Parsing 3 Types of Risk in Digital Assets

·6-min read

To earn a return, one must take risks. Even the theoretical “risk-free rate” – calculated by subtracting the current inflation rate from the yield of the Treasury bond matching the investment duration – carries risk. Those risks include counterparty risk (in the event of a U.S. government default), currency risk (in the case of foreign investments) or a miscalculation of inflation.

In traditional markets, the yield one can potentially earn is typically commensurate with the risk taken – the greater the risk, the greater the potential return and potential loss. In digital assets, high yields are ubiquitous, but it’s not always clear what risks are actually taken to generate these yields.

Jeff Dorman, a CoinDesk columnist, is chief investment officer at Arca, where he leads the investment committee and is responsible for portfolio sizing and risk management.

So why do high yields exist in digital assets, and how are they generated? To answer that, we need to explore the three different types of risk that currently exist in the market.

Counterparty risk – the risk that the principal will not be returned due to the health and solvency of the party that holds the assets.
Duration/reinvestment risk – the risk that yields will be lower at the expiration of an investment
Directional risk – the risk that the price of the underlying asset declines

Counterparty risk

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Two of the most well-known and heavily discussed yield opportunities come from the basis trade (“cash and carry”) and stablecoin lending (e.g., staking USDT with a decentralized finance [DeFi] platform). These yields, which can range from 5% to 40% annually, largely exist because of an industry-wide working capital deficiency. Unlike traditional markets where there is too much cash in the market and a single prime broker can help one execute across any and all venues, in digital assets there is often not enough cash to navigate a fragmented and dislocated market. 

For example, to buy just $1 million of assets, one might need $3 million-$5 million of cash to ensure there is enough buying power spread out across different venues, as the best offer might only appear in one place. Similarly, market makers require cash to facilitate trading at each of these venues. This cash shortage creates demand for dollars, which in turn leads to high lending yields and often higher prices for derivatives that require lower cash collateral. But these yields are not risk-free. Both lending and spot/futures arbitrage introduce counterparty risk.  

The counterparty can be an exchange, an over-the-counter (OTC) dealer, a technology provider, a DeFi protocol or one of the interest-bearing quasi-banks. The recent bankruptcy case of Cred Capital is a stark reminder of how great these risks can be. Back in 2008-2009, after the demise of Lehman Brothers and Bear Stearns, investing became less about what you owned and more about who you owned it with. This same dynamic occurred again in 2011-2012, when brokerages like Knight Capital, MF Global and Jefferies teetered on the brink of insolvency (with MF Global filing).

All risks can be managed, including counterparty risk, when one properly identifies the risks and conducts proper due diligence. But not understanding the risk taken can be costly. 

Reinvestment risk

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Would you prefer a 10% fixed return locked in for one year or a 20% fixed return locked in for one month? To properly assess, one must have a view on what rates will be one month from now. While the 20% yield sounds much better, if rates plummet to 1% by the time that instrument matures you are now faced with 11 months of lower returns that could have been avoided had you locked in the lower rate. When hunting for the best rates, understanding this duration and reinvestment risk matters a great deal.

Every yield instrument has a maturity. Whether you are buying a bond, lending an asset, taking out a home mortgage, doing an arbitrage trade with a lockup or trading an options or futures curve, these investments have a shelf life. As such, investors need to have an opinion on forward-looking rate opportunities regardless of how attractive is the current environment. With digital assets these rates are highly volatile and are dependent on outside factors such as how much leverage is in the market, new participants entering and existing, and new tokens with inflationary incentive mechanisms built in as marketing costs to attract customers. All of these factors determine the forward-looking rate environment, and managing that duration risk is imperative to generating stable returns.

Directional risk

While lending stablecoins and basis trading carry both counterparty and duration risk, these two strategies often carry little, if any, price risk. These are truly market-neutral strategies. But there are plenty of other ways to earn yield that do require a directional market view. MicroStrategy, the first publicly traded company to invest heavily in bitcoin, recently raised $500 million in a secured bond deal at a 6.125% coupon. While that coupon is fixed, the yield an investor earns is variable because the price of the bond may go up or down over the lifespan of the bond, thereby increasing or decreasing the total return of the investment beyond the 6.125% coupon. 

Similarly, yield farming, selling options, staking and acting as a liquidity provider all come with some degree of price risk. While the yield itself from these strategies may be fixed or variable, ultimately the underlying assets one must hold to participate in these strategies can move up or down.  

Like all risks, there is nothing wrong with taking directional risk, as long as the risk is understood. For example, yield farming still offers tremendously high yields because these protocols and applications are essentially giving out quasi-equity in the form of inflationary token rewards to help bootstrap customer growth and network participation. The yield itself is a nice kicker, but ultimately the decision to farm or not is a bet on the growth of the platform itself. Should the platform succeed, the native token with which you’re earning rewards will perform well.  

For example, imagine if early adopters of Amazon Prime received more Prime membership rewards, and delivery persons, frequent shoppers or merchants who provided discounts could earn even more rewards. If Amazon works, Prime membership becomes more valuable and now you can sell your excess Prime memberships that were gifted to you (see my previous CoinDesk article about this). That’s yield farming, and that’s also directional risk.

Conclusion

All three of these types of risk can be mitigated, and managed, if properly understood. But it should also come as no surprise that the yields available via various digital strategies are much higher than yields that can be earned in traditional finance.

The counterparties are all brand new, and therefore much riskier. More risk = potentially higher yields.
The volatility of the asset class means reinvestment risk is greater. More risk = potentially higher yields.
The future path of most digital asset projects is more uncertain, and thus directional risk is greater. More risk = potentially higher yields.

While yields may have compressed in the short run as speculative fervor has temporarily paused, until this market matures further higher risk/higher reward opportunities are not going to go away.

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