Top 5 risk management strategies in crypto: How to keep your eggs safe even when the henhouse crashes
The crash of TerraUSD on May 9, 2022 has left many crypto investors reeling. What some considered as an “island of stability” amidst a sea of volatility has now come crashing down. This has served as a harsh reminder that risks are an inherent part of investing, and that even the most promising projects can fail.
So how can you protect your investments in the volatile world of crypto? The answer is, of course, risk management. So let’s take a look at some of the top risk management strategies for yield farmers and see how those can keep your funds safe in the event of another market crash.
DISCLAIMER: NOTHING IN THIS ARTICLE CONSTITUTES INVESTMENT ADVICE. MAKE SURE YOU DO YOUR OWN RESEARCH BEFORE MAKING ANY DECISIONS.
- Don’t put all your eggs in one basket
- Be patient and don’t FOMO into any investments.
- Get into the nitty-gritty of every investment.
- Stay up to date on the latest developments in the crypto space.
- Use a tool like Waterfall DeFi for risk tranching.
Before we get to the strategies, let’s first take a look at the four main types of risks involved in crypto trading:
- Credit risk is the risk that the counterparty to a transaction will not fulfill their obligations due to, say, financial difficulties.
- Legal risk is the risk that a law will be passed or enforced that prevents you from trading or doing business in the cryptocurrency space.
- Liquidity risk is the risk that there won’t be enough buyers or sellers of a cryptocurrency at the right price.
- Market risk — perhaps the most well-known type of risk — is the risk that the market will move against you.
Now that we’ve covered the risks, let’s take a look at some strategies to help you mitigate them.
Diversify your investments across different protocols and strategies
If you ever had to deal with traditional investments, you know that one of the most important principles is diversification. Cryptocurrency trading and yield farming are no different, and there are a few different ways to diversify your investments:
- One way to do this is to invest in different cryptocurrencies and tokens. This will help you minimize the risk of market volatility, as well as the risk of one cryptocurrency failing (due to, say, a hack or a 51% attack).
- Another way to diversify your investments is to invest in different types of assets. For example, you could invest in cryptocurrencies, stocks, and commodities. This will help you mitigate the risks associated with each type of investment.
- Finally, you can also invest in different risk profiles. For example, you could invest in high-risk and low-risk assets. This will help you spread your risk across a wider range of potential outcomes. We delve deeper into this concept in the section on risk tranching below.
All in all, “never put all your eggs in one basket” is a famous quote that applies perfectly to cryptocurrency trading.
Be patient and don’t FOMO into any investments
Many crypto projects sound mind-blowing the first time you hear about them. Just over a month ago we were all going crazy about projects like Stargate — a token that promised to “kick off DeFi 3.0” — or GMT, which was going to fuse SocialFi and GameFi. Well, guess what, both of these projects have already plunged to what might be a point of no return.
So how can you avoid that seemingly irresistible urge to FOMO into an investment that seems just so amazing? One way is to set a limit on the amount of money you’re willing to risk in any one trade. This will help you stay disciplined and prevent yourself from being drawn in by the hype surrounding any one investment.
How much money you’re willing to risk is ultimately a personal decision, but the 2%/6% rule is a good starting point. This rule states that:
- You shouldn’t risk more than 2% of your account equity on any one trade.
- If you have 6% or more of your total account equity invested in risky assets, you should avoid making any new trades for the remainder of the month.
Getting too emotionally attached to any one investment and ignoring the 2%/6% rule can lead to significant losses. So write it on your mirror and live by it!
DISCLAIMER: The above is not financial advice. Cryptocurrencies are highly volatile assets and you should never invest more money than you can afford to lose. Always seek professional guidance before making any investment decisions.
Get into the nitty-gritty of every investment
You might have heard the term, “due diligence.” It’s a phrase you see thrown around in the business world, particularly when it comes to investing large sums of money. Due diligence is basically all about taking an in-depth look at something — from the financials to the people involved — before moving forward.
Now, we get it, at this point you want to jump into crypto and get started earning — not learn all those boring details they teach in MBA programs. But, the truth is, you’re about to invest your hard-earned money into something that could make or break your future. It’s not gambling — you can’t just put your money down and hope for the best.
So what things do you need to look at when doing your homework specifically for crypto projects? Here are the three most important ones:
What’s the protocol?
At the foundation of every crypto project is a protocol — the set of rules that govern how the project works. For example, Ethereum is a protocol for building decentralized applications (dApps), while Bitcoin is a protocol for transferring value.
Every protocol has its specific properties, such as consensus mechanisms, transaction types, gas fees, etc. Some protocols favor security, while others prioritize speed. Does the project you’re about to invest in fit the protocol’s priorities? Are there any trade-offs or blind spots?
We know, this seems like a lot to process, but it will get easier with time, and it will definitely pay off in the long run.
What problems is it solving?
A great project doesn’t just have a protocol — it also has a purpose. In other words, it’s solving some sort of problem that people actually care about. Take Filecoin, for example. It’s a decentralized storage protocol that’s trying to solve the problem of data centralization. People are willing to pay for a solution to this problem, so Filecoin has real utility.
On the other hand, there are projects that don’t really solve any problems. They might have cool tech behind them, but when it comes to actual use cases, they fall short. These are the projects you want to avoid.
Then there are yet other projects, whose ambitions vastly exceed their actual capabilities. They might have a great protocol and an ambitious roadmap, but bringing them to real-world adoption is a different story. Circling back to TerraUSD, its grandiose plans were to create a stablecoin system that would free itself from any forms of centralized control and/or collateral backing.
But while Terra and Luna Foundation Guard (LFG) have provided enormous funding and support to boost UST’s adoption and utility, its reflexive tokenomics turned out not robust enough to withstand a market downturn, with everything ending in shambles.
Who’s behind it?
Last but not least, you want to take a look at the team behind the project. The world of crypto is still very much the Wild West, and there are a lot of scammers out there. So you want to make sure that the team behind the project is actually legitimate, and that they have the experience necessary to pull off what they’re trying to do.
A great way to vet a team is by looking at their past projects. What did they work on before? Were those projects successful? Do they have any experience in the specific domain they’re working in now? These are all important questions to ask.
Of course, even the most experienced and reputable team can’t guarantee that their project will be successful. But it definitely increases the chances.
Stay up to date on the latest developments in the crypto space
One of the key principles of risk management is being aware of the latest developments in your field. This is especially important when it comes to cryptocurrencies, which are notorious for being volatile and prone to sudden price changes.
Although big crashes are hard to predict, there are some telltale signs that suggest the market might be about to go down. For example, there may be a sudden increase in sell orders (indicating investor panic), or a decrease in buy orders (indicating investor fear).
Now, these do not guarantee a crash, of course, and sometimes the biggest wins come from the biggest risks. But, especially if you are new to crypto trading, playing in such a volatile market can be akin to sailing into uncharted waters with only a vague idea of where the shore is.
So, how can you stay up to date on the latest developments in the crypto space? Here are a few tips:
- Subscribe to a cryptocurrency news website such as CoinDesk or CoinJournal.
- Follow cryptocurrency Twitter accounts for real-time updates.
- Use a crypto tracking app (such as CoinMarketCap) to keep track of the latest prices and developments.
- Read financial articles about cryptocurrencies to get a deeper understanding of the technology and the markets.
- Attend crypto events to learn more about the latest trends and developments.
Granted, not everything will be clear from the outset. But by being proactive and keeping an open mind, you’ll be in a better position to protect your investment and maximize your profits.
Use a tool like Waterfall DeFi for risk tranching
In the “TradFi” world, “risk tranching” refers to the process of allocating investments into different buckets, or “tranches,” based on risk. In the case of DeFi, the concept has not been fully realized until recently, when the Waterfall DeFi protocol was created.
So how does this work, exactly?
Essentially, when you invest in a Waterfall DeFi product, you’re investing in a portfolio of different assets that are divided into tranches based on their risk. The higher-risk tranches will have higher yields than the lower-risk tranches, but they’re also more likely to experience losses.
The lowest-risk “senior” tranche investors are expecting a fixed, albeit lower, yield. So when the overall portfolio yields go up due to the overall rise in prices, these investors will be the first to benefit. The remaining “mezzanine” and “junior” tranches will go next, splitting the increased yield proportionately.
If the yield increase is dramatic, the mezzanine/junior tranches will experience a larger share of the gain, while the senior tranche will experience a smaller share. However, if the yield is not that high, the senior tranche will still get their fixed yield, while the mezzanine and junior tranches might not get anything at all.
This is a way to mitigate the risks associated with investing in cryptocurrencies and other financial assets, without having to trade frequently or risk overexposure. By taking a step back and splitting your investment into different tranches, you can minimize the chances that any one type of risk will take down your entire portfolio.
Take the current crypto crash. While the plunge caused almost all digital assets to drastically lose value, Waterfall’s senior and mezzanine tranches weathered the storm and kept their 3–5% returns dripping steadily. If that’s not a testament to the power of risk tranching, we don’t know what is.
Takeaway: You can’t avoid risk, but you can manage it
Risk management is a critical part of investing, and it’s especially important in the volatile world of cryptocurrencies. By diversifying your investments across different protocols and strategies, being patient and doing your homework before making any decisions, staying up to date on the latest developments, and using a tool like Waterfall DeFi for risk tranching, you can minimize the chances that any one type of risk will take down your entire portfolio.
We hope this article has given you a better understanding of risk management in the crypto world and how to apply it to your trading.
If you have any comments or questions, feel free to leave them down below. We’d love to hear from you!