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FINANCIALLY AESTHETIC · GUIDE 36/37
CRYPTO RISK MANAGEMENT: VOLATILITY, LIQUIDITY & LEVERAGE
FA-7.4 · Crypto & Digital Assets
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RISK FRAME
Leverage turns ordinary volatility into liquidation risk, while thin liquidity makes exits worse than the chart suggests.
Volatility: A Risk Indicator
The value of a stock or fund fluctuates constantly. Volatility is a measure of the magnitude of these ups and downs.
Understanding an investment’s volatility level is therefore useful for assessing its risk: when volatility is high, the value of the invested capital can decline significantly.
High volatility is generally accompanied by the prospect of attractive returns. However, high returns can never be guaranteed.
Stock prices fluctuate to varying degrees depending on investors’ uncertainty about the future of the listed company. Collective investment schemes (funds and SICAVs), which are invested to varying degrees in stocks, also fluctuate. However, they are generally less risky than individual stocks because a diversified portfolio across multiple securities fluctuates less than any single security.
Focus: Stock Volatility and Investment Horizon. With equity investments, it is not uncommon to see declines or gains of more than 20 or 30 percent in a single year. And by investing for just one year, an investor has almost as much chance of incurring a loss as of making a gain. For this reason, equity investments should be viewed as long-term investments - at least five years, and more reasonably 10 years or more - to increase the chances of a return.
Being aware of the possibility of a loss at the end of an investment is one thing. But before investing, every investor must also understand their ability to tolerate fluctuations throughout the life of the proposed investment. You need to be able to remain calm if your investment suddenly drops by 10%.
The Volatility Inherent in Cryptoassets
When investing in cryptoassets, you may face the risk of a speculative bubble: cryptoasset prices are highly volatile and expose buyers to potentially very significant financial losses.
Despite their success, first-generation cryptoassets, such as Bitcoin and Ethereum, are not legal tender and have no intrinsic value. They are therefore speculative and highly risky assets.
For the most part, crypto-assets are not backed by any physical underlying asset (such as commodities or real estate) or economic underlying asset (such as a share of a company’s capital in the case of a stock), but rather by a protocol through which they are issued. Nor do they generate income streams, which are traditionally used to estimate the value of a financial asset (dividends for stocks, coupons and principal for bonds). Also, unlike, for example, gold, silver, or a work of art - which have industrial, patrimonial, aesthetic, or even medical uses, conferring intrinsic value upon them - crypto-assets cannot be valued based on fundamentals. Their price is therefore inherently volatile.
This decline is exacerbated by the market’s high volatility, which is itself amplified by its low liquidity (average daily trading volumes of approximately $46 billion for Bitcoin and $32 billion for Ether).
In reality, only a small proportion of these Bitcoins is in circulation (approximately 20% of the total), and the market’s low liquidity contributes to high price volatility. According to Chainalysis, 85% of the Bitcoin supply was illiquid as of late 2021, either because it is held by investors who are bullish and therefore prefer to hold a large portion of their Bitcoins for the long term, or because it has been permanently lost (loss of access, forgotten accounts, etc.).
Major crypto-assets have delivered returns far exceeding those of other asset classes in recent years (for example, +57% for Bitcoin in 2021 versus +27% for the S&P 500 and the Nasdaq), albeit with high volatility and associated high risk exposure.
The crypto-asset market, which has experienced several periods of contraction since May 2021 and whose market size has been reduced to one-third of what it was in November 2021, faces persistent limitations - high fees, slow transaction speeds, energy costs, and security vulnerabilities - that hinder its development. Also, the ecosystem exhibits vulnerabilities stemming from its high concentration, elevated liquidity risks, and significant risk exposure to market risk, posing risks to financial stability, although the market’s size remains modest compared to other major asset classes (approximately $800 billion in June 2022, compared to about $25,000 billion for the New York Stock Exchange alone or $11,000 billion for the gold market).
The Mechanics of the Decline: Why a Significant Loss Is So Difficult to Recover
The recovery calculation, without an external source
The relationship is a simple arithmetic identity. If a value drops from 100 to 50, it has lost 50%. To recover from 50 to 100, it must then gain 50 from a base of 50, or +100%. This calculation is not a market forecast; it merely illustrates why large losses become increasingly difficult to recover from.
The crypto-asset market has experienced three significant downturns in one year (in May 2021; between November 2021 and January 2022; and starting in April 2022), with Bitcoin now trading around $20,000 - a level below that reached in early 2021.
The total market capitalization of the crypto-asset market, which had been growing rapidly in recent years, has experienced several significant contractions since May 2021. After an initial peak of $700 billion in early 2018 - driven exclusively by Bitcoin’s growth - the market soared again starting in late 2020 and reached nearly $3,000 billion in November 2021. [...] The market size stands at around $800 billion in June 2022, down from nearly $3,000 billion in November 2021.
This trend clearly illustrates the mathematical asymmetry of recovery after a loss: an asset that loses 73% of its value (falling from $3,000 billion to $800 billion) must then multiply its value by a much higher factor to return to its initial level - a 50% loss requires a 100% gain just to return to the starting point, and the deeper the decline, the more the necessary recovery gain grows disproportionately compared to the loss incurred.
As a result, a large number of hedge funds specializing in crypto-assets are facing significant liquidity and capital challenges following the market collapse since April 2022, such as, for example, the Singaporean hedge fund Three Arrows Capital (3AC).
Liquidity: A Factor That Amplifies Volatility and the Risk of Loss
The liquidity of crypto-assets varies greatly, and many crypto-assets see their value plummet, sometimes to the point of disappearing entirely (several thousand in 2021). Also, various platforms and applications are extremely vulnerable to liquidity strains and periods of significant withdrawals. For example, amid severe strains caused by the collapse in the value of crypto-assets, the lending company Celsius (nearly 2 million users and approximately $25 billion in assets under management as of late 2021) faced massive withdrawals (roughly half of its assets under management in just a few months) and was forced to freeze its assets in June 2022 due to a high risk of insolvency. This risk is exacerbated by the fact that liquidity is generally provided by only a few players: more than half of the deposits on major platforms reportedly come from just a few individual accounts, making them extremely vulnerable to sudden movements and thereby posing a risk to the entire ecosystem, particularly given the lack of transparency in liquidity management.
Crypto-asset exchanges and loans do not benefit from the protections afforded to modern bank deposits, such as deposit insurance systems or liquidity support from central banks. As a result, due to their role in transforming liquidity and maturities, they are exposed to the risk of massive withdrawals by investors during periods of liquidity stress or a loss of confidence in their reserve levels.
Finally, stablecoins present specific risks. First, the de-pegging and subsequent collapse of the value of the algorithmic stablecoin TerraUSD (UST) in May 2022 served as a reminder of the persistent fragility of this type of asset, whose peg - maintained in a decentralized manner - is particularly vulnerable to a massive exodus of investors.
Slippage
This type of attack also exploits the mechanisms that allow for price fluctuations in the cryptoassets being traded between the time a transaction is submitted and its confirmation (slippage): users set in advance the maximum slippage they are willing to accept. The risk of “sandwich” attacks can thus be mitigated by setting a lower slippage limit, though this carries the risk that some of the transactions a user submits for validation may ultimately be canceled in the event of excessive price fluctuations, which can pose other challenges.
Consider the example of a user X who has sent a transaction to acquire a certain amount of a crypto-asset A. The malicious bot that has spotted this transaction will then attempt to insert a second buy order for the same asset A before the transaction sent by X (front-running). To do this, the bot generally only needs to pay higher transaction fees than those of the initial transaction, since most blockchains validate transactions in descending order of fees (gas on Ethereum). The malicious bot’s purchase of crypto-asset A drives up its price, causing X - once their transaction is validated - to buy asset A at a price higher than the one originally set, resulting in a loss for them.
Leverage and Liquidation
Financial risks are also significant, especially for retail investors unfamiliar with the complexity of the ecosystem, due to the user-friendly nature of the interfaces used. The high use of leverage, the riskier profile of market participants, the low transparency of most exchanges, the strong pursuit of returns, and the “gamification” of finance - which heightens retail investors’ interest in these complex assets - all contribute to increasing the risk level. These frauds and financial risks are exacerbated by the lack of audits and oversight regulating the sector, as well as the lack of recourse in the event of losses.
A significant class of derivative products with crypto-assets as underlying assets has emerged (options, forwards and futures contracts, contracts for difference, interest rate hedges, etc.). Trading in Bitcoin derivatives on a regulated platform such as the Chicago Mercantile Exchange now accounts for 14% of the open interest and 4% of the trading volume recorded there, even though most crypto-asset transactions take place on unregulated platforms. The total open interest in Bitcoin - which corresponds to the total amount invested in derivatives of an asset - stood at $1.4 trillion in November 2021.
The volatility of crypto-assets, along with their very high correlation, can unsettle certain exposed investors or portfolio managers. In addition to the impact on portfolio valuations, a drop in crypto-asset prices can also affect the DeFi market. When crypto-asset prices fall, the collateral deposited in decentralized finance (DeFi) applications decreases accordingly, requiring the liquidation of positions when investors are unable to restore the required collateral level. Liquidation events on DeFi platforms - whose one-year probability is estimated at 24% by the IMF - have thus been on the rise for several months (the platforms Aave, Maker, and Compound had already faced liquidations totaling approximately $300 million in November 2021) due to the price correction. For platform users, these events result in capital losses and a sharp increase in transaction costs.
Concentration: A Structural Risk in the Crypto-Asset Market
The crypto-asset market is highly concentrated among a few players who exert significant influence over prices. Approximately 10,000 wallets - representing 0.01% of holders - control more than 25% of the Bitcoins in circulation. Also, the market is structured around a few platforms (Binance, Coinbase, FTX, Kraken, etc.), whose failure - for example, due to cyberattacks exploiting vulnerabilities in their infrastructure - would risk destabilizing the entire sector. The issue of regulating these platforms - which handle the issuance, storage, and trading of securities - is also problematic for those located in jurisdictions with favorable tax regimes.
The values of the major crypto-assets remain very strongly correlated with one another (a stable correlation between Ether and Bitcoin, around 0.8), which limits the interest in diversification and explains, among other things, why investors remain largely focused on Bitcoin.
Bitcoin’s correlation coefficient with major stock market indices has risen sharply and is now estimated at 0.3 with the S&P 500 and 0.4 with the Euro Stoxx 600.
Stablecoins pose significant risks both to the crypto-asset ecosystem - given their central role (USDT, or Tether, is involved in 50% of all crypto-asset transactions) - and to the financial sector as a whole.
Position Sizing: Start with the Amount of Capital You Can Actually Afford to Lose
Principal and returns are not guaranteed. These investments are only suitable for investors who are willing to accept that a portion of their savings may fluctuate in value and that they may lose some of the money invested upon resale. In any case, you should maintain emergency savings. Assess your risk tolerance with your regular financial advisor and determine what portion of your savings can be invested in risky assets.
For the purposes of this chapter, position sizing refers to choosing the size of a position within the capital allocation that you can realistically expose to risk. There is no universally applicable percentage for crypto investments: the position size must remain consistent with your capacity for loss, your emergency savings, and the investment’s risk.
Security, Losses, and Lack of Recourse: Risks That Exacerbate the Impact of a Poor Position
The crypto-asset ecosystem is particularly volatile and poorly regulated - numerous cases of fraud and market manipulation are estimated to have amounted to $14 billion in 2021. In the DeFi sector alone, approximately $2.5 billion is estimated to have been lost in 2021 as a result of hacks or protocol manipulations exploiting vulnerabilities. [...] Individual risks related to cyberattacks (phishing, identity theft, ransomware, etc.) are also high, with each successful cyberattack reportedly resulting in a median loss of 30% of the targeted user’s deposits.
When investing in cryptoassets, you may face risks such as hacking: the storage of cryptoassets offers no protection in terms of asset security.
If you wish to invest in cryptoassets, here are five practical tips from the AMF:
1\. Check the AMF’s blacklists before investing,
2\. Use a service provider registered with the AMF,
3\. Ensure the secure storage of your cryptoassets,
4\. Never lose or disclose your private key,
5\. Always verify the accuracy of a public address.
SURVIVAL RULE
Cap position size, avoid leverage you can't model and plan exits under stressed - not normal - liquidity.
CURRENT-RULES CHECK
Legal protections, tax rates, reporting duties, deadlines and product rules change by country and over time. Use the jurisdiction labels in this guide and check the linked official source before acting.
- Investor.gov - Crypto assets - United States - crypto-asset risk.
- FINRA - Margin calls - United States - leverage and liquidation.
- BIS - DeFi lending and intermediation - International - institutional DeFi research.
