THE NATURE OF THE BEAST (Part 3 of 3)
The Risk Protocol (TRP) is a pioneering DeFi primitive that tokenizes risk. Using a novel “splitting” mechanism, we create SMART tokens that are designed to harness crypto volatility. The following is an excerpt from a research study that we had published in 2023 titled “The Nature of the Beast”. The full report can be found here: https://www.riskprotocol.io/insights
The study findings have profound implications for risk managers, portfolio allocators, investors and traders as far as investing in cryptocurrencies is concerned.
For instance, the study suggests that constructing “diversified portfolios” of various crypto assets is harder to accomplish given the higher average correlations between crypto assets and their universally high correlation with Bitcoin. There is always the possibility that there are other tokens like LEO or CVX with little or no correlation with the broader universe of cryptocurrencies, but a broader analysis needs to be conducted to prove/disprove that hypothesis. Risk managers shall be similarly challenged to construct hedges by being long volatility. In TradFi, higher volatility is synonymous with market declines. However, this phenomenon, called leverage effect, is inconsistent within the crypto universe. It is applicable for some cryptocurrencies, the opposite is true for others and for the remainder, there is no statistically significant relationship. We also found that the volatility of crypto volatility is significantly higher than the “vol of vol” of other asset classes. That makes it more difficult to forecast, compounding the woes of risk managers.
From a trader’s perspective, taking into account the calendar effects of crypto volatility would be a key data point in timing of trades. Our study reveals that there are specific times during the day and certain days in the week when volatility is markedly lower. A trader trying to build a large position would want to do it in a period of low volatility. Similarly a trader selling options would want to do so when volatility is observed to be higher and buy options in periods of low volatility.
Finally, from an allocator’s perspective, the increasing correlation between cryptocurrencies and the broader equity markets presents a sticky problem. How much should they allocate to a category that adds volatility to the portfolio without getting much in the way of diversification benefits?
