3 Risk Management Strategies for DeFi
At the same time, this volatility has a flip side: a rather high risk. Let’s take a look at a few strategies for the DeFi market that can minimize these risks.
The total funds in DeFi protocols in 2021 are estimated to have grown from $20.1 billion in January to $120.3 billion in early June. In addition, the average daily trading volume on decentralized exchanges (DEX), an integral part of decentralized finance, also grew by 100%. In Q1 2021 it exceeded $2 billion, while in Q4 2020 it remained below $1 billion.
From the very beginning, investors took a liking to the DeFi segment, since decentralized finance gives them more control over their money. And while early on decentralized finance drifted toward loans and credit, DeFi is now at least 5 full-fledged, interconnected segments: blockchain, decentralized exchanges (DEX), loans and credit, decentralized derivative platforms, and insurance.
Despite its relative stability, the DeFi segment remains rather risky as an investment. The volatility in the tokens of various projects certainly attracts new investors. However, high yield also means high risk. There are several effective methods for managing risks in DeFi.
Strategy #1: Diversified Portfolio
In this strategy, investors fill their portfolios with the most promising, undervalued, and non-overlapping DeFi projects. This evens out the risk of the portfolio losing significant value because of a single asset. You can identify promising tokens by their market cap to total value locked (TVL) ratio. Tokens with the lowest correlation of these values can be considered undervalued, which means there is reason to expect these assets to “catch up” with others in their valuation and grow. Therefore, by buying these cryptocurrencies, traders stabilize their portfolios for the medium and long term.
To further diversify your risks, you can choose projects on different blockchains, such as Ethereum or Binance Smart Chain. Another option is to choose negatively correlated tokens, meaning that when one token is highly volatile in day trading, you should choose a more stable asset for balance. Relatively stable assets include the Uniswap (UNI) and Zilliqa (ZIL) tokens.
Diversifying your portfolio by adding an insurance project is even better, since the demand for protecting capital within the decentralized finance ecosystem is only going to grow. Projects offering DeFi insurance include Cover, Nexos Mutual, Etherisc, and Opyn. Having these tokens in your investment portfolio will allow you to significantly offset an adverse event, if one were to suddenly occur.
Strategy #2: Staking
You can also lower your risks of value loss with stake-able tokens. The cryptocurrencies of certain DeFi projects offer the ability to profit just by storing them. For example, users of the international cryptocurrency exchange CEX.IO can earn up to 16% annual interest for holding tokens. And the profit from staking increases when the coin’s price rises. For example, if a trader invests $100 in ZIL at $0.20 per coin, with 16% interest for staking they would receive about 580 ZIL at the end of the year as their reward. If in that time the price has increased from $0.20 to $0.40, the trader would get $232 when they cash out. Taking into account the coin’s price increase, the profit rises to 132% instead of 20%.
To protect your portfolio against large fluctuations, you can invest in stablecoins that offer staking, such as Dai. This way, the passive income from your tokens can both increase your overall profit from investing in the DeFi sector and offset potential losses if the market plummets. Furthermore, traders can limit their losses to the amount of their potential staking reward. As soon as the losses on their positions get close to the profit they would get from staking, traders can simply close them.
Strategy #3: Hedging
In the basic hedging format, when buying an asset on an exchange, traders immediately open an opposing position in the associated derivative. Such derivatives could be futures, options, or contracts for difference. So if a trader buys UNI on the exchange, to hedge the risk of the asset losing value they would sell a contract for difference for the same amount. In the end, if UNI gains in price, the losses on the contract for difference would be covered by the increase in the cryptocurrency’s value. If instead the price for UNI falls, this difference would be evened out by the opposite position on the CFD.
Derivative trading is offered by specialized platforms, and CEX.IO Broker is one such platform. You can use it to both profit from fluctuations in the prices of cryptocurrencies without having to physically buy them and to hedge assets you’re holding. A contract for difference allows traders not to participate directly in DeFi and avoid the technical risks, uncertainty, and complexity associated with it. To control risks, the platform uses automatic protection orders, such as stop-loss and take-profit.
CEX.IO has created a full-fledged ecosystem for trading and capital management. It allows users to extract maximum profit from movements in the DeFi market and, if necessary, apply strategies to effectively protect their capital.
Users are offered a comprehensive solution right off the bat. There’s portfolio diversification: lots of DeFi coins to choose from for investment and trading. There’s staking, which offers higher yield even compared to the rewards from the network: for example, ZIL staking gives 16% interest, whereas the network gives only 14.2%. Finally, there’s derivative trading for DeFi coins at CEX.IO Broker.
The flexibility of CEX.IO Broker makes it possible to open up to 10 accounts as part of one user account and test different strategies independently of each other. For those who have never encountered the crypto market before, the platform offers the option of a demo account. Once traders feel confident in their abilities, they can transition to a real account and start trading the currency pairs they like.
CEX.IO Broker is a margin trading platform, which makes it possible to start trading with a smaller amount of funds compared to spot trading. This gives the opportunity to increase trading capital by using leverage.