The word risk is used frequently in the context of markets and, in particular, crypto markets.
We’ve explored the topic of risk management previously. In another piece, we explored the idea of risk being on a pendulum. In that, we see how the perception of risk moves back and forth from low to high over time.
Today we’re going to look at what risk is and the most important return to focus on when trading crypto. This is a key topic given the recent failings in DeFi and the crypto hedge fund darling 3AC.
Because the job of markets is in part to price risk and signal where trouble might be. Then markets reward or punish risk takers accordingly.
But sometimes, this mechanism fails.
And sometimes, the perception of the signal about where risk might be is misinterpreted.
Ultimately, when you think about risk, it comes down to considering one simple form of return. But before I tell you what that is, let’s take a look at the concept of risk.
The definition of risk
In Webster’s Dictionary, risk is defined as a chance, degree, or probability of loss. It means to expose to or to incur a hazard or danger.
In his book Against the Gods, the Remarkable Story of Risk, the late Peter Bernstein eloquently describes risk with this beautiful quote:
“The revolutionary idea that defines the boundary between the modern and the past is the mastery of risk: the notion that the future is more than a whim of the gods and that men and women are not passive before nature. Until human beings discovered a way across that boundary, the future was a mirror of the past or the murky domain of oracles and soothsayers who held a monopoly over knowledge of anticipated events.”
For the trader, risk can be thought of in a couple of ways.
In one way, it is a risk of capital loss. So as you create a trading plan with a tap-out point, that downside target is the capital you are willing to risk to test your idea, hypothesis, or trading thesis.
In another context, it is the risk of a complete loss. This can happen if you lose your crypto keys or if you somehow get scammed or hacked. A total loss can occur when you are involved in an untested protocol like Yam. Or this risk can happen if you have assets tied up in a seemingly safe service like Celsius or a flawed project like Terra Luna at the wrong time.
As a trader, you have to manage both of these risks.
And one way you can do this is by understanding how the market signals and prices risk.
Yields may not reflect the real risks
The bond market is a great place to see the relationship between yields and the perception of risk. This relationship is why a discovery about risk, yields, and returns by a Wharton student back in the 1980s was so important to today.
Bonds have ratings attached to them reflecting their creditworthiness and their likelihood of default will be. That risk of default is reflected in the yield. Investment grade paper carries a lower risk of default and, therefore, typically a lower yield.
Funds typically have covenants that restrict their bond purchases to certain ratings of paper. For example, many mutual funds will be restricted to buying only investment-grade bonds. These are bonds with A- or higher credit ratings.
Now, as you move down in grade or credit rating, yields tend to be higher. The higher yields reflect a belief that this bond or the bonds of these companies are less creditworthy and at higher risk of default. And yield reflects the cost of capital where more risk requires higher compensation to assume it.
A future financial legend discovered that this risk/return relationship was at times inaccurate.
When non-investment grade yields were checked against actual defaults, in various instances, the risk was mispriced. In other words, the risk of default in some non-investment grade paper was, in fact, lower than the yields reflected.
This is how the junk bond market (high yield bond market) took on a starring role in the 1980s.
On occasion, yields can reflect an error the other way too. Safety can hide unexpected risks.
Sometimes near risk-free instruments are risky too
In 2007 the Canadian Asset-Backed Commercial Paper faced a problem when it froze up. This previously safe and boring paper, yielding very little, suddenly became perceived as risky.
Many firms and individuals had this paper on their books, and the result was a calamity. The risk of this happening was not priced in. It was a completely unexpected risk.
Then as the financial crisis moved on, we saw investment-rated Mortgage Backed Securities ignite mushroom clouds across numerous firms and funds around the world. Here, risky paper was hidden in a stack of investment-grade mortgages that were, as a package, rated as investment grade.
It was like having a bunch of rotting takeout in the back of a well-stocked fridge.
As we discovered in the GFC (Great Financial Crisis), pricing takes place at the margin. So it was these risky and seemingly inconsequential non-investment grade mortgages that shaped pricing across the whole market. They failed first and infected the rest of the market.
Even the Reserve Primary Fund, the safest of the safe, “broke the buck” after the failure of Lehman Brothers. This demonstrates that even some of the safest financial products were subject to unexpected risks.
Are there any completely safe no-risk assets? Yes and no.
No, because if there is a return of any kind, there is theoretically some level of risk, even if minuscule. And yes, there is a concept of the risk-free rate. This is attributed to government securities backed by the full faith and credit of the government. These securities can be the 3-month US T-bill or the US 10-year Treasury bond. Although, in the current environment, even this assumption may be challenged eventually.
Does crypto have a risk-free rate? Not yet, but it does have a range of risks.
Looking at crypto during the 2022 wreckage, we see a variety of problems being uncovered.
One is that total losses, as in loss of all of the funds of an individual, are far more common than they should be.
And another is that high yields and insanely high interest rates have been more of a honey pot than a warning signal.
The crypto space has a variety of risks, some of which are part of the wider market. Things like market risk. This is when crypto moves with all or part of the broader market. Looking for correlations can help because crypto has moved with the NASDAQ and the larger tech stocks for much of 2022. So whatever conditions affect tech may move the crypto market.
Other elements that can lead to losses (and sometimes gains) include regulatory surprises. These are always present and difficult to account for.
There are risks of code failure, like what took place at Yam and a few others.
You have risks associated with project idea failures like Terra Luna and UST. And there are risks of failed business models like Celsius.
Then there is the liquidity risk. This is the potential for the market in obscure tokens, NFTs, or altcoins to dry up and leave you hodling something with no place to sell it. And no way to price it.
Crypto has other specific risks. Like, for example, potentially losing coins during complex swaps or losing your keys.
There are numerous upside opportunities in crypto precisely because there are hazards. But the challenge is always to balance the opportunities and the hazards. In other words, recognizing risks and taking them into account beforehand.
This brings us back to the core principle of risk to consider in every trade you do.
Choose the right form of return
Risk management isn’t a sexy topic. And during a bull market, talking about risk management is like showing up to a party in the summer without showering for a week.
Nobody wants to talk to you.
But when things get tougher, the places where risk management was absent become clear.
You can read the testimonials in the Celsius bankruptcy trial to get a sense of how bad this can be. Many of these people have lost all of their chips in this one high-risk business.
And if you lose all your chips, you can’t come back to play again tomorrow.
Your job as a trader is in part to keep more of your chips than you lose. Hopefully, a lot more.
So there is value in thinking about your capital like a financial advisor would.
And that means being laser-focused on one simple concept, which is that return OF capital always takes precedence over return ON capital.
Crypto remains a speculative environment. And speculative assets require respect because the risk is always there, reflecting abundant opportunity.
When things start to get uncertain, you have to change the way you think, including unlearning some of your bull market biases.
The other is to approach an uncertain market with more skepticism and experimentation.
The old cliché about there being no free lunch is true. Risk-free projects, ideas, and protocols typically have mediocre financial returns. The projects with the biggest upside are attractive because of their relative risk. That’s what makes them appealing.
But it takes money to make money. Or coins to make coins.
And that means focusing on return of capital or coins in every trade as a primary risk management focus.
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