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The three types of risk that exist when investing in digital assets and how to deal with them

Where high returns are ubiquitous, the risks taken are not always clear

Even the most novice investor knows that to get a return, you have to take risks. Any investment, especially one that “promises” high returns, carries high risks. It is like this: in traditional markets, the return that can be obtained is usually proportional to the risk assumed: the greater the risk, the greater the potential return and the possible losses. However, in the world of digital assets, where high returns are ubiquitous, it is not always clear what risks are actually taken to achieve those “gains.”

According to Jeff Dorman, Chief Investment Officer at Arca, today, with the promise of high returns on digital assets, there are three main types of risk that exist in the market : 1- counterparty risk; 2- duration / investment risk; and 3- directional risk.

Counterparty risk is the risk that capital will not be returned due to the health and solvency of the party that owns the assets. Duration / reinvestment risk is the risk that returns will be less than the maturity of the investment. And Directional risk is the risk that the price of the underlying asset will decline. Let’s see each one.

Counterparty risk

The best known and most discussed performance opportunities come from cash and carry and stablecoin lending (eg, betting on USDT with a decentralized financial platform or DeFi). These returns, which can range from 5% to 40% per year, exist largely because of a working capital deficiency across the industry. Unlike traditional markets, where there is too much cash on the market and a single main broker can help execute in each and every place, in digital assets there is often not enough cash to navigate a fragmented market. and dislocated.

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For example, to buy just $ 1 million in assets, it might take $ 3-5 million in cash to ensure that there is enough purchasing power spread across different centers, as the best offer may only appear in one place. Similarly, market makers need cash to facilitate trading at each of these locations. This shortage of cash creates a demand for dollars, which in turn leads to high yields on loans and often higher prices for derivatives that require less cash collateral. But these returns are not without risk. Both loan and spot / futures arbitrage introduce counterparty risk.

The counterparty can be an exchange, an over-the-counter, or OTC, dealer, a technology provider, or a DeFi protocol, for example.

All risks can be managed, including counterparty risk, when those risks are properly identified and due diligence is performed. But not understanding the risk taken can be costly.

Reinvestment risk

Every performance instrument has a maturity. Whether you buy a bond, borrow an asset, take out a mortgage, arbitrage with a lock, or trade an option or futures curve, these investments have a useful life. Therefore, investors must have a view on future opportunities, regardless of how attractive the current environment is. In the case of digital assets, future interests are very volatile and depend on external factors such as the degree of leverage in the market , the entry of new participants and the existence of new tokens with inflationary incentive mechanisms incorporated as trading costs. to attract customers.

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All these factors determine the future environment, and the management of this duration risk is essential to generate stable returns.

Directional risk

While stablecoin lending and base trading carry counterparty and duration risk, these two strategies typically have little or no price risk. These are truly market neutral strategies. But there are many other ways to get performance that do require a directional view of the market. MicroStrategy, the first publicly traded company to invest heavily in BTC, recently raised $ 500 million in a 6.125% covered bond trade. Although this percentage is fixed, the return obtained by the investor is variable because the price of the bond can rise or fall throughout its life, which increases or decreases the total return on the investment beyond 6.125%.

Similarly, the cultivation of yields -yield farming- , the sale of options, gambling and acting as a provider of liquidity carry a certain degree of price risk. Dorman states that while the actual performance of these strategies can be fixed or variable, ultimately the underlying assets one must have to participate in these strategies can go up or down.

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Like all risks, there is nothing wrong with taking directional risk, as long as the risk is understood. For example, yield farming , or  yield farming , continues to offer tremendously high returns because these protocols and applications are essentially giving out quasi-capital in the form of inflationary token rewards to help drive customer growth and network engagement. . The performance in itself is a good incentive, but ultimately the decision to cultivate or not is a commitment to the growth of the platform itself. If the platform is successful, the native token with which the rewards are earned will perform well.

These three types of risk can be mitigated and managed if properly understood. But it should also not come as a surprise that the returns available through various digital strategies are much higher than those that can be obtained in traditional finance.

The counterparts are all new and therefore much riskier. The volatility of crypto assets leads to a higher reinvestment risk. And the future trajectory of most digital asset projects is more uncertain, so the directional risk is also higher.

Although returns may have compressed in the short term, as speculative fervor has temporarily stopped, until this market matures, the opportunities for higher risk and reward are not going to go away.  This means that potentially higher returns correspond to higher risks.

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