What is Market Risk?

July 28, 2022
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In this article, let’s learn about the different market risks involved in DeFi (Decentralized Finance) and how Coinchange manages to mitigate them.

What is Market Risk?

Whenever you trade assets on any market, inherent risks are always going to exist - nothing is completely risk-free. Market risk affects the performance of the entire market simultaneously and there could be several reasons for that. If we look at the short history of the cryptocurrency market, one could state that it happens to be the most volatile market in existence, with some of the highest percentage gains (and losses) seen to date.

Let’s take a look at some of the market risks to be aware of when trading in the DeFi space.

Impermanent Loss

Impermanent loss is a form of risk that occurs when you provide liquidity to an AMM (Automated Market Maker) by depositing your assets. By design, these protocols aim to keep a set equilibrium quantity of each asset in the pool. If you end up withdrawing your assets from the pool at the wrong time (and the prices have greatly varied from the time you first deposited them) then you’ll be at risk of withdrawing less value of your position than your initial deposit.

This is because of the decentralized structure and dynamic of AMMs. Impermanent loss will be the greatest in pools where the assets have big differences in their price performance. For example, a pool with one stable and one volatile asset will have a higher impermanent loss compared to a pool with two stable assets, which would have little to no impermanent loss.

Fluctuating Prices

Digital asset prices wildly fluctuate, experiencing often massive swings in short periods of time. While cryptocurrencies are generally known for this, many new investors are caught off guard when entering this volatile market. This is especially relevant when you’re required to manage a borrowed position that can suffer from large price swings by becoming liquidated.  

You must understand the potential gains and losses of getting involved in trading within the DeFi space. Having awareness is the first step to not panicking in case of a major downturn. Getting deeply involved in DeFi will also require you to manage your liquidation threshold. 

Unexpected Market Crashes

Even with the usual price volatility in cryptocurrencies, major world events can cause their prices to crash significantly on a dime. These are generally known as black swan events, which we’ve seen happen time and time again throughout history when everyone least expects it, causing further price decreases due to de-leveraging (leverage traders who are forced liquidated such as the most recent bankruptcies of Three Arrows Capital and Celcius).

Given that these are often surprises, it’s very difficult to hedge against them. It’s important to understand that this is an inherent market risk and should be factored into consideration when entering into a position.

Front-running Attacks

Due to the open and transparent nature of DeFi, the possibility of attack vectors are opened that aren’t possible in traditional markets given they’re not permissionless. When trading on a DEX (decentralized exchange), the protocol smart contract will queue your trade to be integrated into the next block in order to settle. During this time, arbitrageurs and bots scan the DEX’s queued transactions and can take advantage of arbitrage opportunities that your trade order can create. 

This leaves you with a certain amount of assets received that are sub-optimal compared to the first trade order that you entered at a specific price - the arbitrageurs and bots can take the difference in profit from the initial entry price compared to the actual price you receive.

How Coinchange Lowers Market Risk Exposure

Now that we know the different market risks involved in DeFi, let’s look at some of the ways Coinchange mitigates them. Coinchange has created an advanced DeFi algorithm that uses custom strategies to lower market risk as much as possible when we put your assets to work on DeFi protocols. This algorithm continuously manages the overall status and health of our position, as it checks for things such as performance, available liquidity, best execution rates, and lowest slippage costs. 

We minimize impermanent losses by participating in stablecoin pools such as USDC/USDT, DAI/USDC etc.  Our DeFi strategies are hedged against market price variations of the tokens. Meaning, we generate yield regardless of the price going up or down.  Our strategies do not involve timing the market or trading the assets based on prices. Our robust risk management framework has helped us weather the unexpected market crashes such as those caused by Terra Luna and the more recent 3AC & Celcius meltdown. And we mitigate the front running attacks by using algorithms that give us the best execution price routing. 

The bottom line is, not managing market risks can erode your DeFi yield drastically. So unless you are proficient with managing the risks mentioned above, leave it up to us to help you earn high yields with the lowest possible market risk. Sign up today using this link: https://app.coinchange.io/signup and get a $50 USDC bonus for joining!

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