We all know about Smart Contracts — say hullo to SMART Tokens…
by Karamvir Gosal
An introduction to The Risk Protocol
As some of you know, over the past 18 months or so, we have been hard at work on a unique crypto project. I wouldn’t say that it has been shrouded in secrecy but we have intentionally been tightlipped about it. Now that we are within striking distance of launch, we wanted to take the wraps off and introduce “The Risk Protocol” to the crypto community.
So, what does The Risk Protocol do? The name should be a giveaway, we are a DeFi protocol that tokenizes risk. And what does that mean? Well, for the crypto insiders, a relevant reference point is Pendle — we essentially do for risk what Pendle does for principal & yield.
Why do we do this? If one believes that institutions are indeed coming, or if one believes in the promise of mainstream adoption of crypto, it is our contention that harnessing volatility is a prerequisite to that happening. We harness volatility using a novel risk allocation mechanism called SMART — it stands for Split Mechanism for Asset Risk-Targeting (or “Risk-targeting” for short) and we have a patent pending on it. SMART is unique both in crypto and in TradFi and there are no comparable products. Think of the SMART mechanism as a risk dial, one can turn the dial down to dampen volatility but one can also turn it up to amplify volatility, if one were so inclined. By “harnessing” we mean that one can “tame” volatility for sure but one can also “trade” or “exploit” volatility. I don’t think there is any disagreement on the fact that volatility is one resource that crypto has in abundance — The Risk Protocol allows users to exploit it to their advantage. We have designed the protocol to have utility for both investors and crypto native speculators/traders.
How does it work?
Using risk-targeting, we can split any cryptocurrency into two halves and each of the halves can be programmed to have certain desirable risk-return characteristics. This is programmable money taken a step further! Let me explain using an example. Let’s say an investor owns 1 BTC but is uncomfortable with the daily volatility. The investor comes up to our platform, deposits the 1 BTC and mints 2 new SMART Tokens, RiskON BTC and RiskOFF BTC. Both RiskON and RiskOFF have a claim on 50% of the underlying BTC. RiskOFF is designed to track BTC but within a band and as a result has significantly lower volatility than BTC. Let’s say it has a floor at -10% and a cap at +15 % and floats within that band. How does it get this profile? By holding options: a long down and out barrier put that provides the downside floor and a short call that caps the upside. Where did it get these options exposure from? By contracting with the 2nd half, the RiskON SMART token, which is the counterparty to all the options that RiskOFF owns. RiskON is the seller of the put that provides the downside protection to RiskOFF and the buyer of the call that RiskOFF has sold. The simple contract between RiskON and RiskOFF is that in return for providing the downside protection to RiskOFF, RiskON gets RiskOFF’s share of the upside beyond the cap. So one can see that while RiskOFF is designed to have much lower volatility than the underlying BTC, RiskON is in fact a levered version of BTC. Both initially start out with equal ownership of the underlying collateral and since we have designed the synthetic options as a costless collar, both have equal values at the outset. Over time however, based on the movement of the underlying BTC, their values diverge. If BTC runs up, RiskON will outperform BTC because of the leverage it is getting from RiskOFF and similarly, in a declining market, RiskOFF will outperform BTC because of the downside protection it is getting from RiskON.
What we have effectively done is that from one asset we have synthetically extracted 2 different “risk flavors” of that asset, designed to appeal to folks with different risk appetites.
The Protocol
RiskON/RiskOFF is just one product. Using the same splitting mechanism, we have created others with different risk profiles and payoffs. Also, I have used BTC merely as an example but this approach is equally applicable to other cryptocurrencies, it is tremendously scalable. Finally, there’s one attribute all products have in common — no margin calls and no liquidations. Like table stakes in poker, one can only lose what puts up initially.
The protocol is powered by a highly sophisticated risk engine with proprietary IP. We have developed advanced quantitative and econometric models that allow us to calculate and publish Net Token Values (NTVs) every second. That involves valuing the embedded derivatives tick by tick and in order to do that one needs volatility forecasts. We have developed statistical GARCH models that forecast volatility for the top 10 cryptocurrencies every second. To execute on this, we have a very strong core team with exceptional credentials and complementary areas of expertise — in advanced math, derivatives, quant investment management, volatility forecasting and of course crypto & blockchain. On our team are individuals with formidable quant and derivatives backgrounds — three of those are the former head of risk, head of research and CEO of one of the largest quant firms globally. An advisor is the former global head of prime brokerage at one of the big Wall street banks. Another advisor is the former CEO of a Chicago based proprietary trading firm that was one of the largest traders of VIX options. I can say quite confidently that the sophistication of our approach is second to none in crypto.
Furthermore, in order to maximize the utility of the SMART Tokens, we have created a risk marketplace that provides liquidity for these new instruments.
Anticipated users & use cases
The arc of financial innovation shows that historically, options markets have generally followed futures. That is because options are generally a more sophisticated product and more difficult for investors to get their arms around. Our SMART Tokens solve for that complexity. By tokenizing risk payoffs, we abstract away the complexity of the underlying synthetic options. Instead, it becomes as simple as “if the market is headed up, you want to be in RiskON and if the market is headed down or trading sideways, you want to be in RiskOFF”.
Our SMART Tokens create new trading and arbitrage opportunities that will naturally attract active crypto native traders. Crypto natives are always on the lookout for new sources of alpha — this new DeFi primitive will serve that up in spades.
One of the use cases we foresee for these new SMART Tokens is traders using them dynamically to express their prevailing risk sentiment. Is the market in risk-on mode or risk-off? As the market swings from bearish to bullish or vice versa we expect traders to dynamically swap from RiskOFF to RiskON (and the other way round). The rewards for picking the right SMART token in a particular market cycle can be pretty astounding. In back-tests that we’ve conducted, if a user makes the right selection for RiskON BTC/RiskOFF BTC on a quarterly basis for the last 1 year, the dynamic allocation strategy yields 2.5x the returns of simply holding BTC. Extend that analysis to the past 3 years and the past 5 years and the outperformance is 10x and 30x respectively vs simply holding BTC. Now let’s say you do the rebalancing more frequently — you pick the right SMART token every month instead of every quarter. Now you outperform BTC by a multiple of 3.8 x over the last 1 year, 53x over the past 3 years and 315x over the past 5 years! Rebalancing weekly yields even more astonishing results. Of course, the above results are achievable only if one has perfect foresight. But even at lower levels of accuracy, the potential for outperformance is very dramatic. For instance, if you rebalance on a weekly basis and accurately pick the right token only 2/3rd of the time, you outperform BTC by 12x over the past 3 years and 50x over the past 5 years.
Another use case is using RiskOFF as collateral in the DeFi ecosystem. RiskOFF just makes better collateral. It’s not a stable coin but it is certainly a stabler coin! RiskOFF ETH and RiskOFF BTC actually had lower volatility than the S&P 500 over the past 3 and 5 years!
Annual Volatility
We believe that RiskOFF is also a natural fit for project treasuries in order to diversify their exposure to their native token. Instead of holding stablecoin, holding a RiskOFF version of their native token would give them the downside protection they seek while also allowing them to participate in the upside (up to the cap).
While we shall launch with RiskON/RiskOFF versions of BTC and ETH, we intend to offer RiskON/RiskOFF for the top 10–15 cryptocurrencies. Given that options markets don’t generally exist outside BTC and ETH (not with any depth), we will be creating new options markets for the top cryptos and expect that to attract users as well.
Finally, we believe that RiskOFF will be very interesting to traditional institutional investors and financial advisors that want exposure to the crypto asset class but are wary of the gut- wrenching volatility. As a team, we all have institutional backgrounds in the investment sector so are very familiar with the needs and sensitivities of these investors. Creating product wrappers for this category of investors would give them a convenient way to access RiskOFF versions of the top cryptocurrencies.
Pioneering a new DeFi primitive
With Risk-Targeting, we will be pioneering a new DeFi primitive. Volatility is a $4 trillion + market in TradFi but at an embryonic stage in crypto. We anticipate risk-targeting to be a $250 bil+ opportunity in crypto ($4 trillion is approximately 10% of the US equity market. 10% of crypto market cap equates to $250 bil.). As a first mover, it is our intention to play a dominant role in this new DeFi category and garner market share consistent with pioneering protocols in other crypto sectors.
As we all well know, the risk sector is a significant and inevitable part of any large financial market. Our over-arching long-term vision is to provide risk solutions for the various types of market risks in crypto. We start with addressing volatility and over time, we will launch products addressing other crypto specific risks. Our goal is to be the dominant provider of risk solutions in crypto.
We expect to launch on testnet next month. In the meantime, we will be releasing more information about our products and what users can do with them. Join us as we uncover insights that allow you to gain an edge investing in crypto. The economic opportunity before us is significant. Become an active member of the community to participate in the opportunity. We invite you to take a test drive on the cutting edge of risk….
Visit: The Risk Protocol
