Bear Market: Managing Risks in a Crypto Meltdown

Bear market:  Raymond Hsu, CEO of Cabital examines the most common strategies that risk investors’ assets.

It’s been a few weeks since the Terra meltdown – one of crypto’s largest systemic shocks. Approximately $60 billion of capital has left crypto, which means yields are drying up fast. As crypto prices plummet, liquidity mining incentives dry up, and on-chain activity slows down, DeFi yields continue to fall.

In fact, the situation is so dire that the crypto Fear and Greed Index dropped to a level of extreme fear not seen since March 2020. The catalyst for the downward swing was the Federal Reserve indicating it would raise interest rates by half a percentage point. This resulted in a wider market selloff, with bitcoin plummeting alongside tech stocks.

The bitcoin price dropped further due to one of the largest crypto crashes to date. It was a classic death spiral scenario started by the TerraUSD (UST) stablecoin losing its $1 peg, followed by its sister token Luna crashing. The scenario added even more downward pressure on the market, which reacted by selling hundreds of million dollars’ worth of UST, which increased the volume of Luna. The increased volume drove down the Luna price and led to a mass exodus from UST.

The fear currently gripping the crypto market is comparable to the dotcom bubble bursting and the Global Financial Crisis of 2008 according to a Bank of America Research report.

Bear Market: What does this mean for stablecoins?

The days when stablecoin deposits into money markets would yield mid-double-digits are long gone, as it’s now exceedingly difficult to find greater than 6% returns in these same protocols.

The drying up of yields also comes amidst outflows from DeFi as a whole, as following the collapse of UST, TVL (Total Value Locked) across all chains has fallen nearly 38% from ~$137 billion to ~$85 billion in the span of a week. 

The UST collapse is far-reaching, affecting the number one stablecoin Tether (USDT), which briefly lost its peg to the USD, dropping to 95c on 12 May before swiftly regaining its peg.

To exacerbate the situation, US regulators have raised concerns about stablecoins after the UST crash. This provides regulators with the perfect opportunity to propose sweeping stablecoin regulations and federal compliance.

Why did stablecoins offer high APY in the first place? 

The reason why APY rates were so high was the fundamental lack of access to debt and credit from traditional banks and traditional brokerages with crypto as collateral. It created the opportunity for DeFi pools to conduct that lending at higher rates because there’s a demand for it.

Stablecoins’ demand constantly exceeds its supply due to exchanges requiring more stablecoin liquidity to maintain trading activity. Furthermore, stablecoins act as a safe haven when crypto prices face high volatility. Another reason is that while DeFi booms, the demand for stablecoins as collateral is also rising.

As a result, stablecoins holders can charge premium interest rates, and crypto exchanges and DeFi firms desperate for stablecoins offer high-interest rates to attract new stablecoin lenders.

These DeFi firms then pass those higher rates to the people providing the capital that they’re lending. There’s essentially a much wider spread in crypto than at traditional financial institutions.

Due to the recent market volatility, crypto earn product’s APY on stablecoin has dropped. DeFi firms’ interest rates have been revised to maintain risk aversion policies and to ensure they remain sustainable and competitive within the crypto market.

Bear Market: How the industry is responding

If you’re an investor, it’s imperative to understand the common reinvestment strategies used by crypto asset management platforms and DeFi asset managers and firms that use your assets. We’ve taken the liberty of breaking these difficult-to-follow concepts into simpler terms so that you can be confident that you know what the risks are for each particular strategy.

There are some programs that have been updated to circumvent the risks of investing assets in a volatile market. As we update our risk-averse strategies to keep your principal safer, the APY rate becomes less. More risk equals higher APY, less risk keeps your assets safe while still turning a profit. 

It’s easy to be swayed by attractive APY rates, but sometimes the risks involved simply outweigh the rewards. 

Bear Market: Investment Strategies

Advantages of CeFi approach:

For CeFi, experts can choose to only work with the leading brands in the crypto space. While for the quant trading funds, experts would conduct detailed due diligence on every investment, including but not limited to several in-person conversations and key financial statement screens, to ensure the loan/debt is backed by collateral from the borrower.

Disadvantages of this approach:

A lack of independence and decision-making in regard to where your assets are being used. If you opt to invest your principal for a certain amount of time, they’ll be illiquid as the principal is locked in. This might prevent an investor from aping into a new project in time to be profitable.

Investors with a high-risk appetite may not be satisfied with the risk-averse strategies as they won’t find extremely high yields as one would find with new projects that offer too-good-to-be-true APY rates. 

Next, we now look at two common investment strategies that industry players use.

First Strategy: Liquidity provider for Automated Market Makers

What is a liquidity provider?

A liquidity provider is an investor who provides their crypto assets to a platform to assist with decentralized trading. In return for providing assets to the pool they are rewarded with fees generated by trades on that platform.

What is an AMM?

An automated market maker (AMM) is a type of decentralized exchange (DEX) protocol that prices assets based on a mathematical formula. AMMs allow assets to be traded automatically without permission thanks to smart contracts and by using liquidity pools instead of a traditional market of buyers and sellers.

Advantages of this approach:

AMMs incentivize users to become liquidity providers by adding a trading pair in exchange for a share of transaction fees and free tokens. Users automatically obtain liquidity provider (LP) tokens from the AMM by providing liquidity.

In most cases, LP tokens represent the crypto assets the user deposited into the AMM along with a proportional scale of the trading fees collected over time in the particular liquidity pool into which the user deposited assets.

Because LP tokens typically accrue trading fees over the time the user’s assets remain in the liquidity pool, the LP tokens potentially accrue value over time as well.

There are currently three dominant AMM models: Balancer, Curve, and Uniswap.

Disadvantages of this approach:

In the case of the Curve AMM model, many assets are pegged to one another resulting in several risks: 

1. Investors are exposed to the underlying assets in each pool – should the market lose confidence in one of the pool’s assets, a Curve pool can become imbalanced, meaning not all LPs will be able to exit with each asset in equal proportion. 

What does this mean? Let’s use UST as an extreme example; UST’s decline impacted related decentralized finance (DeFi) applications, such as 4pool on Curve. 

Launched in early April, 4pool is composed of two decentralized stablecoins, UST and FRAX from Frax Finance, and two centralized stablecoins, USD Coin (USDC) and Tether (USDT). It worked until it didn’t: 4pool’s liquidity currently stands at a few thousand dollars rather than the millions its creators had hoped for. As an investor/provider, if you have a 1% share of the liquidity pool, your current investment might be worth 1% of the few thousand dollars.

2. Investors are subject to two layers of smart contract risk from both Convex and Curve. This risk then evolves into more risks, which are: 

• Potential permanent loss of 1:1 peg 
• Risk of smart contract exploits (including economic/protocol design exploits)
• Volatility of yield: APRs can rapidly change from the time of deposit
• Illiquidity: high volatility of rewarded tokens, high slippage exiting positions
• Gas fees: high gas fees create friction and limit the behavior of liquidity providers and users

3. Impermanent Loss

Another risk associated with liquidity pools is impermanent loss which means one might incur a loss in one’s principal.  Losses are automatically incurred when the price ratio of a pooled asset fluctuates from the deposited price. Impermanent loss frequently affects pools containing volatile assets. The higher the price shift the higher the loss incurred.

However, the loss is impermanent as the price ratio will likely revert. The loss will only become permanent once the LP withdraws the assets before the ratio reverts. In the event that the price ratio remains uneven, the potential earnings from LP token staking and transaction fees could cover such losses.

Second Strategy: Spot-future arbitrage

A relatively new quantitative trading mechanism in the crypto market boasts an annualized return of 3% to 7%. This mechanism is spot-futures arbitrage.

This technical strategy consists of three different parts:

1. Arbitrage
2. Spot Price
3. Futures (Perpetual Futures)

This strategy relies on arbitrage (the practice of taking advantage of a difference in prices in two markets) between the spot price (the current price) of an asset and its perpetual future.

A perpetual future is an agreement to buy or sell an asset without a predetermined price without an expiry date.

It would be difficult for traders to predict the settlement price and the cost of funding perpetual futures were it not for a funding mechanism where long (buyers) and short (sellers) traders exchange a funding rate every 8 hours.

The funding rate links the price of perpetual contracts to the spot price to avoid excessive deviations between the two.

When the funding rate is above positive, buyers need to pay proportional funding fees to sellers. This results in long positions closing to stimulate sellers. Conversely, when the funding rate is negative, sellers need to pay proportionate funding fees to buyers. This results in short positions closing to stimulate buyers.

Advantages of this approach:

Spot-futures arbitrage uses the price volatility of assets to turn a profit by buying up short positions in the perpetual futures market while also holding the same amount in the spot market.

Disadvantages of this approach:

• The spot-futures arbitrage strategy requires the use of perpetual contracts to establish a position that involves the use of leverage. When the price of a currency changes significantly, the chances of being liquidated in a position dramatically rise. This may happen frequently as crypto price volatility is much higher than stock or bonds. If one didn’t develop or abide rigorously with its risk management strategy, it could cause catastrophic losses as we have seen many times in financial history.
• A change in the direction of the funding rate – when the direction of the funding rate changes during the operation of the spot-futures arbitrage strategy, investors may suffer from losses due to the shift from being a recipient of funding fees to a payer.
• Leverage is especially common spot-futures arbitrage, and it significantly increases risk. Leverage refers to using borrowed capital to trade assets. Leverage amplifies the buying or selling power allowing trades with more capital than what is available in the wallet. Depending on the crypto exchange up to 150 times leverage is available.

Trading with high leverage might reduce the initial capital necessary to trade, but it increases the chances of liquidation. If the leverage is too high, even a 1% price movement could lead to dramatic losses. The higher the leverage, the smaller the volatility tolerance will be.

Bear Market: Being Transparent on Risk Profile

The above strategies are some of the common investment practices that promise high APY rates but it’s often complicated with the excessive risk involved. As such it’s prudent to consider a platform that employs strategies that turn a profit while remaining safe.

A responsible investor should try to understand how each platform makes money and determine their own risk appetite, knowing their risk-reward ratio on every investment decision. Always taking steps to protect themselves from a long-tail risk or black swan event.

Considering long-term investments in volatile conditions could lead to extraordinary returns as illustrated by bitcoin’s low price in 2017 versus its all-time high in 2021.

About the author

 Raymond Hsu is the CEO and co-founder of Cabital, a leading cryptocurrency wealth management platform. Cabital’s mission is to help empower people from all walks of life to generate high-yield passive income from their digital assets and create a more sustainable financial industry. Prior to co-founding Cabital in 2020, Raymond worked for fintech and traditional banking institutions, including Citibank, Standard Chartered Bank, eBay, and Airwallex. 

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