of the core services they provide.

The Importance of Risk Management

It’s important for committed investors to be able to protect themselves from detrimental price-action. When faced with volatile markets, there are few classic strategies investors and traders in all kinds of markets take that can also be applied to crypto. One of the most general ones is making sure that your portfolio is balanced. 

In the crypto space, this means spreading your position across multiple coins, and potentially also investing in non-digital assets that tend towards less volatile price-action. Even so, total market shocks remain a thing, and in crypto, altcoins which have strong fundamentals can often be affected by the Bitcoin price movement, and the concept of ‘as above, so below’ still holds true; When Bitcoin rips, the alts move with it. When it dips, they also tend to fall. 

This unified crypto-market movement can be useful for a savvier investor. Futures can also offer a way to hedge against volatility. If you’re a holder, and want to keep accumulating but are fearful of impending bears, then Bitcoin short contracts alongside your bullish position can help protect against losses if Bitcoin decides to do its lemming act again in response to the latest government regulation or an influencer’s nefarious or misplaced tweet. 

There are more advanced options too, including buying puts and collaring your investments. However, Futures are complex, risky (even when used by experienced traders) and require a great deal of skill to consistently execute effectively. It’s certainly not a good idea for the average investor.

Methods of Protecting Against Losses 

The most common tools available to the average investor are stop loss and take profit orders. These allow you to set up buy and sell orders at a particular price point. 

A stop-loss order is when you set a price below the current market value where you’ll swap your asset out for a stable one. This means if you go to bed and your crypto drops 30%, but you set an order to sell at -10%, then you can avoid the most damaging repercussions of a downswing. 

Take profit orders are similar. Sometimes crypto rapidly ascends before falling back just as quick as the hype wears off and the long road to project functionality is revealed ahead – and earlier investors cash their gains. Take-profit orders means that should this kind of mountain appear on the charts before you have time to close or position (or even notice that it’s changed), then you can see some of those gains.

The issue with both these tools is they do put your assets on an order book, and that means you may miss out on some spectacular gains that you’d otherwise get. 

Flash crashes are still a common occurrence in crypto markets, even on major exchanges. One of the more extreme examples of this was in 2017 when the price of Ether on GDAX (now Coinbase Pro) plummeted 99.9% when a massive sell order was enacted on the platform, causing over 800 traders to lose their assets to stop loss orders they had in place. 

Flash crashes don’t just happen as a result of Black Swan events either, most times they occur without monumental unexpected global events, and are often caused by runaway algorithmic trading, poorly-coded oracles or smart-contracts, such as when Bitcoin’s price crashed from $43,000 to $5,000 on Pyth Network’s Data Feed in September 2021, causing all Solana programs which rely on it to liquidate traders who had stop losses in place. 

Take-profits can be damaging for a lot more simple reason – the coin goes past the Oort Cloud on an announcement that, if you’d read it when it dropped, you’d have cancelled your sell orders immediately (e.g: “The Federal Reserve announces it will recognise Shiba Inu as the new global reserve currency”). Altogether, it means that stop-losses and take-profits are blunt tools for the job.

Swapping into Stablecoins

Finally, you can just hedge against volatility by swapping into stablecoin assets. Although there are a great many ways to make your stablecoins productive, it effectively takes you out of the market until you wish to re-enter it properly, and thus you may find yourself buying back in at a higher price than what you sold at – particularly as crypto reaches its great adoption phase. 

It’s also worth noting that most traders (particularly those new to the space, lured by the promise of easy gains) have a tendency to trade on gut and emotion, something which more experienced market participants know to be thoroughly dangerous, and a sure-fire way to blow up a portfolio quickly. 

Moreover, certain stablecoins aren’t quite as effectively tied to their peg as they should be, and there are fears that some have insufficient collateralization, or that they are vulnerable to the same style of market implosion that protection is being sought against. 

This happened with UST earlier this month, which not only lost its own peg, but essentially took Luna with it. This is despite crypto exchange Binance promoting it as a “safe and happy earn” just weeks before the algorithmic stablecoins colossal $40 billion collapse.    

In the crypto space, and this applies to all tokens not just stablecoins, there is still a technical risk due to exploits and other types of hacks.

On-Chain Risk Management

What’s needed, then, is a more on-chain attitude to risk management where volatility is protected against and insulation against market shocks is achieved, but without having to surrender control of your assets and be given more choice over the risk you are prepared to take.

There are a few DeFi and smart contract protocols who are attempting to do this. Cover is a peer-to-peer insurance offering which helps users protect against smart contract bugs and exploits. Unslashed finance also offers users protection against oracle failures and unforeseen validator issues that can damage the price. 

iTrust finance is a complete insurance suite, rewarding their users for staking their coins which are used to fund an underlying asset pool to ward against Black Swans. All these protocols have caveats on why and in what circumstances they will pay out, but they do offer protection against some of the worst kind of volatility that can occur. 

One protocol that is seeking to offer more generalised protection against price-action is Bumper, which lets users pay premiums in exchange for a redeemable policy for as much as 95% of their protected asset. The advantage of this is that the asset can still be deployable in the DeFi ecosystem and can be used to earn a yield. Not only that, but in the event of a price reversal after crashing through the downside floor, the holder does not miss out on the upside potential either. 

Conclusion

Crypto is a young market, volatility is rife. Yet as it matures and larger and more collective investors join the space, the need for a robust and effective on-chain price protection protocol is growing. 

Protocols like Bumper may see mass adoption by offering users a simple to understand and execute method to hedge against volatility, with none of the inherent downsides of traditional investment risk management.


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