Crypto Risk Management: Part I - Are Crypto Assets “Too Volatile”?

In the earliest days of European map-making, cartographers commonly placed giant monsters and sirens of the deep in places where unknown dangers may have lurked.

hic sunt dracones (“here are dragons”)

In reality, these fantastic beasts posed no threat at all. Losses – of goods, ships and even lives – were of course caused by storms, rocky coastlines, scurvy and even rival adventurers.

Our own biases often force us to focus on irrational risks while missing those that should be obvious and more likely to occur. Nobel-winners Kahneman and Tversky identified many of the mistakes we make on a daily basis that result in our misjudging or risk and reward. Loss aversion, narrow framing, confirmation bias, etc all conspire to make truly objective risk adjudication almost impossible.

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Crypto assets have been ignored by large swathes of the population precisely because of the many biases we as humans succumb to on a daily basis.

One of the main reasons why countless investors and capital allocaters have missed out on adding a digital asset allocation to their portfolios is because they thought of the sector as either “too risky” and/or prices are “too volatile”.

There is no doubt that crypto investing is risky. Indeed, all investments have some risk.

To successfully invest in this asset class, it’s important to be honest about the risks so that one can proactively protect against the most damaging outcomes, and allocate in a way that enables one to stay in the game to see the fruits this industry is likely to bear in the long term.

Crypto investment risks include, but are not limited to:

Market price risk - With highly volatile assets, there is a risk that one needs to sell during a drawdown period, or that an entry price is less than optimal (and there is a long wait for returns to be realized). Mitigants include dollar cost averaging, hedging using options and limiting the use of leverage.
Liquidity risk - Many assets, including crypto venture capital and traditional private debt, are extremely illiquid. Illiquidity is mitigated by limiting exposure to small-caps and lockups, or matching long-term funds with long-term positions.
Risk of smart contract failure - Crypto networks and protocols are simply code that can fail on occasion, resulting in real token losses. Mitigations include using audited and seasoned protocols, and the purchase of insurance.
Governance, or “rug pull”, risk - “Insider” parties such as developers may have the means to steal assets out of the smart contracts. Risks can be mitigated as in 3.
Counterparty risk - A borrower, exchange or custodian could fail, resulting in lost assets. This risk is quite low in decentralized finance. Exchanges tend to be insured.
Operational risk - Trading and transferring assets has a unique set of risks that differ from those in traditional finance. Secure management of keys is mandatory in crypto.

Over the coming weeks, we will examine each of these risks and discuss how Hartmann Capital views and mitigates each one. Before we delve into the details, however, this short introductory essay addresses perhaps the most important question of all: Are crypto assets as an asset class “too volatile”?

Are crypto assets “too volatile”? Does it matter?

It’s true that a headline declaring an asset a scam when it falls 40% in a short time, as Bitcoin has done this year, attracts more attention than any positive headline involving creeping growth in market capitalization and crypto adoption. What is ignored when mainstream and social media focus on crypto volatility is that BTC remains up just over 200% (or 3x) year on year, even after the recent correction.

In fact, Bitcoin has been declared dead 423 times, according to one source.

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The mainstream press when they call Bitcoin a Ponzi scheme only seeks to add to non-Bitcoiners’ confirmation bias: Those that missed the early years of BTC keep hoping that they will be proven right, even if it is less and less likely that their dreams will come true as crypto becomes more widely adopted.

Worse, mainstream media mimics mainstream financial markets practice, which is to continually fault crypto assets for being “more” volatile than traditional assets. This is because the main measure of efficiency in modern portfolio theory (MPT) is that assets should be what is called “mean-variance” efficient, as measured by the Sharpe Ratio.

The Sharpe ratio divides the asset’s historical return (above the risk free rate) by the asset’s historical risk as measured by the standard deviation of returns:

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Sigma here is a measure of the variation in returns, usually daily.

In simple terms, assets that are more volatile on a daily basis need to yield more than so-called safer assets to justify their inclusion in a portfolio. Low Sharpe ratios are indicative of poor portfolio performance.

The S&P 500’s Sharpe ratio has been running around 1 with the recent extended credit cycle.

This concept of market risk determining required return is nearly a century old and has well overstayed its welcome. Nobody, not even in mainstream finance, ever asks why we care about the Sharpe ratio.

Crypto assets indeed have experienced many periods of extremely high volatility. This is however no reason to avoid allocating to the asset class. The idea that day-to-day volatility is bad ignores the time horizon of one’s investment and the potential returns available.

If the expected return of an asset is high and the time horizon long, the daily volatility is a meaningless measure.

If you locked your portfolio in a drawer for two to three years, and at the end you came out with high returns, did the daily fluctuations matter?

So far, it has paid to be a crypto believer, even if there have been many large corrections. Using Bitcoin as our proxy for the long-term crypto asset markets, the March COVID crash resulted in a just over 45% drawdown from the previous high close in February 2020. However, the complete correction began in June 2019 when BTC made a then-all time high close of $12,852, bottoming at $5,032 on March 16, 2020: An 8.5 month bear market and a 65% decline.

While appearing catastrophic, it should be remembered that the US Stock market fell almost exactly this much in 2007-9, over 16 months. While the US stock market rebounded after the Global Financial Crisis to hit all time highs this year, BTC outperformed every possible asset since that March low. BTC hit a new all time high (ATH) seven months after the COVID crash bottom in March.

Six months later, in April of 2021, BTC was up 1000% (or 11x).

As of July 15 2021 the drawdown from the all time high in April has almost matched the COVID correction at down 48%. Yet BTC is still up on the year and is up 245% over the last twelve months.

Note that these returns are before any fees that could have been earned through yield farming or lending to centralized institutions.

Sharpe Ratios

We explained above that Sharpe ratios aren’t much use for those with a long time horizon. Asset returns trump all other measures ex post. If you don’t ever have to sell in a drawdown, the volatility is meaningless, unless of course you count the emotional cost.

Sharpe ratios are poor measures for other reasons too. Almost all asset classes have additional risk that cannot be measured, even in hindsight, by standard deviations of daily returns. Almost all asset returns are “fat tailed”, meaning they fall more than expected in corrections, and standard deviation and price direction are correlated (standard deviations rise as prices fall).

Even though we think the Sharpe ratio is a poor measure of value, it’s worth examining how BTC Sharpe ratios compare to the stock market. Remember that the long bull market in stocks has resulted in a Sharpe ratio of approximately 1.

Crypto by any measure has hit it out of the park, even after considering the latest correction in the history of the asset class.

For those with long time horizons and no need to sell, the daily volatility is meaningless. Even with the five year Sharpe ratio for BTC at near US equity levels, BTC returns have been many multiples of those of the US stock market. More than 2x over one year and 15.65x over five years.

Drawdowns as Opportunities

Even if we feel confident in the long term prospects for crypto, riding out long bear markets and large drawdowns can be mentally and emotionally draining. This is when we need to trust in the future of crypto in the long run, just like stock market investors have done on many occasions, and for which they have been amply rewarded.

During our lifetimes alone we have seen incredible bear markets in US equities. In each case these were tremendous buying opportunities:

Regular fluctuations have historically offered tremendous buying opportunities. As long as one can remove themselves from the emotional roller coaster that price declines tend to elicit, corrections may be considered opportunities.

As Warren Buffet has often said

We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.

In crypto as in equities, opportunities have followed the largest drawdowns.

As a hedge fund, Hartmann Capital is attempting to minimize market crypto price risk by:

Choosing the assets with the best value propositions within the crypto asset class
Short positions
Hedging using options
Market timing/ momentum trading
Adding additional returns to crypto positions through yield farming, staking, lending
Using leverage sparingly so that drawdowns do not force us out of positions

Leverage and Drawdown Risk

There is one time we do care about drawdown risk, and that is if we can’t afford losses. Many crypto investors use leverage, some extremely aggressively. Exchanges offer as much as 100x leverage on the most active assets, and a 1% move can therefore wipe out an over-margined position. Even at lower leverage, highly volatile periods incentivize large traders to “gun for stops”, forcing the highest leveraged positions to capitulate and sell at the worst possible time.

Since BTC’s all-time high, there have been four days where liquidations at exchanges topped $4 billion, with $9.26 billion sold to cover margin on April 17, 2021.

It should be obvious that leverage does not mix well with excessive price volatility, sharp drawdowns or illiquidity gaps that appear at some exchanges during corrections.

One can sleep through volatile markets and not ever notice market risk. However, when even light (2 - 3x) leverage is deployed, a sudden flash crash, or even a seasonal 50% retracement can be life of death for a levered investor. This is the only time when market price volatility does matter in the short run.

Having navigated these markets institutionally for over 3 years, we have seen countless competitors crash and burn for this reason alone. As a result we rarely use leverage, and the few times we do, such as after historic crashes, we never collateralize levered positions with our entire book, but rather limit our leveraged positions to our highest-conviction assets, and even then allocate only single percentage points as collateral.

Diversification Benefits?

We will talk more about diversification within the crypto asset class in a future blog. However it is worth mentioning that the numbers above apply only to Bitcoin. For much of crypto’s history this didn’t make much difference. Crypto assets have exhibited very high correlation to BTC, especially in major corrections.

In the thirty days to March 13 2020, the COVID crash, Bitcoin and the other major cryptocurrencies at the time (XRP, XLM and ETH) were correlated almost 100%, crashing between 47.5% and 56.1%.

However, in March 2020 “DeFi summer” and the rise of governance and reward tokens had not yet occurred, and both the Metaverse and Web3 hardly existed.

In this latest correction, subsectors and individual assets have broken away from BTC dominance. Since Bitcoin’s all-time high and nearly 50% decline to date, Ethereum is almost unchanged and metaverse assets such as Axie Infinity (AXS) have outperformed.

This type of action bodes well. If the crypto market is driven by more than just the Bitcoin price, diversification will have multiple benefits, including dampening price volatility. It should also put a greater premium on token selection, benefiting those who can identify value rather than simply hold BTC for the long term.

Allocation Strategy: Optionality

How should we allocate to crypto? One way to look at the asset class is to think about optionality, as venture and angel funds do.

Venture capitalists and angel investors take even bigger risks in the long term than crypto investors. The average investment is likely to underperform, yet investors hope for a few large victories, or even a Unicorn (startups valued over $1 billion) to compensate for the rest of the losers.

Perhaps crypto investing should be thought of in the same way as VC/angel tech investing at the turn of the millenium. If crypto really is the new new thing, like the internet was, the industry will grow, even if we do not yet know who the winners will be.

The losses should we be wrong may equally as great, except one can’t lose more than their initial investment.

To put some over-simplified numbers on it, let’s say there is a 10% chance of making 10x return over the next 5 years, a 10% chance of making 5x return over the next 5 years and an 80% chance of losing everything. The expected return is 50%. Nothing beats that over the long run. The downside is 100% loss. We mitigate this by sizing the investment appropriately.

If one can make an annual return of 5% on a diversified portfolio in the long run, allocating 10% to crypto assets is simply taking two years of average returns in order to have a 10% chance at more than doubling the total portfolio over the five years (10x on 10%) and 10% chance of increasing it by 50%.

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One thing we know about options is that volatility is a positive. The more an asset is volatile the more likely the option is to expire profitably “in the money”.

In other words, if I increase the variability of the scenario above, the expected payoff could actually rise. If now it’s a 10% chance of a 20x and a 90% chance of losing one’s crypto investment, the weighted (expected) total return rises to 34.8%!

So perhaps volatility in crypto is a feature and not the bug that the mainstream would have us believe?

A crypto portfolio is not about riding the latest “pump and dump” memecoin and praying that the market doesn’t collapse before you get out. It’s not even about hedging Fed money printing and the risks of hyperinflation with BTC with the expectation of a 10x.

A crypto allocation is an option on the global crypto developer ecosystem. Will crypto change the world, establishing a new decentralized “Web3”, wrenching power away from BigTech monopolists? Will it give gamers and collectors better ways to establish ownership without relying on the centralized platforms? Will it serve as the base for a virtual reality metaverse? Will it offer more transparent, efficient, faster and cheaper financial services for all?

Crypto investing is a long term, asymmetric bet on technological revolution as well as on the resourcefulness and innovation skills of highly motivated and often-brilliant developers and team leaders.

Or would you rather bet against the next Bill Gates? Or even the current Jack Dorsey?

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