Rethinking Risk In Crypto
How have we been thinking about risk?
After what we see with the insolvency of 3AC, Celcius, and the contagion effect of the blowout, we ask why didn’t they put in better risk management measures?
This got me thinking, what is risk and why didn't the companies comprehend the risk they take on by leveraging? Isn’t it common sense to protect your downside?
That’s when i realized there might not be a fixed way to quantify risk. If there were a perfect quantifiable definition of risk, wouldn't all firms make better decisions and avoid complete insolvency?
According to the academicians who developed capital market theory, risk equals volatility, because volatility indicates the unreliability of an investment. They called it market beta.
However, this measurement does not account for long-tail black swan events which could wipe out a portfolio.
In crypto, the Luna Terra crisis was an example of such a long-tail event where it is highly improbable but its occurrence caused much destruction to the portfolio of many both institutions and retails alike.
Therefore volatility as the only metric for risk is flawed as it does not actually align with the interest of an investor which is to avoid losing money.
Volatility says “I won’t buy it because its price might show big fluctuations,” or “I won’t buy it, because it might have a down quarter.”
On the other hand, what we are actually thinking when evaluating risk is “I need more upside potential because I’m afraid I could lose money”.
That makes a lot more sense than “I need more upside potential because I’m afraid the price may fluctuate.”
That means what we actually care about is the risk of loss rather than the risk of volatility.
Risk means uncertainty about which outcome will occur and about the possibility of loss when the unfavorable ones do.
How should we then measure risk?
In Security Analysis, Ben Graham and David Dodd put it this way :
“the relation between different kinds of investments and the risk of loss is entirely too indefinite and too variable with changing conditions, to permit of sound mathematical formulation.”
Measuring risk then is a matter of judgment where the probability of an uncertain outcome had to be weighted with the cost of losses. That explains why we see risk management strategies in companies as there is no fixed way to quantify improbable outcomes. Black swan events are not something we can extrapolate from data and it's something that can break companies.
The expected result is calculated by weighting each outcome by its probability of occurring; it’s a figure that says a lot — but not everything — about the likely future.
Given the difficulty of quantifying the probability of loss, investors who want some objective measure of risk-adjusted return — and they are many — can only look to the so-called Sharpe ratio.
The Sharpe ratio is a measure of risk-adjusted return. It describes how much excess return you receive for the volatility of holding a riskier asset.
In crypto, we have seen that risks have common patterns. UST was not the first stable Algo-backed coin. There was a likelihood that UST could have gone down the same path as other Algo stables. Smart contract even after audits still presents risks of getting exploited.
This means that when evaluating a crypto coin or a Defi product, we should take these probabilities into account when considering the high yield that we are presented with.
Return alone — and especially return over short periods of time — says very little about the quality of investment decisions. The return has to be evaluated relative to the amount of risk taken to achieve it.
The next important step is to then identify risks
Recognizing risk often starts with understanding when investors are paying it too little heed, being too optimistic, and paying too much for a given asset as a result.
High risk, in other words, comes primarily with high prices. Whether it be individual security or another asset that is overrated and thus overpriced, or an entire market that’s been borne aloft by bullish sentiment and thus is sky-high, participating when prices are high rather than shying away is the main source of risk.
In the bull market, the fact that prices are going higher and higher makes people feel that there is no way prices are going down, i.e super cycle thesis. They tend to care less about the risk of loss and the collective euphoria and overvaluation caused greater risk for the entire market.
What are some examples of risk?
Here are some that are put forward by Howard Marks :
A fundamentally weak asset — a less-than-stellar company’s stock, a speculative-grade bond, or a building in the wrong part of town — can make for a very successful investment if bought at a low-enough price.
Second, risk can be present even without weakness in the macroenvironment. The combination of arrogance, failure to understand and allow for risk, and a small adverse development can be enough to wreak havoc.
Mostly it comes down to psychology that’s too positive and thus prices that are too high. Investors tend to associate exciting stories and pizzazz with high potential returns. They also expect high returns from things that have been doing well lately.
Final Thoughts
After this whole crypto blowout, I am not sure about the likely effects of the contagion. With the risk of how the Feds are still taking money out of the market, I will be staying out and just observing.
However I still fundamentally believe in the future of web3 where the use of Blockchain technology could change the way we cooperate and see more use cases for that. With that, I will still expose myself to the upside by building in this space.
